WHO EVER HEARD OF A SEVERANCE PAY PLAN?  YOU NEED TO READ THIS.

by Stephen A. Drake, Ph.D., CPA and CFP

 

Many medical professionals (professional) are looking for additional ways to get an individual, corporate or LLC income tax deduction. An interesting tool is the severance pay plan (SPP) that can provide a tax deduction of up to 2x last year's compensation. It can also come with some substantial estate tax benefits that can really make a difference in the tax and financial planning for the professional.

SPP's are recognized under the Internal Revenue Code Section 419A. They have been in existence for a number of years but are not taken advantage of nearly as much as one would expect. Sometimes this is for lack of knowledge of the SPP by the professional but also by the financial advisor. These plans are not pension plans but rather a type of nonqualified deferred compensation. As such, the professional can contribute both to these plans and to their qualified pension plans. The combination of these contributions creates the maximum possible deduction.

As an example, if a doctor age 60, contributes the maximum to his pension plan then his contribution will typically be between $160,000-$170,000. If he or she also wants to start a SPP then he can contribute another amount equal to not more then 2x last year's compensation. If compensation was $250,000 then the deductible contribution to the SPP will be $500,000. The contribution to the SPP can also be anything less then the maximum. But, the total contribution to the qualified plan and the contribution to the SPP is the amount of the income tax deduction. In my example, this is $660,000. Using the 50% tax bracket (40% Federal and 10% State), this is an immediate income tax savings of $330,000.

The assumed $500,000 contribution to the SPP can be invested in different ways but it is not quite as flexible as a typical qualified plan investment. Since the SPP has potential taxable earnings rather then nontaxable earnings in a regular pension plan, the SPP is subject to income tax on the earnings. As a result, the investments in the SPP are put into nontaxable investments such as municipal bonds, annuities or as part of a life insurance policy. With these types of investments, there is typically little or no taxable earnings.

Another difference between the SPP and a qualified plan is when a SPP participant dies, the SPP balance goes to other plan participants in the group not the professionals' family or estate. To prevent this, the SPP insures the participant to the extent of the investment or a higher amount. In the example above, this coverage would be for at least the $500,000. When the professional withdraws the SPP on severance, this amount cannot be rolled over into an IRA but it can be withdrawn over a 24-month period. This could be as long as 3 taxable years. Although the distribution is taxable just like a qualified plan there are no early withdrawal penalties at age 59 1/2 years of age or required distributions at 70 1/2 years of age. The professional need not wait until age 59 1/2 years to begin taking the severance pay thus there is flexibility as to when the distribution begins. This is based on the time of severance not on age. If the recipient takes the distribution over a 3 taxable year period then this spreads out the income tax consequences over this period.

For the professional who has a life insurance policy as part of the SPP, this can be kept in tact when the SPP ends. As part of the planning when establishing the SPP it is often beneficial to set up an irrevocable life insurance trust (ILIT) to hold and own the policy. When this is correctly done then the proceeds of the policy are not part of the professional's estate and can pass to the surviving family members without an income or estate tax. This is illustrated in the following example:

Doctor Jones has an ILIT with a $1M policy in it as part of the SPP. When the professional dies, then the $1M policy is not in his estate for estate tax purposes. By accomplishing this, this will save $500,000 in estate taxes to the Jones' family assuming a 50% estate tax bracket. In many cases it is poor planning to leave the policy in the name of the estate and for the estate to be the owner of the policy. But, there are exceptions to this rule depending on the nature of each family situation.

In most pension plans, the professional must include employees in the qualified plan and contribute a certain amount for the employees. The general rules are that if an employee is 21 years old, worked for 1 year and has worked approximately 1000 hours during the year they must be covered in the plan. With the SPP, the professional must also include employees with similar working parameters. However, if the employees are leased from an employee leasing company then they are not part of the contribution base. Thus, the professional is not discriminating with employees since they are not his employees. This is a very important distinction between the SPP and the qualified plan. With leased employees the professional is contributing only for himself to the SPP. Quite often, the leasing company can provide benefits to the employees that may not be available through the professional's practice. The largest benefit is having a broader selection of medical coverage, better benefit coverage and other nontaxable fringe benefits.

The IRS has challenged and commented on the SPP with the Booth and Neonatology cases and certain letter rulings. But, it is clear from these cases and rulings that a carefully worded trust agreement for the SPP will work. Good plan agreements typically have a large law firm and a legal opinion on the structure of the SPP. The professional should be aware that not all SPP's are created alike and a reputable plan administrator should be found. Nevertheless, the SPP is a tool that every medical professional should consider.

 

 

Stephen Drake has advised clients for 25 years in income tax, estate tax, wealth enhancement techniques and financial planning. He can be contacted at sdrake@optimafr.com or 877-218-7800 toll free.