Fed Tax Incentives: Credit for Small Employer Pension Plan Startup Costs
Background
Eligible small employers use the Form 8881 to claim the Credit for Small Employer Pension Plan Startup Costs for qualified startup costs incurred in establishing or administering an eligible employer plan pursuant to Internal Revenue Code, § 45E. For such employers, the credit is 50% of the qualified startup costs paid or incurred during the tax year. The credit is limited to $5,000 per year for the first credit year and each of the following two tax years (potentially eliminate up to $15,000 in taxes). See I.R.C. § 45E(b). No credit is allowed for any other tax year (I.R.C. § 45E(b)(2)).
Eligible small employers include those that have had no more than 100 employees during the tax year preceding the first credit year who received at least $5,000 of compensation from that employer during that tax year.
Small employers that during the three tax years preceding the first credit year established or maintained a qualified employer plan with respect to which contributions were made, or benefits were accrued, for substantially the same employees as are in the new qualified employer plan are not eligible employers.
Amount of the Credit
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The credit is 50% of your ordinary and necessary eligible startup costs up to $500 for the first credit year and each of the 2 taxable years immediately following the first credit year, and zero for any other taxable year. (I.R.C. §§ 45E(a), (b))
Eligible Employer Qualification to Claim the Credit (I.R.C. §§ 45E(c), 408(p)(2)(C)(i)):
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Had 100 or fewer employees who received at least $5,000 in compensation from you for the preceding year (I.R.C. § 408(p)(2)(C)(i)(I));
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I.R.C. § 408(p)(2)(C)(i)(II) 2-Year Grace Period — An eligible employer who establishes and maintains a plan under this subsection for 1 or more years and who fails to be an eligible employer for any subsequent year shall be treated as an eligible employer for the 2 years following the last year the employer was an eligible employer. If such failure is due to any acquisition, disposition, or similar transaction involving an eligible employer, the preceding sentence shall not apply.
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Had at least one plan participant who was a non-highly compensated employee (I.R.C. § 45E(d)(1)(B)); and
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As defined by the IRS, a "Highly Compensated Employee" is an individual who:
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owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
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for the preceding year, received compensation from the business of more than$125,000 (if the preceding year is 2019 and $130,000 if the preceding year is 2020), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation. See IRS Retirement Plan Definitions link
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In the 3 tax years before the first year you’re eligible for the credit, your employees weren’t substantially the same employees who received contributions or accrued benefits in another plan sponsored by you, a member of a controlled group that includes you, or a predecessor of either. (I.R.C. § 45E(c)(2)).
Qualified Startup Costs are Ordinary and Necessary Costs Paid or Incurred (I.R.C. § 45E(d)(1)(A)):
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establishing or administering an eligible employer plan (e.g. starting a SEP, SIMPLE IRA or qualified plan) (I.R.C. § 45E(d)(2)); or
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retirement-related education of employees about the plan (I.R.C. § 45E(d)(1)(A)(ii)).
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I. R.C. § 4972(d)(1)(A) In General — The term “qualified employer plan” means—
- I.R.C. § 4972(d)(1)(A)(i) — any plan meeting the requirements of section 401(a) which includes a trust exempt from tax under section 501(a),
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I.R.C. § 4972(d)(1)(A)(ii) — an annuity plan described in section 403(a),
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I.R.C. § 4972(d)(1)(A)(iii) — any simplified employee pension (within the meaning of section 408(k)), and
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I.R.C. § 4972(d)(1)(A)(iv) — any simple retirement account (within the meaning of section 408(p)).
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I.R.C. § 4972(d)(1)(B) Exemption For Governmental And Tax Exempt Plans — The term “qualified employer plan” does not include a plan described in subparagraph (A) or (B) of section 4980(c)(1).
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I.R.C. § 4980(c)(1) Qualified Plan — The term “qualified plan” means any plan meeting the requirements of section 401(a) or 403(a), other than—
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I.R.C. § 4980(c)(1)(A) — a plan maintained by an employer if such employer has, at all times, been exempt from tax under subtitle A, or
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I.R.C. § 4980(c)(1)(B) — a governmental plan (within the meaning of section 414(d)). Such term shall include any plan which, at any time, has been determined by the Secretary to be a qualified plan.
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An eligible employer plan is a qualified employer plan with at least one employee eligible to participate who is not a highly compensated employee (I.R.C. § 45E(d)(1)(B)). All eligible employer plans of the same employer are treated as one eligible employer plan. I.R.C. § 4972(d)(2).
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Eligible Tax Years
You can claim the credit for each of the first 3 years of the plan and may choose to start claiming the credit in the tax year before the tax year in which the plan becomes effective. See I.R.C. § 45E(b), I.R.C. § 45E(d)(3).
First credit year. The first credit year generally is your tax year that includes the date that the eligible employer plan becomes effective. However, you may elect to have the preceding tax year be the first credit year, and claim the credit for qualified startup costs paid or incurred during that tax year.
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For example, a calendar-year eligible small employer whose eligible plan is first effective on January 1, 2018, may elect to treat 2017 as the first credit year and claim the credit on its 2017 tax return for qualified startup costs incurred in 2017.
The credit is part of the general business credit and you may carry it back or forward to other tax years if you can’t use it in the current year.
No Deduction Allowed (I.R.C. § 45E(e)(2))
You generally can’t both deduct the startup costs and claim the credit for the same expenses. However, unlike a tax deduction, a tax credit reduces your tax liability on a dollar-for-dollar basis. Note, you aren’t required to claim the allowable credit (I.R.C. § 45E(e)(3)).