EDUCATION CENTER
GTT RESOURCES: FRINGE BENEFIT PLANS

Robert A. Green, CPA's below article appeared in the January 2004 issue of Active Trader magazine: Work in the FRINGES. Some traders have the opportunity to take advantage of "fringe benefit" plans that can reduce their tax liability. Find out if there's an arrangement that fits your situation.

Here is the original article submitted, before editing by the magazine.

By Robert A. Green, CPA and CEO

If you are interested in opportunities to convert more of your non-deductible family expenses into deductible business expenses, you should learn about “fringe benefit" plans.

Most small businesses, including trading businesses, overlook fringe benefit plans; many larger companies rely on fringe benefit plans to attract and retain employees.

Fringe benefits, commonly known as “perks,” include: retirement plans; health, life and disability insurance; education, dependent care and adoption assistance; meals, lodging and parking; and many other types of plans.

These plans are somewhat complex and some require written “accountable plans” with annual reporting. So, you will need the help of a competent CPA and/or attorney specializing in “employee benefits.”  It’s wise to get a quote on costs and a projection of tax benefits to see if it’s worthwhile for you. Our firm has this experience and we are happy to help you.

If you can convert $15,000 of family expenses into business expenses and save taxes at 40-percent margin tax rates, you generate tax savings of $6,000. If your professional fees and other costs are $1,500, your return is 4-to-1. Plus, your costs are deductible business expenses, and there are also tax credits for forming retirement plans.

The basic plans are easy for owner/traders.

Most business traders want to cover the basic employee benefits, which include compensation, retirement plans and health-insurance coverage.

These are the easier plans to set up for owner/traders. Click here to learn more about retirement plans.

Retirement plans are available “off the shelf” from most financial institutions and there should be no additional expenses required.

There are also no additional expenses required in obtaining a health-insurance plan; the only costs are the monthly premiums.

Sole proprietor (unincorporated) business traders may not set up retirement plans or deduct health-insurance premiums (both are AGI deductions) because trading gains are not “earned income.”

Business traders need to form a separate legal entity to pay themselves a fee or salary on which they can then base tax-deductible retirement and health-insurance plans.

Other fringe benefit plans are not so easy for owner/traders.

Fringe benefit plans are designed for larger companies with a large number of rank-and-file employees.

“Discrimination” rules are intended to prevent highly compensated employees (owner types) from monopolizing the majority of the plan benefits. If owners and management want these benefits, they must also cover all employees.

The problem for owner/traders is that their entities of choice are “pass-through” entities and many fringe benefit plans are not allowed for these types of owner/employees.

Self-employed individuals (and pass-through entity owner/employees) who want to benefit from fringe benefit plans can do so if their spouses work for the business. By covering employees and spouses, they become entitled to benefits by virtue of being the spouse of an employee.

The power of fringe benefit plans.

A very effective way for small businesses to maximize tax savings is to find ways to convert fixed personal expenses into allowable business expenses.

For example, many traders covert some of their home expenses into deductible home-office expenses. At-home traders also take business depreciation on furniture, fixtures and equipment.

Fringe benefit plans provide additional opportunities to convert more family expenses into business deductions.

The employee (your spouse) is reimbursed by your trading business for his or her non-business related education, dependent care, at-home meals and more. These types of expenses would not otherwise qualify for business expense treatment, as they are not “ordinary and necessary” for a business.

Your company deducts the reimbursed amounts as a business expense and your employee excludes the reimbursement from income. That means the reimbursement is not included in their gross wages reported on a W-2 or gross compensation on a Form 1099-Misc. In many cases, the fringe benefit is also not included in wages calculating payroll taxes (FICA and Medicare).

For more information on all types of fringe benefits and what is excludable for income vs. payroll tax, see IRS Pub 15-B, Employer’s Tax Guide to Fringe Benefits at www.irs.gov.

Don’t feel bad for the IRS and think it’s just a giveaway.

Fringe benefit plans are win-win for the employer and employee; only the IRS loses.

Don’t feel bad for the IRS because most fringe benefits plans are geared for C-Corporations, and c-corps are subject to “double-taxation” (paying taxes first on the corporate level up to 34 percent, and then a second time on the shareholder level – qualifying dividends and long-term capital gains are taxed up to 15 percent).

Fringe benefits pale in comparison to the extra costs of double taxation.

You don’t need a C-Corp for fringe benefits, so choose a much better type of entity for trading businesses.

C-Corps are a poor choice of entity for business traders. Double taxation is costly, especially if you are highly successful. If you have trading losses, you can not pass-through those losses to your individual tax return for immediate tax relief.

With a “pass-through” entity, a business trader avoids double taxation and gets immediate tax refunds on trading losses. All items of income or loss are passing through to the individual tax level and taxes are not paid on the entity level.

Public companies and other larger companies don’t have a choice of entities; they can only be a C-Corp. It is simply not possible (and not allowed) to pass items of income and expense to what could be thousands of individuals.

Smaller businesses are allowed to use pass-through entity taxation and almost all prefer it.

