An article on Keogh plans published in the Business & Finance Section Dec. 9 implied that self-employed professionals who set up corporate plans in lieu of Keogh plans before Dec. 31 may claim tax deductions for all of 1979. They may claim deductions only for the period since incorporation.
A recent Tax Court decision could prove of considerable significance to persons planning to establish a retirement account before the year-end deadline. It affirmed the existence of a loophole in the law that prohibits a professional from making larger proportional contributions to his or her own retirement fund than to those of employes.
Antidiscrimination provisions in Keogh plans stipulate that if an employer puts into a tax-deferred account up to 15 percent of his or her income for an annual maximum of $7,500 (whichever amount is smaller), the employer must pay an equal percentage of the employe's salary into a retirement fund. Despite this, physicians, dentists, lawyers, accountants and other self-employed professionals have continued to put aside a greater percentage of their income for themselves than for their secretaries, nurses and clerks through a particular kind of corporate entity known as a professional associaton.
Dr. Lloyd M. Garland of Lubbock, Tex., whose case was decided Oct. 4, was one of those. He was the sole owner and employe of a professional "association" that in turn became a 50 percent owner of a partnership with another doctor. The partnership hired employes for the practice. Garland's professional association had a pension plan for him alone.
The Internal Revenue Service maintained that the physician's retirement plan did not qualify under tax codes because the employes were not covered as well. Garland argued that they were employed not by his professional association but by the partnership, which was not required by law to set up a plan for its workers.
The tax Court ruled in Garland's favor, saying that the doctor's plan qualified under IRS rules. It declared: "We see no reason to fortify (the law) with more stringent tests" than Congress set for Keogh plans. In other words, by establishing a separate corporate entity, Garland could avoid funding any retirement plan for his employes.
This is the first ruling in a very controversial area. The IRS has not indicated yet whether it will appeal the case. Instead of appealing, the IRS could declare its nonacquiescence, which means that it could challenge in court anyone else who tried such an arrangement. Eventually the arguments may wind up in the Supreme Court, or Congress may choose to close the loophole.
Asked whether the savings to the employer would warrant taking such a risk, Barry R. Goodman, a certified financial planner, replied that it depended upon the situation. At the request of The Washington Post, his firm, Goodman & Associates, constructed a hypothetical case to show the advantages (and disadvantages) of a professional association plan.
Dr. A., 59, earns $200,000 annually in partnership with Dr. B., also 59. A's son, 29, also a physician, is due to go into partnership with them at a salary of $50,000 annually. Drs. A and B currently have six employes. In one of their offices, they have a 19-year-old receptionist earning $10,000 a year. Their nurse 50, has been with the doctors for 15 years and earns $18,000. There is also a nurse practitioner, 30, who receives $21,000. In the other office, the receptionist, 18, gets $9,000 a year. A nurse, 55, earns $16,000; and a nurse practitioner, $25,000.
If the physicians elect to set up Keogh plans, they may chose a defined-contribution plan, to which they may contribute a maximum of 15 percent of their annual income, up to $7,500, whichever is smaller. Or they may choose a defined-benefit plan that offers them a specified income upon retirement; contributions are made in amounts necessary to produce those benefits. In either case, the employers must contribute an equal amount, 15 percent or $7,500 for each employe.
Under a defined-contribution plan, if the three doctors each put in the maximum $7,500 for themselves, they collectively would have to contribute $14,850 more for their employes, for a total of $37,350 annually. Of that figure 60.24 percent would go toward the physicians' benefits.
Were the plan set up now.Drs. A and B would receive annuities of $5,386 each upon retirement. After 36 more years work, A's son would get an annuity of $91,998 upon retirement. The faithful 50-year-old nurse would get $2,400, whereas the 19-year-old receptionist would get $31,000 upon retirement. (The receptionist thus gets more than the nurse because she ends up working a greater number of years after the plan's inception.)
Under a defined-benefit plan, the contribution is based on a formula that allows a percentage of final salary depending on years worked, up to a maximum of $50,000. The older men thus would be permitted to put away $8,354 each year tax-deferred, assuring them an annuity of $6,000 on retirement.
The junior doctor would contribute $2,935 annually to assure himself a $36,000 income when he stops working 36 years from now. (If this sounds like a ridiculously small amount, it is because that retirement figure is based on 1979 dollars. The IRS undoubtedly will raise it before the year 2015, and the plan then could be amended.)
