Solo defined benefit plans are relatively straightforward. But complexities arise when there are multiple owners involved in a defined benefit plan.
The owners often want different contribution amounts. They might actually want the same contribution, but they have different ages and W-2 compensation. How are the differences addressed?
In this post we’re going to talk about some issues and potential problems that arise when there are multiple owners in a defined benefit plan. Let’s get started.
Some Background
This post is based on a common situation we see. You might have two partners that equally own a partnership through their individual S-Corps. So, the income from the partnership is split evenly between two S-Corps.
The owners will then issue W-2s through their S-Corps and take the deduction there for define benefit plan. We will also assume that there are no other employees except for the owners.
Unfortunately, partnerships break up often, so I wanted to ensure this was spelled out clearly for you.
401(k) Contributions
You have one 401(k) plan, but you should each have a separate 401(k) investment account. You can each make your own contributions and manage your own investments.
The 401(k) employee deferral is reflected on your W2s, and the profit-sharing contributions will be deducted on each of the S-Corps. However, the defined benefit plan works a little differently.
Defined Benefit Plan Contributions
With a defined benefit plan, there is one “pooled” account. All plan contributions are made to this account. Because we have structured the plan so the contributions will be equal, you will each take the same tax deduction on your S-Corp tax returns.
Because of the pooled account, you must manage the investments together. The investment balance will, of course, fluctuate over time, depending on the assets in the account. Most partners in a plan would look at the asset balance and assume it’s split equally between the two of you. But that’s not the case.
The plan is designed to guarantee each participant an interest crediting rate of 5%. So, if one partner leaves the partnership, they might think they get half the account balance. But in reality, they will get their annual pay credits, plus 5%. This will result in a difference between the amount they get paid out and the investment account balance.
Example
For example, let’s assume the plan assets earned 8%. Each of you would personally get a credit of 5%, and the extra 3% would remain in the plan and be unallocated. This unallocated amount rolls over to the following year.
Any excess returns would remain in the investment account and not go to the terminating partner. In addition, if there were losses, the remaining partner would get shorted.
If you terminate the plan together, we typically have an approach to level up the contributions. But the above scenario would be a situation where one partner left, and the other one wanted to carry on with the defined benefit plan.
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Final Thoughts
We understand why people go into business together. Unfortunately, it often does not work out. In addition, when one partner exits a partnership there are sometimes disagreements. Communication often breaks down.
When you add these challenges to the difficulties of understanding how to defined benefit plans work it can lead to many problems. Hopefully, you won’t encounter these issues. But if you do, it makes sense to understand how these plans work upfront.
