Many employers are unaware that, in certain circumstances, they may be eligible for a valuable tax credit in connection with their establishment of a retirement plan. Although this particular tax credit has been available for over a decade, it is still surprising to see the general lack of awareness that most plan sponsors have regarding this tax saving opportunity. As a result, this article is intended to familiarize readers with this tax credit so that they can attempt to evaluate its application to their (or their client’s) tax situation.
Effective for tax years beginning on or after January 1, 2002, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) created a tax credit for “small employers” who establish a new “eligible employer plan”. The credit is equal to up to 50 percent of the “qualified plan start-up costs” incurred for a period of up to three years. In addition, a $500 maximum limit applies in relation to the credit for each of the three years that the credit may be claimed. An employer may elect to initially apply the credit to the year the permissible plan is established or to the year before establishment. Also, the employer may not deduct any start-up costs if it claims the credit. For those readers who possess a greater familiarity with the Internal Revenue Code of 1986, as amended (“Code”), and the tax credits available there-under to businesses, this credit is allowed in connection with the general business credit permitted under section 38(b).
As you can see, there are several very important “defined terms” included within the authorizing language for the credit that are critical to determining its availability to any particular plan sponsor. First of all, only a “small employer” is eligible to claim this tax credit. In this context, a small employer is defined in the same manner as it is used in conjunction with SIMPLE plans. Thus, in general, a small employer for purposes of this tax credit is an employer with 100 or fewer employees who received at least $5,000 of compensation from such employer for the preceding year.
Another important consideration is that the credit is only available with respect to the establishment of an “eligible employer plan”. In general, an eligible employer plan is a tax-qualified plan under section 401(a) of the Code (such as a profit sharing plan, 401(k) plan and/or defined benefit plan, among others), Simplified Employee Pension Plan (“SEP”) or Savings Incentive Match Plan for Employees (“SIMPLE”). In addition, in order to qualify for the credit, the newly established plan must have at least one participating non-highly compensated employee. This final “eligible plan” qualification is of great importance because it effectively eliminates the credit with regard to “solo(k)” plans.
Finally, the credit may only be applied in connection with “qualified plan start-up costs”. For this purpose, qualified plan start-up costs are any ordinary or necessary expenses incurred with regard to the establishment of such plan, its administration or certain costs incurred related to employee investment education expenses.
For costs paid or incurred in tax years beginning after December 31, 2001, for retirement plans that first become effective after that date, you may be able to claim a tax credit for part of the ordinary and necessary costs of starting a SEP, SIMPLE, or qualified plan (including a 401(k). The credit equals 50% of the cost to set up and administer the plan and educate employees about the plan, up to a maximum of $500 per year for each of the first three years of the plan. For plans that become effective after 2002, you can choose to start claiming the credit in the tax year before the tax year in which the plan becomes effective.