Most taxpayers are aware that the basis upon which the federal income tax is computed is "taxable income," which is generally equal to taxable revenue less deductible expenses. This concept, of course, applies to a physician practice (unless the practice is exempt under other provisions of tax law). One type of expense that is deductible under the tax law relates to contributions to qualified retirement plans. While the concept of the qualified retirement plan is an incredibly complex one, the tax law, as well as the Internal Revenue Service and the courts, provide opportunities to taxpayers such as physicians and their medical practices to maximize deductions in a manner that also maximizes benefits to members of management and owners (particularly the physicians). The focus of this article is on one such opportunity provided under the tax law, referred to as the defined benefit plan.

As a general proposition, a qualified retirement plan, such as a defined benefit plan, provides significant current tax benefits by allowing an employer, such as a physician practice, to claim a deduction for current contributions to a qualified retirement plan while permitting the deferral of taxation of the related income of the participants until a later year, such as a year in which a distribution from the plan occurs (typically upon retirement). The Internal Revenue Code provides a complex set of rules (accompanied by an equally complex set of regulations issued by the Internal Revenue Service) that govern qualified retirement plans, and specify the means by which a plan is "qualified." Absent such qualification, the current tax benefits as described above are generally lost.

Comparison of Defined Benefit Plans to Defined Contribution Plans

The Internal Revenue Code prescribes two basic types of qualified retirement plans: defined benefit plans and defined contribution plans. By far, the defined contribution plan has been the plan of choice among most physician practices. However, as suggested below, the defined benefit plan may be more appropriate in many cases.

According to the Internal Revenue Service, a defined benefit plan is a plan that is established and maintained by an employer primarily to provide systematically for the payment of a definitely determinable annuity to participants over a period of years, usually for life, after retirement. That is, future retirement benefits are mathematically projected and defined, generally based upon factors such as years of service and compensation received by participants. Such projections are completed on the basis of actuarial assumptions, computations and plan provisions. The current annual contribution is then computed using techniques that attempt to determine the present value of the future projected benefits compared to the current value of plan assets. This step is intended to ensure that the future benefits of the participants will be adequately available (i.e., "funded").

Unlike a defined benefit plan, a defined contribution plan provides an individual account for each participant. The ultimate retirement benefit is unknown and, thus, not "defined." Rather, the current contribution amount is defined. It is determined on the basis of a formula for allocating the current contribution amount among the plan’s participants. This process is typically a simple one, although more sophisticated techniques exist.

Defined contribution plans have historically been popular among smaller employers, unlike defined benefit plans, which have historically been associated with larger entities. This popularity among smaller employers has been largely due to the relative simplicity of defined contribution plans and lower administrative fees. For example, an actuary is usually not required. The most popular types of defined contribution plans are profit sharing plans (including 401(k) plans) and money purchase plans (although money purchase plans have been less popular in recent years).

For the reasons set forth below, as physician practices (and the accompanying baby boomer population) become more mature, the landscape necessarily begins to change, warranting consideration of the defined benefit plan as a viable alternative for the practice.

Defined Benefit Plans

The primary focus of a defined benefit plan is the determination of a projected annual benefit that is generally payable upon the retirement of the plan’s participants. The computation is complex, generally taking into account a participant’s compensation and years of service. As an example, a plan might provide that a participant is entitled to a monthly benefit upon retirement for the remainder of his or her life, computed on the basis of a percentage of the participant’s average annual compensation multiplied by (or for each) year of service. There are, of course, other means by which to compute projected benefits that are beyond the scope of this article.

As a general rule, the tax law provides that the annual benefit with respect to a participant may not exceed the lesser of $165,000 or 100 percent of the participant’s average annual compensation for his or her high three years. The law further provides that the term "annual benefit" refers to benefits that are payable annually in the form of a straight-life annuity. However, there is no reduction in the maximum limit for a joint & survivor form of annuity. Once the annual benefit has been projected, an actuarial calculation is then completed in order to determine the present value of the projected benefit. This present value amount represents the current value of the projected benefit that will be paid in the future (generally, as stated above, upon the retirement of the plan’s participants). As a very general (and intentionally oversimplified) proposition, the present value might be said to play a role in the amount that should be funded by the employer as of the beginning of the current year.

Tax Deduction

The employer is entitled to a deduction equal to an amount necessary to satisfy a concept known as the plan’s "minimum funding requirement" for the plan year. The minimum funding requirement is simply a concept that ensures that the plan will be adequately funded to pay the plan’s projected benefits. The law requires the establishment and maintenance of a so-called "funding standard account" that acts as a running accounting record in order to facilitate the satisfaction of the minimum funding requirement. Generally, the minimum funding requirement is satisfied if there is no deficiency (technically referred to as an "accumulated funding deficiency") in the funding standard account. For example, a funding standard account deficiency will exist if employer contributions for the year, along with certain other items, are not sufficient to satisfy the funding requirements for the plan.

Making a contribution that satisfies the minimum funding requirement generally entitles the employer to a deduction. Care and caution must be exercised, however, in applying the foregoing deduction rule, since it is subject to numerous limitations and other rules, including the full funding limitation and other limitations of an actuarial nature.

Applicability to Physicians and their Practices

While complex, defined benefit plans may be beneficial to certain physicians and their practices because the present value of the projected benefit ultimately controls the deduction in many respects. To the extent that there is less time between the current year and the projected retirement date of the physician, the present value could be relatively larger, potentially resulting in an increased tax deduction. Participants who have experienced longer periods of service and plan participation will experience increased projected benefits (assuming a formula that takes service into account), in which case the present value will be relatively larger. As such, a defined benefit plan will be attractive to a physician practice in which the physician is moderately close to retirement and has experienced a longer period of service, particularly in those cases in which the other participants are not close to retirement and have not experienced longer periods of service.

Consideration of the defined benefit concept in such a case is thus critical, since the annual deduction may actually well exceed the limitation with which most physicians are familiar (generally $41,000 or 100 percent of compensation for 2004 in the case of a traditional profit sharing plan). Therefore, a review of the existing retirement plans of a physician practice is warranted in such cases, and should be a normal part of the year-round and year-end tax planning process. In all respects, due to the significant complexity of the concept of the defined benefit plan, the benefits to be derived from such a review must be weighed against the cost associated with establishing and maintaining a defined benefit plan. Therefore, it is advised that the physician practice contact ERISA counsel and appropriate professional assistance (including an experienced actuary) in order to further explore this concept.