401(k) Plans for the Small Business Owner

The 401(k) plan has become very popular among small business owners as a result of changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). These changes have made the 401(k) plan, in comparison to most other retirement plans, more beneficial and flexible for the small business owner. For the purposes of this article, we will refer to this special 401(k) plan as the "small business owner 401(k)", or SBO-401(k). 

The name assigned to the SBO-401(k) varies among financial institutions. An independent 401(k) is one of the most generic. Other examples include the "Individual(k)," "Solo 401(k)," "Uni-K Plan," "one-participant K" and "Self-Employed 401(k)." If you are not sure which name your financial service provider uses, ask about the "401(k) plan for the small business owner." The IRS provides this handy primer on such plans.

A common misconception about the SBO-401(k) is that it can be adopted only by sole proprietors. In fact, the SBO 401(k) plan may be adopted by any small business, including corporations, limited liability companies (LLC) and partnerships, provided that the only eligible plan participants are the business owners (or their spouses who are also employed by the business).

Individuals who are employees of one company (in which they have no ownership) and participate in its 401(k) can also establish a SBO-401(k) for a small business they run on the side, funding it with earnings from that venture. However, their aggregate salary deferral contributions to both plans cannot collectively exceed the IRS-established annual contribution maximums (see below). Also, if their own company is operated as a corporation, contributions to the plan can be based only on the W-2 wages they receive from it.

For small business owners who meet certain requirements, most financial institutions that offer retirement plan products have developed truncated versions of the regular 401(k) plan for use by business owners who want to adopt the SBO-401(k). The result is less complex documentation used to establish the plan. For instance, a 20-page document for the regular 401(k) plan may be reduced to a three-page document for the SBO-401 (k). Make sure that you receive the proper documentation from your financial services provider.

The SBO-401(k) plan may be adopted only by businesses in which the only employees eligible to participate in the plan are the business owners. For eligibility purposes, your spouse is considered an owner of your business. Therefore, if they are employed by your business and are eligible to participate in the plan, you are still eligible to adopt the SBO-401(k).

If your business has non-owner employees who are eligible to participate in the plan, your business is not eligible to adopt the SBO-401(k) plan. So, you may have employees in addition to yourself and your spouse and still be eligible to adopt the plan for your business only if these other employees are not eligible to participate in the plan. The determination of whether other employees are eligible depends on the eligibility requirements you select for the plan. The requirements that you choose must remain within the following limitations:

Age: You may choose to exclude employees who are under age 21.

Years of Service:

• For 401(k) Employee Elective Deferral Contributions: You may require an employee to perform one year of service before they become eligible to make elective deferral contributions.
• For Profit-Sharing Contributions: You may require an employee to perform up to two years of service in order to be eligible to receive profit-sharing contributions. However, most SBO-401(k) plans limit this requirement to one year.
• For plan purposes: An employee is considered to have performed one year of service if they work at least 1,000 hours during the year. While you may generally choose to require fewer than 1,000 hours under a regular qualified plan, most SBO-401(k) plans include a hard-coded limit of 1,000 hours.

When determining eligibility requirements for your plan, you may also exclude non-resident aliens who receive no U.S. income and/or those who receive benefits under a collective bargaining agreement.

– Exercise Caution with Elections Making the wrong elections could result in your being excluded from the plan or non-owner employees being eligible to participate in the plan. For instance, if you elect to have an age eligibility requirement of 21 even though you are only 20, you would be excluding yourself from participating in the plan. Or, say you elect zero years of service as a requirement to participate in the plan, but you have five seasonal employees who work fewer than 1,000 hours each year and are over age 21. These employees would be eligible to participate in the plan because they meet the age and service requirement. Consequently, their eligibility would disqualify your business from being suitable to adopt the SBO-401(k) plan. Instead, you could adopt the regular 401(k) plan. – Check Plan Document Provisions Some SBO-401(k) products, by definition, require further exclusion. Before you decide to establish an SBO-401(k) plan, be sure to check with your financial services provider regarding the provisions of the plan.

There are two components to the SBO 401(k) plan: employee elective deferral contributions and profit-sharing contributions.

For 401(k) Elective Deferral Contributions: You may require an employee to perform one year of service before they become eligible to make elective deferral contributions.

For Profit-Sharing Contributions: You may require an employee to perform up to two years of service in order to be eligible to receive profit-sharing contributions. However, most SBO-401(k) plans limit this requirement to one year.

• Elective Deferral: You may make a salary-deferral contribution of up to 100% of your compensation/income, but no more than the annual limit for the year, which is $19,000 or $26,000 for age 50 or over in 2019 (both figures are $500 higher than 2018).
  
• Profit-Sharing Contribution: The business may contribute up to 25% of your compensation (20% in the case of a Sole Proprietor or a Schedule C Tax Payer), but no more than $56,000 for 2019 (up from $55,000 in 2018).
  
• Contribution Limits: The combined salary-deferral and profit-sharing contributions must not exceed $56,000 for 2019 (up from $55,000 in 2018). However, if you reach age 50 by year-end, you may contribute an additional $6,000 for catch-up contributions in 2019 (the same amount is permitted for 2018).
  

