Scott D. Fletcher is the President of and a Principal in Fletcher Law Firm, P.A., in Little Rock, Arkansas. Fletcher Law Firm is a tax law firm that provides full service plan administration services to employers and plan sponsors and provides outsourced plan administration to third-party administrators, financial institutions, accountants and other professionals. [scott@fletcherlawfirm.net]
How would you like to know how to turn every $1.00 into $1.50 overnight? The last great tax shelter for a McDonald's franchisee is a retirement plan. With a retirement plan, money is put in a retirement account for the owner (and generally others). For every dollar put into the account, the owner gets to keep either the whole dollar or at least a substantial part for themselves. Then, Uncle Sam gives them an income tax deduction for putting the money in the account. Because the combined current federal and state income tax rates could amount to 50% or more, if just one dollar was put in the account, the owner would be trading $1.00 for $1.50 (the 50¢ coming in the form of an income tax reduction or even a tax refund). Would you like to make this type of money overnight? If so, read on because this article is intended to show you how.
According to many advisors of McDonald's franchisees, many owners do not have any retirement plan because of the number of employees. Those who do have a plan usually only have a 401(k) plan. In an article in the February 1999 issue of Financial Planning magazine, the author, Donald Jay Korn, noted that "while 401(k) plans remain popular, there are situations in which defined benefit [retirement] plans may be better for clients." McDonald's franchisees are just those clients who are often better off! Mr. Korn researched who would be better off by interviewing many accountants, actuaries and tax attorneys and determined that the ideal client is found "when the principals of a company are in their late forties or older while most employees are younger, with a high turnover rate. In such circumstances, large amounts can be contributed on behalf of the principals and relatively little to the accounts of the rank and file." This defines the typical McDonald's franchisee.
So, why is a defined benefit plan better than a 401(k) or other defined contribution plan? The answer is funding limits and employee costs. With a defined contribution plan, the money put in the plan (called the contribution) is defined as a percentage of salary and the percentage for the employees must generally be the same as that of the owner. This means high employee costs. Also, with 401(k) and other defined contribution plans, a $30,000.00 per participant ceiling applies. Even in 2000, to actually accomplish this level of funding two or more defined contribution plans are required, which can get expensive. This limit does not apply with respect to defined benefit plans. Therefore, plan funding can be significantly more than $30,000.00 for the owner with a defined benefit plan. Mr. Korn also pointed out that his research revealed that the maximum pretax contribution in a 401(k) plan by an employee (including an owner) is $10,000.00, which is "not significant to someone with a large income. Moreover, a certain percentage of the rank-and-file must contribute to a 401(k). If they don't, employers may have to make 401(k) contributions for lower-compensated employees or reduce the amount that highly compensated employees may contribute. In some cases, principals may not be allowed to contribute even the $10,000.00 maximum."
The reason the rules for a defined benefit plan are so different is because the nature of the plan is so different. The traditional defined benefit plan is where the employer promises to provide its employees (including the owner) a specific amount of income called the "defined benefit" at retirement. In order to provide the owner with an income of $100,000.00 per year, adjusted for inflation, when he or she attains 58, as much as $1,000,000.00 or more may have to be accumulated prior to the owner reaching that age. In order to have at least $1,000,000.00 for the owner at retirement, the amount of the plan contributions will be substantially more than just $30,000.00 per year.
Taking this theory and putting it into practice is what Fletcher Law Firm, P.A. did in 1999 when a defined benefit plan was designed for a McDonald's franchisee with 271 employees which permitted the franchise to fund $458,270.00 into the plan, with $433,052.00 (94.5% of the total contribution) going to the owner and the owner's spouse. Just think, a reduction in income taxes of up to $216,526.00 in 1999! Better yet, the money in the retirement account cannot be touched by any creditors and the money grows tax-free. At just a 10% per year rate of return, money doubles every 7 years. Can you imagine how much $433,052.00 can grow to by the owner's retirement? Now, think about doing this for up to ten (10) years or even more. The numbers can get astronomical. Unfortunately, not all McDonald's franchisees are taking advantage of this legal tax shelter.
This strategy also rewards only those employees who are loyal and remain with the owner for a number of years. In the above example, a "vesting period" of six years was used. This means that even though money was put in the plan for the rank and file, if they leave before six years, they do not get all of it. In fact, a portion of the money put in the account for them will remain in the account after they leave thereby increasing the amount that is transferred to the remaining participants, namely the owner.
