Pension Plan gone awry

[Nashville]

A client of mine with four employees has been arranging a pension-plan for his employees, but with a strange arrangement.

1) He writes the employees a check for 6% of their compensation.
2) Each employee deposits their check with a pension plan custodian of their own choice. Employer gets
confirmation that each employee has in fact made the deposit within a few days of receiving his check.
3) I allow him to deduct the checks as a pension plan fringe benefit expense.

After reading this far, I'll bet some of you are already alarmed at this arrangement. But hold on to your seat. It gets better.

In spite of the inherent dangers above, everything has worked well for years and years without a hitch, UNTIL...

4) One of the employees received her 6% in March, and deposited the money into a ROTH. YIKES!! And, as fate would have it, this employee is also my client.

To report in a manner that makes all parties happy, my questions:

a) How does the employee with the Roth report the receipt of the 6% check. Is it compensation? Is it pension income?
b) Is the employer still entitled to deduct all such payments as a pension plan fringe benefit expense?

[Burke]

A Roth can be part of a pension plan. I am gathering she did not send it to the custodian who adminsters this pension plan? I am not sure such an arrangement is legit, but will have to pass judgement on to others more familiar with pension plan rules. Once the employer pays the employee, does he have any control at all over what's done with it? If not, that's compensation.

[Nashville]

Good observation

Good observations and grasp of the situation, Burke.

Employer does not go through a common custodian. He issues checks and they are told to find a custodian of their own choice. There are "strings attached" to the payments to employees, but I don't know whether there could be any enforcement if the employee went to Las Vegas instead of putting it in a plan. Employees have, without exception, put the money in their own plan.

The deposit of the employee's money into such plans means that the payments are not compensation, but are tax free and result in a zero basis in the plan for each employee.

However, putting the money in a Roth means the money has never been taxed. Seems like the check should be taxable to such an employee, but how??

[sea-tax]

nash-
Sorry to be the notifier of bad news- but I think what you have is a client who has underreprted his taxable wages to employees and therefore underreported his fica and medicare taxes, suta and futa taxes.

To have a pension plan you must have plan documents and most importantly file the necessary Form 5500. This situation sounds to me like your client while well intentioned missed a few but important steps.

No plan that I am aware of allows the empoyer to pay the employee money and hope they put it into a qualified retirement plan.

All retirement plans and pension plans that I am aware of require some common things, plan documents, 5500, custodians and tpa. Whether it be a 401k, SEP, 403B, 457 or other type of defined contribution plan. For Defined Benefit plans some of the same requirements would be needed.

I think as you dive into this you will find that your client has under reported his taxable wages to his employees each year and therefore will have to amend all the payroll reports, w-2 w-3 and tax returns.
Good luck and I will always leave room for me to be wrong but I just don't see how it could be treated anyother way.

[Corduroy Frog]

For Sea-Tax

I am glad to hear from you and wish you would join us more often.

I knew some of you would be uncomfortable with this arrangement, and I am as well. Will take your knowledge under advisement and approach the client.

[Traveling EA]

Retirement Plan

I am in agreement with SeaTax - with the exception that a SIMPLE plan still requires a plan document, but no 5500's annually. At least that is my understanding.

[JoshinNC]

What type of "pension plan"

is this? Money paid to an ee who then contributes the money to an individual retirement account (IRA or ROTH) is not a "pension plan", it's additional compensation paid to the ee and then they are voluntarily saving it for retirement (a SIMPLE kinda works that way, in that the ee has the right to choose any custodian they want to hold the funds, but the employer still deducts the deferred wages from total wages, diverts them to the chosen custodian, and directly makes a matching contribution, but this ain't what you've got going on). These are wages, pure and simple, reported as such by the employer and the employee. On the face, not only will the employer need to amend all payroll tax returns, but so will all the ee's when they received their corrected W-2's.

[Burke]

All retirement plans and pension plans that I am aware of require some common things, plan documents, 5500, custodians and tpa.

What is "tpa?"

[JoshinNC]

Third

What is "tpa?"

Party Administrator.

[sea-tax]

Curduroy
Thanks for the kind words- I do come by once and a while a lurk and I do post when I have something to say
Usually all you smart people post before I have time to respond my brain just works a little slow.

Anyhow Traveling you are correct a simple IRa does not require a 5500. I got a little carried away with myself

Josh- glad to see you agree with me- having confirmation is always nice.

[ruthc]

Agree with JoshinNC

Josh, I fully agree with you.
I worked for an entity that did not want to get into setting up retirement plans and only wanted to give to certain people's retirement. So the owners gave certain employees a separate check for whatever was agreed upon at their review. It was for a few management employees. Here is the difference. I received a PAYROLL CHECK for the amount and taxes were withheld from it. I had to set up an IRA whereever I wanted, but always had to submit proof to the owners that it was put into the IRA (not just any bank account). So I paid taxes on it.

[Burke]

So in effect, they were evading the non-discrimination rules for pension plans. IRS might have had some real heartburn over how that was handled on audit.

In the original post, that does not appear to be the motive. He is treating it like a SIMPLE, 3% of salary + 3% match, to all employees, but not funding it until the end of the year (it appears) so he did not have to deposit employee contributions each month, nor meet the requirement to fund every year, etc.

[Burke]

However, putting the money in a Roth means the money has never been taxed. Seems like the check should be taxable to such an employee, but how??

Putting aside the problem of the issuance of such checks and whether they should have been taxable wages, can she not "recharacterize" the ROTH as a traditional IRA?

[JoshinNC]

In effect

So in effect, they were evading the non-discrimination rules for pension plans. IRS might have had some real heartburn over how that was handled on audit.

In the original post, that does not appear to be the motive. He is treating it like a SIMPLE, 3% of salary + 3% match, to all employees, but not funding it until the end of the year (it appears) so he did not have to deposit employee contributions each month, nor meet the requirement to fund every year, etc.

They were doing some convoluted bastardization of multiple retirement plans, none of which would stand muster under scrutiny. Best thing to do is collect a hefty retainer, start the amended process for all the payroll tax returns, issue the corrected W-2's and prepare for the onslaught of complaints from the ee's.

[ruthc]

Was audited!

Burke,
The company had been in business for many, many years and was audited each year. The auditors were fully aware of how it was set up and probably were the ones that suggested doing it this way. They are still very much in business. They would never have done anything that was not ethical nor incorrect!