In comparison to other popular retirement plans, the SBO-401(k) plan has high contribution limits (as outlined above), which is the key component that attracts small-business owners. Furthermore, for other retirement plans, the contributions may be limited to only employer contributions or – where salary deferral is allowed – the limit is less than that for the SBO-401(k) plan.

The following is a summary of contribution comparisons for the popular employer plans used by small businesses:

(To learn more about SIMPLE plans, see Introduction to SIMPLE 401(k) Plans, SIMPLE IRA vs. SIMPLE 401(k) Plans and Plans the Small Business Owner Can Establish.)

Let's use an example to illustrate:

Suppose that Jill, a sole proprietor who is under age 50, has a net profit of $70,000. Jill wants to adopt a retirement plan for her business, and would prefer to adopt the plan that allows the highest contribution limit. The following table outlines the approximate maximum Jill would be able to contribute with each plan for 2018 (note that the 2019 contribution limits are higher):

The Calculation As mentioned earlier, you may make employee elective deferral contributions of up to 100% of your compensation, but no more than the elective deferral limit for the year ($18,500 for 2018). Profit-sharing contributions are limited to 25% of your compensation (or 20% of your modified net profit if your business is a sole proprietorship or partnership). The total SBO-401(k) contribution is the employee selective deferral contribution plus the profit-sharing contribution of up to $55,000 for 2018. If your business is a corporation, the profit-sharing contribution is based on W-2 wages you receive. For instance, if you receive $70,000 in W-2 wages, your profit-sharing contribution could be up to $17,500 ($70,000 x 25%). When added to your salary-deferral contribution of $18,500 (as of 2018), this would be $36,000. If your business is a sole proprietorship (like Jill's business) or partnership, then the calculation gets a little more involved. In this case, your profit-sharing contribution is based on your modified net profit and is limited to 20%. For instance, in the example with Jill above, her net profit was $70,000. After making the necessary adjustments, Jill determined that her modified net profit was $65,045.65. The maximum employer contribution would therefore be $13,010.93 ($65,045.65 x 20%). Jill's maximum contribution is $31,510.93, which is the total sum of both her $18,500 maximum salary-deferral contribution and $13,010.93 maximum profit-sharing contribution. The IRS provides a step-by-step formula for determining your modified net profit in IRS Publication 560.

Loans: Like other qualified plans, you can borrow from the SBO 401(k) up to either 50% of your plan balance or $50,000, whichever is less. Check the plan document to determine if any other limitations apply. 

5500 Filing May Not Be Required: Because the plan covers only the business owner, you may not be required to file Form 5500 series return unless your balance exceeds $250,000.

No Discrimination Testing: Generally, certain nondiscrimination testing must be performed for 401(k) plans. These tests ensure that the business owners and higher paid employees do not receive an inequitably high amount of contribution when compared to lower paid employees. These tests can be very complex and may require the services of an experienced plan administrator, which can be costly. Because the SBO 401(k) plan covers only the business owner, there is no one against whom you can discriminate, so these tests are not required.

Deducting Contributions: Similar to other employer plans, the SBO 401(k) allows you to deduct plan contributions of up to 25% of eligible compensation. For plan purposes, compensation is limited to $280,000 for 2019 (up from $275,000 in 2018). Earnings of more than that amount are disregarded for plan purposes.

The SBO is not suitable under the following circumstances:

• You have employees other than business owners who are eligible to participate in the plan.
• Your compensation is sufficient to allow you to contribute the $56,000 limit (2018 limit is $55,000) as profit-sharing contributions.
• Your business is incorporated and you earn sufficient W-2 wages to allow the maximum contribution of $56,000. The benefit of an SBO 401(k) is being able to make the maximum contribution possible. Since the dollar limit is $56,000 for 2019, adopting an SBO-401(k) is not necessary if you receive W-2 wages from your business that would allow the maximum contribution amount of $56,000 to be achieved with pure profit-sharing contributions. Of course, if you are at least age 50, adopting the SBO-401(k) would allow you to make the additional catch-up contribution of $6,000.

The SBO-401(k) plan must be established by the last day of the tax year for your business. If you operate your business on a calendar year, the deadline will be December 31. However, if your business is incorporated, you may want to establish the plan sooner in order to make salary-deferral contributions, as they must be based on current or future wages, not wages paid before the plan is established. The Dec. 31 deadline may change before long, however. The Family Savings Act - H.R. 6757, which would allow employers to adopt a solo 401(k) plan up to the business tax filing date, passed the House in September 2018 and is awaiting a Senate vote

Profit-sharing contributions must be made by your tax-filing deadline, including extensions. Amounts representing salary-deferral contribution must be contributed by the 7th business day of the month following the month to which the deferral applies if your business is incorporated. For instance, amounts deferred from your salary in September must be deposited to your 401(k) account by the 7th business day of October. Because salary deferral contributions cannot be based on compensation earned before you make an election, you must make your election before the first pay period by which you want to begin making salary deferral contributions.

For unincorporated businesses, your selective deferral contributions may be deposited by your tax-filing deadline, including extensions. However, your salary deferral election, including the amount you plan to defer, must be made by the last day of your tax year.

If you own more than one business, you must check with your tax professional to determine whether you are eligible to adopt the SBO-401(k).  Ownership in another business that covers employees other than the business owner could result in your being ineligible for this type of plan.