Tax credits are every business owner’s best friend when it comes to saving money and enjoying the business’s income profits. Tax credits are not tax deductions; there is a difference. Tax deductions reduce taxable income, while tax credits reduce income taxes owed. Therefore, one area every business owner should peek into is that of business tax credits.  

Because, as mentioned earlier, tax credits reduce a business’s taxes dollar-for-dollar. There are several different tax credits available for small businesses across the US. One crucial tax credit is the Retirement Plan Startup tax credit. This blog dives into the tax credit’s purpose, requirements, and other limitations.

Retirement Plan Startup Tax Credit
The tax credit is an excellent source for eligible small businesses considering starting a retirement plan for their employees. The retirement plan can be a SEP, a qualified plan (for example, a 401K), or a Simple IRA. The beauty of the credit is that a business can take it for three (3) years. The IRS Form used to calculate the tax credit is Form 8881. Next, let us look at the purpose of the Retirement Plan Startup Tax Credit.

Purpose of The Tax Credit
The Retirement Plan Startup tax credit is for the purpose spelled out in its name; it is a tax credit a business can apply against the retirement plan startup costs it has (or will) incur. Eligible startup costs care a) setup and administrative costs b) the cost of educating employees about the plan.

There is a $5,000 tax credit limit for each year. However, a business’s tax credit could be as low as $500. Before we look at how to determine how much credit a business can apply, we will look at some of the requirements for a business to be eligible for the credit.

For a business to take the Retirement Plan Startup tax credit, it must meet the IRS requirements. The three main requirements are:

  • The business must have at least one plan participant who is not a highly compensated employee, also known as a NHCE
  • The business must have 100 or fewer employees who received at least $5,000 in compensation in the preceding year
  • In the three tax years before the first year that the business is eligible for the credit, its employees were not primarily the same employees who received contributions or accrued benefits in another plan sponsored by the business, a member of a controlled group which includes the business’s owner(s), or a predecessor of either.

Note that a highly compensated employee is someone who either 1) owns more than 5% interest in the business or earned more than a certain amount in the previous year ($135,000 for 2023), or 2) an employee who was ranked in the top 20% of earners at the company.

With the three main requirements spelled out, let us now consider how much tax credit a business can apply in a given year.

How Much of the Tax Credit Can Be Applied
The tax credit upper limit is $5,000 for a given year. The lower threshold is $500. How does a business know how much of the credit to apply? Let us turn to the IRS rule. The rule states that a business with 1-50 employees may deduct 100% of the tax credit using the guidelines below. If a business has 51-100 employees, it is limited to only 50% of the eligible startup costs up to the greater of:

  • $500, or
  • The lessor of either –
    • $250 multiplied by the # of NHCEs eligible to participate in the plan OR
    • $5,000

Confusing? Let us use an example to make things clearer. Company Z has 60 NHCEs and startup costs of $8,000. We first calculate the amount of eligible startup costs that can be considered for the tax credit, that is, $8,000 X 50%, or $4,000. Next, we multiply 60 by $250 = $15,000. That is greater than $500, so we move on to the second bullet point above. The lesser of $5,000 and $15,000 is $5,000.

If Company Z’s considered tax credit was more than $5,000, we would apply the tax credit limit of $5,000. However, remember that the limit for them is $4,000. Therefore, Company Z can only apply a $4,000 tax credit if it meets all the tax credit requirements.

Now, let us assume Company Z has 20 NHCEs and $5,000 in startup costs. The entire $5,000 startup costs can be considered for the tax credit since the NHCEs are less than 51. Next, we multiply $250 by 20 = $5,000. This is greater than $500, so we move on to the second bullet point above. The lesser of $5,000 and $5,000 is $5,000. Therefore, Company Z can take a tax credit of $5,000 (which equals its total startup costs) as long as it meets all the tax credit requirements.

Other Limitations
At least two (2) other limitations should be considered when considering the Retirement Plan Startup tax credit.

  1. A business can not apply the startup costs as both a tax deduction and a tax credit, and
  2. If the retirement plan is a solo 401K plan, the tax credit cannot be applied because the owner is the business’s only employee.

The rules and calculations for the tax credit can be confusing. Therefore, it is advisable to seek the assistance and expertise of a CPA or tax accountant.

DISCLAIMER: The information provided herein does not constitute the provision of legal advice, tax advice, accounting services, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional legal, tax, accounting, or other professional advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation and for your particular state(s) of operation.