As the Senate and House move to reconcile a tax bill, retirement industry advocates arecautioning that lower tax rates on so-called pass-throughbusinesses could lead some business owners to reconsider offering401(k) savings plans.

In the House version of the Tax Cuts and Jobs Act, 30 percent ofowners’ profits from pass-through businesses—sole proprietorships,partnerships, limited liability companies, and subchapterS-corporations—would be taxed at 25 percent. Under current law,business profits are taxed at the individual rates of businessowners.

The Senate version of the TCJA would allowbusinesses to deduct 23 percent of the first 50 percent of owners’income.

While the lower tax exposure will not doubt be welcomed by smallbusiness owners, lower rates on pass-through income will makecontributing to a 401(k) plan less attractive for S-Corp owners,says Adam Pozek, a Boston-based retirement plan consultant andpartner at DWC.

The “hyper-technical” implications for S-Corp owners, and someLLC owners that elect to file as S-Corps, comes down to how smallbusinesses deduct plan contributions, according to Pozek.

“In partnerships or sole proprietorships, plan contributions arededucted against earned income, or the individual tax rate ofbusiness owners,” explained Pozek.

“But for S-Corps, the deduction is taken at the corporate level,and applied against what will be a lower pass-through rate,” headded. “So they will be deducting plan contributions at a lowerrate, but taxed on the savings in retirement at a higher ordinaryincome rate.”

Some fear the upshot will be S-Corp owners terminating 401(k)plans, and instead directing personal income to non-qualifiedinvestments, which would be taxed at the capital gains rate inretirement, or at a substantially lower rate than the highestordinary income rates.

“Under the reform bills, business owners can generally realizegreater economic value by simply paying taxes now and investingretirement contributions outside the plan,” said Pozek.

“If that is the case, why incur the expense and complianceresponsibility of maintaining a plan at all?” he added.

More generous ‘new comparability’ plans may fall victim

According to the IRS, there were more than 4.6 millionS-Corporation owners in the U.S. in 2014, compared to 1.7 millionC-Corporations. There are now more than 1 million LLCs.

Pozek does not see the threat to S-Corp retirement plansponsorship as existential. “I think we would see some drop off,but not a wholesale termination of plans.”

But that doesn’t mean the implications for rank-and-fileemployees of S-Corps won’t be real under the new pass-throughstructure.

In order for business owners to maximize retirement plandeferrals—the legal max was $60,000 in 2017—S-Corp sponsors oftenset up “new comparability” 401(k) plans.

Under that design, sponsors can distribute larger plancontributions to older and higher wage participants.

In order for those plans to satisfy IRS and ERISAnon-discrimination rules, lower-wage rank-and-file participantsmust also benefit from higher employer contributions.

For owners to maximize their own deferrals under a newcomparability plan, company profits must be distributed to allemployees at the lesser of one-third the highest contribution rateof owners, or 5 percent of an employee’s compensation.

Unlike other employer match structures, the 5 percent profitdistribution to rank-and-file employees must be made even whenemployees don’t elect to make their own contributions.

S-Corps that can afford the plans benefit from maximizing ownertax deferrals, getting older workers higher contributions in thepre-retirement years, while assuring younger workers are saving atrates that often outpace standard 401(k) offerings.

Pozek says about half of DWC’s S-Corp clients have acomparability plan in place. “It’s definitely not an unusualstructure.”

New pass-through rates will lead to reduced employercontributions

Eric Droblyen, CEO of Employee Fiduciary, a Florida-basedconsultancy that customizes retirement plans for small and midsizedbusinesses, also doubts the new pass-through rates will lead towidespread plan termination.

“Will a small minority terminate plans? It’s conceivable. Butbusiness owners’ personal tax reasons are not the key reason whythey sponsor plans,” Droblyen told BenefitsPRO.

He--and others--cite a study by Pew Charitable Trusts, whichshowed that only 5 percent of small business owners said theprimary reason they sponsor retirement plans was to shelter theirown savings. Attracting the best employees and helping them preparefor retirement were far more common reasons for sponsoringretirement plans.

The real impact small business tax reform will have onretirement plans will be seen in plan design, and on more “exotic”offerings like new comparability plans, says Droblyen.

Beyond the higher overall contribution rates required in newcomparability plans, sponsors also pay a premium for thespecialized expertise required to design and administer the plans,which have to be cross-tested against a specific group’sdemographics, sometimes annually.

Instead of adopting plans that maximize contributions asefficiently as possible, Droblyen sees sponsors opting for morecommoditized plan offerings.

That may end up hurting the average participant in an S-Corpplan--even more so than business owners.

“Rank-and-file savers really do benefit from more generousbenefits in new comparability plans,” said Droblyen, who said astudy of the plans administered by Employee Fiduciary shows highrates of the profit-sharing plan model.

Moreover, the adoption of defined benefit plans among smallbusinesses—a trend Droblyen says is on the rise—will also beimpacted. “Those will get crushed under tax reform,” he said.

While there is little doubt that lower pass-through rates willmake pre-tax retirement contributions less attractive for S-Corpowners, it won’t be a death knell for small business planadoption.

“I think the change will be worse for retirement plan industryprofits than small business 401(k) plan sponsorship,” saidDroblyen. “Why would an employer pay more for plan design expertiseif it won't deliver tax savings? “