Before 2003, health insurance premium deductions were limited to 70 percent AGI deductions (lower amounts in prior years). Starting in 2003, health insurance deductions were raised to 100 percent, putting them on par with C-corps.

Starting in 2002, retirement plan contribution amounts were significantly raised for profit-sharing plans, putting them on par with C-Corps.

Fringe benefit plan amounts are the same for C-Corps and pass through entities.

There are no remaining advantages to a C-Corp. Business traders can use a pass-through entity coupled with the “spouse of a non-owner employee” strategy to unlock every conceivable tax benefit.

Choose the best pass-through entity for you early in the year.

A sole proprietorship (unincorporated business) is good for all fringe benefit plans, except a retirement plan for the owner/employee. That is the biggest benefit, so consider a separate entity instead.

Limited Liability Companies (LLC) are good for many traders. An LLC files a partnership tax return, unless you elect to be taxed as a C-Corp (not recommended per above). If you are the single member, then it’s a “disregarded entity” (no partner, so no partnership return) and you file a Schedule C, similar to a sole proprietorship (except you can have a retirement plan).

Most LLCs don’t pay franchise taxes in their home state and have nominal annual report costs (less than a few hundred dollars). You can have “special allocations” with LLCs.

C-Corps may elect S-Corp status and then be taxed as pass-through entities. Most states have nominal franchise taxes, which can be less than a few hundred dollars. Allocations are based on capital accounts only.

Single traders who have other jobs and are a “close call” for trader tax status (business status) may prefer an S-Corp over a single member LLC; filing a separate tax return can deflect IRS questions.

Click here to learn more about entities for traders.

Owner/employees of “pass-through” entities are not allowed fringe benefits.

Congress structures the tax code based on give and take. Most fringe benefit plans are given to C-Corps and then taken away for owner-employees of pass-through entities.

All partners (in LLCs and general partnerships) and more-than-2-percent shareholder-employees in S-Corps are not entitled to most fringe benefits (except retirement plans).

While S-Corps can provide some of these benefits and deduct their costs, benefits are taxable to the more-than-2-percent shareholders.

Some benefit plans (such as the Mini 401(k) plan) only apply to pass-through entity owner-employees.

There is a clever solution, as pointed out above – being covered as the spouse of a non-owner employee (your spouse).

Statutory or non-statutory plans.

Fringe benefit plans include “statutory” and “non-statutory” plans.

Statutory employee benefits (those benefits that are carved out by separate sections of the Internal Revenue Code) include: qualified retirement plans, group-term life insurance, medical coverage, educational assistance, certain meals and lodging, dependent care assistance and adoption assistance.

Non-statutory fringe benefits (IRC 132) include: no-additional-cost services; qualified employee discounts; working condition fringes; de minimis fringes; certain transportation benefits; reimbursement of moving expenses, retirement, financial and tax planning services; club dues; Christmas gifts and interest-free loans.

What to do as a sole proprietor.

Sole proprietor traders who operate a trading business together with their spouse as co-owners lose sole proprietor status and are treated as a “defacto” husband and wife general partnership.

This is advantageous in many cases. Click here to learn more about husband and wife general partnerships.

If your spouse is an owner, you can’t use the above solution for “being a spouse of a non-owner employee.” You can have retirement plans and deduct health insurance premiums.

If you structure your sole proprietorship so that your spouse is a non-owner employee, you can use this solution for unlocking all possible fringe benefits. The one benefit you can’t get is a retirement plan for yourself.

Retirement plan strategies.

As the only owner of your trading business with your spouse as your only employee, you don’t have to worry about discrimination rules and can contribute the maximum allowable amounts to both of your retirement plans.

With a 25-percent profit sharing plan and/or a Mini 401(k) plan (combines an elective deferral [$12,000 for 2003 and $13,000 for 2004] with a 25-percent profit sharing plan), you can control your annual tax-deductible contributions by elective deferrals and percentages or by the amount of the fee you declare to you and your spouse.

Defined contribution plan limits are $40,000 for 2003 (raised to $41,000 for 2004).

Choices of retirement plans include plans based on business income or plans based on any type of earned income (wages included).

Business plans include profit-sharing plans, defined benefit plans, 401(k) plans, Mini 401(k) plans, SEP plans and SIMPLE plans.

Earned income plans include traditional IRAs, Roth IRAs and education IRAs; they are phased out at higher levels of AGI.

Some plans require an annual Form 5500 and others do not.

Highly profitable and/or older traders may want to contribute significantly more than $40,000 per year and they can consider a “defined benefit plan.” These plans require customization and actuaries, so the costs are higher.

Click here to learn more above retirement plans.

Health-insurance premiums.

Health-insurance premiums are rising dramatically and are a significant cost for families.

The new trend is for employers to cut back on these fringe benefits by passing on more of the premium to the employee, often times with a “flexible spending account” or wage withholding.

Business traders with entities can deduct health insurance premiums (by creating earned income, see above).