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Because of the high turnover rate of the McDonald's rank and file employees, many will not get any percentage at all. The six year graded vesting period permits an employee to become vested over time based on a percentage for each year of employment once becoming a participant in the plan. Below is a chart which reflects the applicable percentages by year:
| Year |
Percentage |
| 1 |
0% |
| 2 |
20% |
| 3 |
40% |
| 4 |
60% |
| 5 |
80% |
| 6 |
100% |
Thus, an employee would have to remain with the owner for six years to receive all of their money. If they left early, some of the money would not leave with them. For example, if an employee's account balance was $5,000.00 and they chose to leave immediately after the third year, they would leave with $2,000.00 ($5,000.00 x 40%) and the remaining $3,000.00 would stay in the plan thereby putting more money in the owner's account.
One of the experts Mr. Korn interviewed indicated that in "organizations where the principals are considerably older than their employees, and the principals are making a great deal of money" as much as "85% to 90% of the amounts contributed go to the principals' accounts." Does this not sound like a McDonald's franchisee with the older owner making most of the money and the younger rank and file employees making slightly over minimum wage? Generally, Fletcher Law Firm, P.A. designs it's defined benefit plans where the owners receive 90% or more of the total amounts put in the defined benefit plan. If the employee costs are too high, it is also possible to restructure the organization in order to reduce the employee costs or concentrate the employee costs for managers or other persons who are not allowed to own more than 25% of the McDonald's franchise.
For example, in 1999 Fletcher Law Firm, P.A. designed a strategy to allow a defined benefit plan to be sponsored by and put into a separate equipment leasing company that a 48-year-old McDonald's franchisee owns in part and works for in part. Of course, rent is paid by the McDonald's franchise store to the equipment leasing company. Then, with a salary of just $59,250.00, as much as $100,256.00 could be funded into the defined benefit plan for the McDonald's franchisee and spouse which is sponsored by and put in the equipment leasing company. As shown by this example, it does not take a high salary to put a significant amount of money into a defined benefit plan on an annual basis and the employee costs can be minimal.
One of the misconceptions concerning a defined benefit plan is that once you start putting in money, you are stuck putting in the same amount of money every year. This is not true. The defined benefit plan can be designed to allow significant funding in years that are good and very little funding in years that are not so good. Thus, the defined benefit plan is very flexible for the McDonald's franchisee.
Thanks to legislation signed into law and effective beginning January 1, 2000, the problem of funding a defined benefit plan after already having in place a defined contribution plan or 401(k) plan has been completely eliminated. This is "a blessing for an employer who is trying to maximize plan benefits and contributions" according to Lorraine Dorsa, the author of an article in the Autumn 1999 issue of the Journal of Pension Benefits. Ms. Dorsa concluded that "as the baby boomers age and reach the point (generally age 45 or so) in which a defined benefit plan can provide a contribution of significantly more than $30,000, a defined benefit plan may be the plan of choice" even if a 401(k) or other defined contribution plan has been in place in light of the recent change in the law, namely the repeal of Internal Revenue Code Section 415(e).
In addition to defined benefit plans being beneficial for funding on an annual basis, they are perhaps even more useful when a McDonald's franchise or other business is sold. Generally, when a business is sold, significant income taxes are paid in the year of the sale whether capital gain tax treatment applies or not. Over the years, many clients of Flecther Law Firm, P.A. in a number of different states who own McDonald's franchise stores have sold their franchise without paying significant income taxes. For example, Fletcher Law Firm, P.A. designed a strategy for one franchisee that operated as a C corporation to sell a store in 1999 and not pay any income taxes since $327,533.00 was funded into a defined benefit plan for only the owner (age 42) and the owner's spouse (age 36). Another client was able to sell its business without paying any income taxes since $755,658.00 was funded into a defined benefit plan for the owner and his family. Therefore, no matter whether a C corporation or an S corporation or some other business entity, help is just a toll-free telephone call away.
For more information or to discuss your situation with the author, please contact Scott D. Fletcher of Fletcher Law Firm, P.A. by telephone toll-free at (866) 907-7600 or by e-mail at scott@fletcherlawfirm.net. There is no charge for the initial consultation. References of franchisees, certified public accountants, certified financial planners, attorneys and other professionals are available upon request.
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