Qualified Plans for Lemonade Stands

Pension Memo
October 2004

Let’s take a look at the rules for qualified retirement plans in very small businesses.  I have been getting a lot of questions lately about setting up qualified retirement plans for “second-income,” or “side,” businesses.

Don't underestimate the number of these businesses.  They are everywhere.  A business executive at a large corporation does consulting work out of his house.  A school teacher moonlights in the evenings and weekends tutoring students in their homes.  A doctor provides expert testimony in lawsuits.  A college political science professor advises a candidate running for office on regional voting patterns.  I call these businesses “lemonade stands.”  They are more than a hobby, but they are not the owner’s principal source of income.  These entrepreneurs often want to put some of that income into a qualified plan.  We’ll be seeing even more of these businesses as baby-boomers, facing retirement or unemployment, realize that they will need a much larger nest egg. 

These "lemonade stand" businesses can support a qualified retirement plan.  In fact, the new pension laws allow a large portion of earnings from very small businesses to be contributed pre-tax to qualified plans.  Unfortunately, the complex tax and pension rules that “real” businesses face also apply to these micro-businesses.   Many owners of these businesses set up qualified plans, only to learn on an IRS audit that the plans are disqualified. 

Overview   There are three steps for maintaining a qualified plan for lemonade stand businesses.  First, the owner must generate income that will support the plan.  Second, the plan must not run afoul of the “controlled group” and “affiliated service group” rules.  Third, the owner must select the right kind of plan. 

Step One: Income Requirement    Contributions to qualified retirement plans are based on “compensation” paid or earned for personal services.  Just having “income” is not enough.  If I own a condo in Florida and rent it for the winter, the rent I receive cannot be used as a basis for a retirement plan contribution.  Income from rent, like dividend and interest income, is not from my personal services.

Income for retirement plan contributions must be compensation for active services as a sole proprietor, a partner, or as an employee.  How do you distinguish “passive” income from “active” compensation?  That’s easy.  The income must be subject to social security or payroll taxes.  A sole proprietor or a partner pays self-employment tax on “net earnings from self-employment” and an employee pays FICA.  These taxes run about 15%, which is a heavy price to pay for the opportunity to make a plan contribution.

I have heard rumors about small businesses owners who do not report the income from their businesses.  I have never seen this myself, and needless to say, I am shocked at such goings on.  However, if such a business owner wanted to make a retirement plan contribution on these earnings, he must first report the income (and pay income taxes) and pay the self-employment taxes.      

Step Two:  Avoiding the Pitfalls    Once you have determined that your lemonade stand will generate enough income to support a qualified plan, the next step is to see if the owner's other business relationships are a roadblock.

The “controlled group” and “affiliated service group” rules disqualify many lemonade stand retirement plans.  Many well-intentioned, capable financial advisors do not understand these traps. 

The “controlled group” and “affiliated service group” (“ASG”) rules are "anti-abuse" restrictions designed to prevent the manipulation of business ownership to skew retirement contributions in favor of the highly paid.  These rules force separate employers to be treated as a single employer for pension plan purposes.  Separate employers in a controlled group or an ASG must use the same retirement plan.  These rules prevent the artificial fragmentation of a single employer into multiple employers that would allow generous contributions for owners, but smaller or no contributions for the rank and file.  Unfortunately, like many IRS “anti-abuse” rules, the controlled group and ASG rules are overbroad, vague, and complicated. 

For example, a CPA is a partner in a large accounting firm in New York.  During tax season, the CPA moonlights out of his second home in Florida by preparing income tax returns for several Florida clients.  He most likely cannot have a plan for that side business because it would be disqualified under the ASG rules.  Similarly, three surgeons work through their medical partnership.  The three doctors also own a laboratory in a separate corporation that does diagnostic testing for a hospital.  The medical partnership has a conventional 401(k) profit sharing plan.  The lab cannot have a separate plan, and depending on the number of employees in the medical practice and the laboratory, the plan in the medical practice may be in jeopardy unless the lab employees are also included.  In fact, if the three doctors owned a cattle ranch in Texas, that ranch could not have a separate retirement plan either.  The common ownership of the businesses is fatal.

The controlled group and ASG rules are not obvious.  Professional help is generally required to navigate them.

Step Three:  Plan Selection    Now that you have the right kind of income, and the controlled group/ASG rules are not a problem, the next step is selecting the right plan.  This is critical.  My recommendation is to select the simplest plan that suits your needs.  Complexity means problems.

Going from the simple to the complex, the first choices should be a conventional IRA or a Roth IRA.  Contributions are limited to $3,000, but the first $3,000 of compensation can be put into the plan.  That limit will increase to $5,000 in 2008.  I favor the Roth IRA if the lemonade stand owner is in a low tax bracket.  Roth IRAs are particularly attractive for students.  For example, if your 18 year old nephew cuts lawns and baby sits during summer vacation, putting all he can into a Roth IRA makes great sense.  The self-employment tax is a small price to pay for a lifetime of tax-free growth and then tax-free retirement income. 

If you need a larger contribution than the IRAs allow, the next choice should be the simplified employee retirement plan, or SEP.  The SEP is an employer funded IRA.  Contributions can be up to 25% of annual compensation.  There is almost no paperwork for a SEP, and SEPs do not file annual reports on Form 5500.  So, SEPs “fly under the IRS radar.”  SEPs have been available for more than 25 years.  I have never had a client regret using a SEP. 

A drawback of the SEP is that the contribution cannot exceed 25% of income.  You cannot put all the income into the SEP.  If you earned $10,000 from your lemonade stand, the SEP contribution is limited to $2,500.  You’d do better with an IRA.   

This restriction can be avoided with the next two plans, the SIMPLE-IRA and the “one person" 401(k) plan.  The SIMPLE-IRA plan allows contributions to the full extent of the first $9,000 of compensation.  In a 401(k) plan, the participant can contribute the first $13,000 of compensation to the plan.  So, if you made $13,000 from that lemonade stand, the full $13,000 can be contributed to the one-person 401(k).  (This is an over-simplification, as there are adjustments for payroll taxes and the like, but you get the point.)  The 401(k) plan works very well if the owner’s spouse participates in the business, as contributions can then be doubled.  On the negative side, 401(k) plans require considerable documentation and they must file Form 5500.  However, the financial services industry provides excellent packages that streamline all this for the customer.

The IRAs, SEP, SIMPLE-IRA, and one-person 401(k) plans will accommodate almost all lemonade stand businesses.  However, if that business is more than a lemonade stand and generates greater income for the owner, the next level of plans is the “exotics”.  These include the defined benefit plans, 412(i) plans, cash balance plans, and new comparability plans.  These are not “off the shelf” products and require professional assistance.  However, they can accommodate very large annual contributions.

Conclusion     Qualified plans for “second income” businesses  -- the lemonade stands – are a great opportunity to salt away extra money for retirement.  To stay out of trouble, follow the three steps.  First, make sure the income is compensation for services.  Second, analyze the controlled group or affiliated service group issues.  (You may need help figuring this out.)  Third, select the simplest plan that will suit your needs.

© 2008 Parrs & Perotto, LLP.