These rules only apply for any calendar month in which a trader isn’t eligible to participate in any subsidized health plan maintained by any employer of his or her spouse.

No AGI deduction is allowed to the extent that the deduction exceeds the trader’s fee earned from their trading business, with respect to which the plan providing the medical care coverage was established.

These rules also apply to partners in partnerships and more-than-2-percent shareholders of S corporations where the partnership or corporation pays for health insurance coverage for its partners or shareholders.

If any of your health-insurance premiums are not deductible from AGI, you can add those amounts to your itemized deductions for medical expenses (these are deductible if they are in excess of 7.5 percent of AGI).

Medical reimbursement plans.

Families have lots of medical expenses not covered by insurance: co-pays, dental, vision and non-covered procedures.

Consider setting up an uninsured medical plan to pay noncovered medical costs (IRC 105(b)). 

Owner/employees are not covered, so set up the plan to cover non-owner employees and their spouses (you the owner/trader).

All medical benefits are excludable from income and payroll taxes.

Life insurance plans.

Non-owner employees can exclude the first $50,000 of group-term life insurance coverage (IRC 79). Excess coverage is taxable to the employee according to an IRS table; the table lists approximate market rates for term insurance.

Your trading business can deduct the life-insurance premiums and your spouse (the non-owner employee) only reports taxable income on the excess coverage. Compare the actual premium cost to the IRS table rates (the phantom income) to see if it’s beneficial for excess coverage in this plan.

You can also have a “carve-out” plan – a replacement individual plan or cash in lieu of the policy.

Dependent care assistance plans.

Many traders with families spend money on dependent care assistance and can benefit from this type of fringe benefit plan.

Employees can exclude up to $5,000 of employer-paid dependent care costs (not to exceed earned income; this is covered in IRC 129). The plan must be written.

These excluded amounts can not be part of a child care tax credit. You should consult with your accountant to see which is preferable for your situation.

If you opt for a child care credit instead, note both spouses need earned income. Using a pass-through entity, a trader can pay a fee (earned income) to both spouses.

Are flexible spending accounts (FSA) good for traders?

Big companies use “flexible spending accounts” (FSAs) with “salary reduction” to shift the cost of fringe benefit plans onto employees.

It’s good for employees because it lowers their taxable salary amount; the excluded amounts are pre-tax. With some FSA plans, the excluded benefits are also exempt from payroll taxes (such as is the case with dependent care assistance FSA plans).

Be careful of the “use it or lose it” features in FSAs. If you don’t use the FSA amount deposited or withheld, you may lose it for good.

Business traders don’t need FSAs as they are not concerned with shifting the burden to other family members.

Educational assistance plans and education deductions.

Employees can exclude up to $5,250 of employer-paid educational assistance (IRC 127).

It applies to just about any kind of course or program including graduate level courses, even if it isn't job or business related.

Excess amounts can still qualify for the exclusion under the working condition fringe benefit rules. For example, if you take computer training for $10,000 it can all be excluded (because it's job related).

Excludable amounts are not subject to payroll taxes.

Traders face challenges in deducting education expenses as normal business expenses. Business related educational expenses paid after a trading business is commenced are deductible business expenses. However, education expenses paid before business commencement may be non-deductible.

For a tax deduction, your education expenses must help you maintain or improve your employment or business skills, or be required for you to keep your job (or your business), your salary level or your current status. The education cannot, however, enable you to meet the minimum qualifications for your job, or qualify you for a new trade or business.

A stock broker is already in the trading field, so pre-trading business education can be deductible. An attorney studying the trading business before starting to trade may be denied the deduction. Protect your deduction by paying education bills after you commence actual trading.

There are also many types of educational credits available for all family members.

Adoption assistance.

Employees can exclude adoption assistance up to $10,000 if their AGI is below set limits (IRC 137). The exclusion applies to income and payroll taxes.

Meals and lodging plans.

These expenses can be fully excluded providing you meet the following conditions:

The meals must be provided on the employer’s premises. Many traders don’t go out to lunch; they are glued to their screens throughout the day, just like other traders working for large firms.

Lodging must be furnished on the employer’s premises and the employee must accept it as a condition of employment.  This lodging exclusion is too aggressive to consider for at-home traders. The home office rules are intended to cover these expenses

Shift income to children.
If your children are of working age and truly capable of helping you in your trading business, consider paying them wages or fees and including them in your employee and fringe benefit plans.

This also shifts some of your income from higher marginal tax rates to a child’s lower marginal tax rates. Consider Roth IRAs for your working children. You can trade their Roth IRA and all the income builds tax-free on a permanent basis; whereas traditional IRAs are tax-deferred only (i.e., they are taxed upon withdrawal).

Bottom line
Fringe benefit plans are somewhat complex and cost some money to implement, but they can be well worth the effort and cost. Consult with a trader tax expert who also is experienced in benefits law. They can determine whether any or all of these plans are right for you and your family.

If you have any questions on fringe benefit plans, consider a consultation with a GTT CPA. Feel free to post questions on our message board and/or e-mail us at info@greencompany.com or call us.

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