Job Protection Act Affects Small Businesses’ Pension Plans

President Clinton signed the Small Business Job Protection Act of 1996 into law on Aug. 20, 1996. This Act makes sweeping changes that affect family businesses and their owners.

Pension simplification provisions of the Small Business Job Protection Act are particularly broad and will affect nearly every small business owner. Here are a few provisions and how they will affect you.

5-Year Averaging for Lump-Sum Distributions Repealed
Beginning after 1999, a participant who receives a lump-sum distribution from a qualified plan can no longer use five-year forward averaging on that distribution. If, however, you were eligible for 10-year forward averaging because you were least 50 years old on Jan. 1, 1986, you will still be able to make that election.

This could be a significant change for those not eligible for 10-year averaging and who have small lump-sum amounts. Unless your lump-sum distribution is under approximately $250,000, or you are in dire and immediate need of your qualified plan money, it may be better to roll the funds over to an individual retirement account (IRA) to defer the payout rather than making a 5- or 10-year averaging election. Thus, for family business owners with large sums in a qualified plan, the repeal of five-year averaging will have little or no effect.

For participants with small amounts in qualified plans, the new law could be detrimental. In states where lump-sum distributions are not taxed, being unable to elect five-year averaging could raise state tax significantly. If you would benefit from five-year averaging, consider making a distribution from your plan that qualifies for five-year averaging before the end of 1999. The rules are complex, however, so call us before you take action.

SIMPLE Enacted, SARSEPs Repealed
New Salary Reduction Simplified Employee Pensions (SARSEPs) will not be allowed after 1996, though existing SARSEPs may continue.

Instead, for companies with fewer than 100 employees, a new plan known as Savings Incentive Match Plan for Employees (SIMPLE) may be implemented. To qualify, an employer must have fewer than 100 employees who earn at least $5,000 in the immediately preceding plan year. Also, the employer cannot maintain any other plan in addition to SIMPLE.

If an employer goes over the 100-employee limit, there will be a two-year grace period during which the plan will continue to be qualified. A SIMPLE plan can either be an IRA for eligible employees, or part of a 401(k) plan. If the rules are followed, a SIMPLE is not subject to nondiscrimination and top-heavy rules.

Under SIMPLE, an employee can contribute up to $6,000 per year. The employer must match employee contributions up to 3% of pay under two alternative tests. Amounts are fully vested, including employer contributions and distributions, which are treated as if coming from IRA accounts. The penalty for early withdrawal is increased to 25% from 10% if an individual withdraws money within two years after the start of participation in a SIMPLE plan.

SIMPLE plans will probably replace some 401(k) plans where employee deferrals are not significant because of simplified reporting requirements. Some SIMPLEs may replace Simplified Employee Pensions (SEPs), particularly where rank-and-file employees make less than $5,000. Among wealthier family businesses, however, SIMPLE plans probably will not have widespread appeal.

Family Aggregation Rules Repealed
Here’s probably the most significant change for family business owners: A married couple and their children who are under the age of 19 are no longer aggregated as one person for the $150,000 compensation limit in qualified plans. Family business owners should see a return to higher contributions to qualified plans for the family unit and a relief from the cumbersome requirements as a result of this change.

Nondiscrimination Rules Modified
The new law generally makes 401(k) plans more appealing by simplifying the testing. One provision of the law, which went into effect in 1997, allows you to elect to use the prior year average deferral percentage and average contribution percentages in determining how much compensation can be contributed. Effective beginning 1999, certain new safe-harbor rules are used to make testing easier and allow larger contributions for the highly paid.

Other Provisions
Several other provisions in the legislation affecting family businesses are:
• The $5,000 death benefit exclusion is repealed and the excise tax on prohibited transactions is increased from 5% to 10% on the initial level.
• The combined plan limit is repealed. The law currently cuts back the amount of money that can be put into a plan where individuals formerly maintained a defined benefit plan and now have a defined contribution plan or maintain those plans simultaneously. If you were cut back by prior law limitations, you may find you can put more money in the plan if you so desire.

There are many more provisions of the Act, but the ones we’ve discussed are the most applicable to family businesses. Planning for these changes should be done as soon as possible. Please call us for an appointment to evaluate how they can benefit you and your business.