Posted on January 16, 2012
Lost in the dollar volume of the Marcellus Shale opportunities is the traditional and prudent desire to “set some aside” for retirement. The concept of saving for retirement is, by itself, worthy. However, it is easy to forget about saving when there is so much money – why worry? If you have to ask, go look at the percentage of lottery winners who have filed for bankruptcy. For the rest of us, let’s move ahead and the others will catch up. Saving for retirement in a qualified retirement plan protects the assets from the reach of creditors. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 exempts qualified retirement plan (e.g. profit sharing, 401(k) and pension) assets from the debtor’s bankruptcy estate. In addition, the contributions to a qualified retirement plan are tax deductible. The taxation is deferred until distribution from the qualified plan trust and distribution need not commence until the participant attains age 70 ½. So, why bother to incorporate some retirement planning into your Marcellus windfall? The short answer is: 1. Set some aside for that rainy day in retirement and your beneficiaries; 2. Protect some of the assets from creditors, just in case; and 3. Take advantage of the tax deferral opportunities (and in the case of Roth 401(k) planning, future tax free distributions).
? Although royalty income is not earned income for purposes of determining a retirement plan contribution, compensation paid for management services rendered by a general partner or the manager of a limited liability company that serves as general partner to a limited partnership, is earned income and can be the basis for retirement contributions. If you are dealing with Marcellus property, a prudent planning move is to discuss the suitability of a family limited partnership with your tax, financial and legal counsel. Family limited partnerships allow for easier management of the property, prevent dilution via marital dissolution or inheritance among divergent family and generational chains, and are a great aid in preserving and protecting your assets – in this case the Marcellus asset. The limited partnership requires a general partner and the general partner is entitled to compensation for the management and administrative services rendered. The compensation must be reasonable and it may be necessary to obtain an independent CPA or other professional to assist in establishing a reasonable level of compensation. For retirement plan purposes, the maximum compensation (or earned income in the case of a self-employed person) that may be taken into consideration is $250,000 (for plan years beginning in 2012).
? Retirement plans involve lots of rules and regulations. However, in this scenario the plan would typically cover only one (1) person. Consequently, the nondiscrimination rules will not apply (absent the general partner’s ownership of other business ventures) and the administration for a one participant plan is not burdensome. Assume that a 55 year old general partner is paid $100,000/year to manage the limited partnership. The partnership will have royalty income, from which to pay the general partner for a period of 12-15 years. If the general partner establishes a single participant 401(k) plan, the general partner may defer $17,000 plus an additional $5,500 as a catch up contribution (either as traditional pre-tax or as a Roth contribution). Assuming a 30% tax rate, the general partner saves $6,750 in federal income tax. The tax savings is more than enough to pay for the cost of the plan. At age 70 and assuming continued contributions of $22,500 each year and 5% earnings rate, the general partner has accumulated approximately $485,000. Although the general partner must commence required minimum distributions at 70 ½, the general partner may designate children as the beneficiaries to continue the tax deferral after the general partner’s death. If, on the other hand, the general partner makes these contributions as Roth deferrals (and pays the $6,750 tax at the time of contribution) the $22,500 will accrue earnings tax free, the total accrued benefit is not subject to lifetime required minimum distributions and when the general partner’s children (as beneficiaries) commence distribution after the general partner’s death, they do so over their life expectancies. In this example, let’s assume that deferrals stopped at age 70, but the general partner did not need the money and did not take any lifetime distributions. The general partner lived happily until age 85 at which time the Roth account (still assuming 5% earnings) had grown to $1,008,000). The general partner had designated a child, age 55 at the time of the general partner’s demise as the beneficiary. The child would receive income tax free distributions over the remainder of the child’s life (approximately 30 year life expectancy), equating to approximately $64,000/year income tax free (assuming 5% return).
The foregoing example is based on 401(k) elective deferrals only. The plan could be structured to provide a profit sharing contribution. Based on this $100,000/year general partner income, a self employed general partner could contribute approximately an additional $16,000 as a profit sharing contribution and an employee general partner could receive $25,000 in each case in addition to the 401(k) deferrals. The maximum amount that may be contributed for the general partner (401(k) plus profit sharing contributions plus the $5,500 catch up for those who have attained age 50) in 2012 is $55,500. So, why bother? The retirement plan provides a tax deferral tool, the power of which is enhanced, with tax deferred (or in the case of Roth contributions, income tax free) compounding.
? If the general partner’s compensation or earned income is sufficient, a pension plan can be established. The maximum contribution to a pension plan is the amount necessary to fund a single life annuity of $200,000 per year. This would require significant general partner remuneration, but if the circumstances (e.g. compensation, age of participant) are appropriate, the plan would be funded with approximately $2,500,000 to fund the annuity commencing at the general partner’s retirement at age 65.
? Speak to your advisors and get information as to what works for you and what best suits your planning needs. For additional information, please contact Dave Mosier at 814-459-2800 or email@example.com.
David M. Mosier is an Shareholder at Knox McLaughlin Gornall & Sennett, P.C.’s Erie office.