Contributions for other employes amount to $9,917 annually under this defined-benefit Keogh plan, assuring them annuities of between $3,200 for the older nurse and $14,700 for the young receptionist. Total contributions would be $29,560, representing a savings of $7,790 over the defined-contribution Keogh plan.
Because the older employes fare better than younger employes under defined-benefit plans (66.45 percent of the contributions under this plan go toward the older peoples' benefits), Goodman recommends that the young doctor switch to a defined-contribution plan after his father and partner have retired in six years.
Contrst these plans with the type Garland used. After individual incorporation, the three doctors form a partnership, which in turn employs the nurse and receptionists. Under a defined-benefit plan, each corporation is entitled to pay its chief executive (the doctor) 100 percent of final salary up to a maximum of $98,100, so to fund this pension A and B theoretically could each put aside $136,592 (out of $200,000) annually tax-deferred.
A defined-benefit plan would not be avantageious for the younger physician, so his corporation should set up a defined contribution plan for him. This would allow him to set aside up to 25 percent of his salary, which amounts to $12,500 annually.
This arrangement leaves the physicians free to decide whether to set up a pension plan for their other employes. If, unlike Garland, they decided to make some contribution, they could choose the percentage of pay they desired. According to Towers, Perrin, Forster & Crosby, the top 100 U.S. industrial companies last year averaged 11.2 percent of covered pay in contributions to pension funds. One-third of all companies contributed less than 10 percent. Therefore, even if the physicians paid 10 percent to their employes' fund their annual expenses for employes would be cut back to $9,900 from the maximum $14,850 they would have paid under Keogh.
And if their employes' benefits were integrated with Social Security, the ultimate cost to the partnership in pension outlays could be much less.Corporations often justify this type of pension system on the grounds that more valuable employes -- in this case the doctors -- should be given larger rewards for their services and that these employes have paid more into the Social Security system.
Critics contend that integrating private pensions with Social Security payments to arrive at a similar percentage of final salary deprives lower-paid workers of their just rewards. For example, the employer earning $100,000 a year and the janitor earning $10,000 each may receive 40 percent of final pay as a pension, but virtually all of the janitor's benefits will come from Social Security payments.
In another recent development in self-retirement plans, Chicago Title and Trust Co. is offering to Keogh, Individual Retirement Account and small corporate profit-sharing plans an investment vehicle featuring instant flexibility for participants. This permits holders of retirement accounts to shift their investment mix at will by making a phone call to CT&T.
The mix offered to those who set up retirement programs through CT&T consists of three managed, no-load mutual funds -- a stock fund, a bond fund and a money market fund. They represent varying degrees of risk, the money market fund being the most conservative and the stock fund the least conservative.
During a year of test marketing, CT&T found that 90 percent of the participants spread their funds among the three. Most switched no more than twice a year, although a few did frequently. The cost of this CT&T program is 1 1/2 percent of assets annually, which is ultimately borne by the beneficiaries. The standard pension managememt fee runs about 1/2 percent or less.
Many large corporations with profit-sharing plans now allow employes to choose how their company-paid retirement fund contributions are invested. Changes usually can be made annually or even quarterly, but day-to-day flexibility is unknown. Phil Alden of Towers, Perrin, Forster & Crosby expressed skepticism that a large paternalistic corporation would approve of its employes' "playing the market" with their company-sponsored retirement funds, particularly if the profit-sharing plan is the company's only form of retirement fund.
However, if the profit-sharing plan complements a defined-benefits plan, Alden thinks the idea could have great appeal. According to a recent survey by William M. Mercer, Inc., the nation's largest employe-benefit consultant, 70 percent of employers would like to see greater flexibility in benefit plans, providing more employe choice.
CT&T's program undoubtedly also will appeal to sophisticated Keogh plan participants and recipients of lump-sum distributions who want to roll them over into an IRA to maintain their tax-deferred status. Plan participants who entrust their retirement funds to banks, savings associations or insurance companies often find themselves locked into investments they cannot change rapidly without incurring stiff penalties.
According to the IRS taxpayers in 1977 contributed $1.8 billion to 575,000 Koegh plans and $2.5 billion to 2.5 million IRA accounts.
Keogh participants must establish plans by Dec. 31 in order to qualify for a tax deferral on 1979 income. However, they may make contributions to these plans until the date tax returns are due (usually April 15 unless an extension is granted). IRA participants can establish and contribute to accounts until the filing date.