Old-fashioned pensions, or defined benefit plans, may have new appeal for some small-business owners as a result of business taxation changes included in the 2017 Tax Cut and Jobs Act.

These changes allow owners of specific types of businesses to deduct up to 20 percent of their business income—as long as income from the business is below certain thresholds, per Sec. 199A of the Tax Reform Act.

“Defined benefit plans give the business owner the ability to reduce their taxable income and stay below these thresholds," says Jerry Lynch, a financial planner with JFL Total Wealth Management in Boonton, New Jersey.

Since the 1970s, defined contribution plans such as 401k plans and Individual Retirement Accounts have become far more popular than defined benefit plans.

According to the U.S. Department of Labor, in 1975 there were 103,346 defined benefit plans and 207,748 defined contribution plans. By 2015, the number of defined benefit plans had shrunk by more than half to 45,672, while defined contribution plans more than tripled to 648,252.

—Jerry Lynch, financial planner, JFL Total Wealth Management

The new Qualified Business Income deduction that is part of the 2017 tax overhaul (Sec. 199A) makes defined benefit plans more attractive for many business owners who have incomes of more than $415,000.

“Below $315,000, business owners qualify for a 20-percent deduction from their income," Lynch explains. “In simplest terms, if they make $315,000, they get taxed on only $252,000 of income, which is a terrific benefit—a $63,000 deduction."

As income climbs above the level required to get the Qualified Business Income deduction of 20 percent, the tax burden rises.

“From $315,000 of income to $415,000, they get phased out of this deduction, meaning they receive and get taxed on an additional $100,000 of income, plus lose the $63,000 deduction," Lynch says, referring to a business-owning married couple filing jointly. “So they are getting taxed on $163,000 of income and they only made $100,000 more in income."

How Defined Benefit Pension Plans Help Cut Taxes

If a business has a defined benefit pension plan, the owner can contribute much more to a retirement plan than he or she could with a defined contribution plan like a 401k. This can help reduce business income below the level required to get the Qualified Business Income deduction set up by the 2017 tax law.

For example, a business owner over age 50 with $415,000 of income can typically put a maximum of $61,000 into a 401k. That will reduce business income by $61,000, which won't be enough to get below the $315,000 Qualified Business Income cap.

If the business has a defined benefit plan, however, the business owner typically will be able to put up to $220,000 into the plan, reducing business income below the $315,000 cap and allowing for the 20 percent deduction.

"I always stay start with a 401(k), generally with a “NewComparability" feature that allows the owner to get as much as $61k in total contributions as generally these are flexible contributions—you don't have to make them," Lynch says. 

The owner doesn't have to contribute the maximum, he adds, just enough to reduce income enough to qualify for the 20 percent deduction.

“If historical income is around $450,000, and I can put in $61,000 into the 401(k), I would try to design a plan that would define a cash target for the business owner at $100,000 in the defined benefit plan, effectively bringing down his income to around $290,000 to $315,000," Lynch says.

Which Businesses Are Looking at Defined Benefit Plans?

The Qualified Business Income deduction is available to businesses organized as sole proprietorships, S corporations and partnerships, but not C corporations.

It is also restricted for the most part to businesses providing services in the legal, health, accounting, consulting, financial, brokerage, performing arts and athletics fields, according to an IRS explanation of the new tax law.

For those who qualify, a defined benefit plan can do more than just reduce taxes. It may also benefit companies that are seeking to improve employee satisfaction and retention and increase their attractiveness in the job market.

How? Owners of businesses seeking to take maximum advantages of defined benefit plans generally are required to offer membership in the plans to other employees of the business as well. And offering employees and potential hires a defined benefit plan can be seen as an attractive perk and can help boost retention and attract top-quality candidates, Lynch notes.

“Employees get a nice benefit they probably would not have received and the owners get the deductions they need," he says.

The Downside of Defined Benefit Plans

However, there are two reasons defined benefit plans lost popularity in recent decades: increased cost and increased complexity.

Business owners who look into defined benefit plans to save on taxes may find that administration fees are likely to be several thousand dollars a year for a small plan.

“It's going to be expensive," says Craig Bolanos Jr., founder and CEO of Wealth Management Group in Inverness, Illinois. “And it's clumsy. You're definitely going to have to hire not just a CPA but a TPA—third party administrator—to get the job done."

Finally, setting up a defined benefit plan generally requires a commitment to continue funding the plan at the same level for several years, meaning they are only suitable for businesses with predictable, stable cash flow sufficient to cover the required contributions.

“Make sure you feel real comfortable with your cash flow, as defined benefit contributions, for the most part, are not flexible," Lynch warns.

While defined benefit plans still aren't for every business or every owner, the new tax law may mean these long-neglected plans are likely to be more popular in the future.

“This is a tremendous planning tool and in the right situation can be a home run for the owner," Lynch says.

However, most businesses will wait until after filing 2018 taxes upon realizing the impact of the 2017 tax change before setting up defined benefit plans, Bolanos says.

“You'll see incremental adoption in 2018," he predicts, “and a tidal wave of adoption in 2019 spurred by the loss of opportunity."

Read more articles on taxes.

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