How to Boost Tax Deductions by Retroactively Adopting a Workplace Retirement Plan

July 2021

BY

Norma ShararaManaging Director, National Tax Compensation & Benefits

Joan VinesManaging Director, National Tax Compensation & Benefits

Employers who could use a federal income tax deduction for 2020 can consider retroactively adopting a broad-based, tax-qualified retirement plan, such as a discretionary profit-sharing plan, cash balance plan or traditional pension plan and making employer contributions before the extended due date of their 2020 income tax return. An employer could retroactively adopt a 401(k) or 403(b) plan and make a profit-sharing contribution (but no salary deferrals) for the prior year, since participants must make deferral elections before the amounts are earned.

For decades, employers generally could deduct plan contributions made by the extended due date of their federal tax return to fund such a plan for the prior year, so long as they adopted the plan before the end of that prior year. But the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 allows more time for adopting the plan. New Internal Revenue Code Section 401(b)(2) allows employers (including “owner-only” businesses) to adopt the plan within the same time period for making deductible contributions, retroactively effective to the prior tax year. Thus, employers now can adopt and contribute to a tax-qualified retirement plan for last year, all by the extended due date of its federal income tax return for last year in order to deduct the funding on the extended income tax return. The deadline for filing federal income tax returns for calendar year S corporations and partnerships is March 15 (or September 15 if extended) and for C corporations and sole proprietors it’s April 15 (or October 15, if extended).

This change in the law reverses the IRS’s position (going back to the 1970s) that employers had to adopt the plan before the end of the tax year, even though they had until the extended due date of their tax return for that year to fund contributions that they wanted to deduct on the extended return. In the “old days,” employers either rushed to adopt retirement plans by year end or, at tax time, grudgingly realized that they had missed an opportunity by not adopting the plan by year end.

Since 2020 was such a tumultuous year, some employers who planned to adopt a retirement plan might still be operating under the old rules and may have missed this big favorable change in the rules. Moreover, when looking back at their 2020 tax year, some employers may find that 2020 was an unexpectedly good year financially, due to generous federal and state stimulus and other relief. For example, many employers benefited from the CARES Act--including the Paycheck Protection Program (PPP), the employee retention credit (ERC), and delayed payroll tax deposits — as well as from the Families First Coronavirus Relief Act (FFCRA) paid sick and child care leave, the Small Business Administration (SBA)’s expanded Economic Injury Disaster Loan (EIDL) program, the Federal Reserve’s Main Street Lending Facility, the Restaurant Relief Fund, the Shuttered Venues program, etc. Some of that relief is still retroactively available for 2020 for employers who are eligible to claim it in 2021.

The SECURE Act change in the law applies to all tax years starting on or after January 1, 2020, so it is a strategic tax planning technique that is not linked to COVID disaster relief and remains available for future years’ tax planning.

 
The ability to adopt a broad-based, tax-qualified, workplace retirement plan after the close of the tax year and still get a deduction for last year based on contributions made to that plan by the extended due date of the employer’s federal income tax return presents a new planning opportunity for 2020 (and beyond) that may generate immediate tax savings. This new tool can be helpful to employers who may not have been able to focus on year-end tax planning and are surprised by their tax bill.

In sum, employers who filed an extension for their 2020 tax return may want to consider if retroactively adopting a tax qualified retirement plan may help offset their 2020 tax liability. Employers who did not file an extension of their 2020 federal income tax return may not be able to retroactively adopt a plan for the prior year, but they could keep this planning technique in mind for future years. As with all tax planning strategies, employers should consider the impact of changing tax rates on the value of tax deductions for retirement plan contributions in the prior, current or future years.