Tax risks of small business employee benefit plans

by Tony Novak, CPA, MBA, MT
, revised 11/29/2011

We know that small business owners face enough risks on a daily basis without the need to be worried that the IRS may deny the tax deductions taken for improper employee benefit plans. Fortunately, the audit and disallowance rate of small business employee benefit plans is a relatively small risk. Yet taking a "better than sorry" approach, this article lists many of the things that can go wrong, from a tax perspective, with a small business employee benefit plan.

 We list the potential problem issues in categories of risk ranging from “high risk” to “medium risk ” and “low risk”. A separate category is included at the end to include those issues for which we cannot estimate the risk.

This article considers only the federal tax risks, not legal risks or other business risks that may arise. Also, this issue addresses only tax risks that are applicable to the employer, not those that may be faced by the employee.

High Risk Issues

Deposits not verified by custodian

If you take a deduction for a retirement plan, for example, and do not actually make the deposit with an approved custodian, there is a high probability that the error will be caught. The IRS uses a computerized matching program that appears to be very efficient.

Unqualified HSA custodian

If you opened your health savings account with a custodian that does not properly administer and report the health savings accounts then your tax deduction for the contribution is likely to be denied. This error would likely be caught in the IRS’s automated unreported income matching program. (Apparently this was a problem in the first years of Health Savings Accounts but is no longer a problem since bank employees are better informed about HSAs).

Improper investments

Just like IRA accounts, HSAs have rules about allowable investments. A violation causes the entire amount to become taxable immediately.

Purchase of real estate is a problem regardless of how great the investment return. Investments in the employer's stock would face certain restrictions and should probably just be avoided.

FICA wage tax issues

Any issue that results in an under-reporting of taxable wages is a high risk issue, not because of the risk of being caught, but rather because of the severity of penalties. Small businesses have literally been shut down because of sloppy accounting in this area.

Treating owners as employees

Owners of sole proprietorships, partners, members of an LLC and shareholders in an S corporation may not be treated as employees under most employee benefit plans. It makes no difference that the owner is actually working in the business the same as a regular employee. This is a common item examined in routine audits of a business reporting on a Schedule C or Form 1120S. The risk is that if improper reporting is discovered in one year, the other years before and after are likely to be also opened for examination of the same issue.

Medium risk issues

Discrimination issues

When some employees do not receive a benefit enjoyed by others, the result is often a complaint to the IRS. It is important to know that in the absence of a complaint, this would be a “low risk” issue. But the frequency of audits suggests that disgruntled employees are quick to point the finger of suspicion. Discrimination is allowed in all employee benefit plans as long as it follows prescribed formulas. Discrimination issues fall into two categories: Discrimination as to eligibility and discrimination as to benefits. In either case, perhaps the best way to avoid tax problems is to have an outside accountant review the benefit plan transactions at the time the tax return is prepared.

Lack of third party documentation

Most pension plans require an actuary’s report. Self-administered 401(k) plans require that the trustee be bonded by an insurance company.

Health Reimbursement Arrangements require that cash benefits be verified by an independent auditor. Without these third party documents, deductions would likely be denied in a general audit.

Health plans that defer income

Health reimbursement plans are not intended to defer income from the current year and postpone it to a future year. While this is difficult to detect from a general audit stance, the IRS happens to be on the lookout for this issue.

Low Risk Issues

Improper wording in plan documents

While benefit plan documents should be updated every few years to account for changing legal requirements, the IRS admits that many (perhaps even the majority of) small business do not fully comply with current law. Yet seldom, if ever, do we hear of a major tax problem arising from a faulty small business benefit plan document. Most issues can be corrected through the IRS’s voluntary correction program for employee benefit plans.

Group health insurance administration

Federal law requires that small business group health insurance plans abide by state laws with regard to eligibility, participation and contributions. Yet a high percentage of small business health insurance plans do not meet these stated requirements. The IRS either looks the other way or, more likely, does not bother to look at all.

Unknown Risk

Health savings account deductions

Health Savings accounts were brand new in 2004, so we have little information on IRS examination procedures. Tens of thousands of taxpayers are expected to improperly claim this deduction over the next few months. With a lack of automated audit programs and little human resources attached to the issue, it is quite possible that these errors will go undetected.

Deferred Income Plans

New regulations published in late 2004 are very clear. What’s not clear is the IRS enforcement plan at the small business level. Businesses with these benefit plans should be reviewing them now to determine what changed should be made. Presumably, employers who make corrections within a reasonable time will be OK.

About Freedom Benefits

Freedom Benefits Association (www.FreedomBenefits.org) provides low cost employee benefit plans for small businesses without commissions or ongoing fees.

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