April 22, 2016
By Peter Alwardt, CPA
The use of limited liability companies (“LLCs”) and their election to be treated as a partnership for tax purposes has increased significantly in recent years. As a result, we have seen confusion regarding which compensation is used to determine contributions to the company’s qualified retirement plan on behalf of the LLC members. Let’s examine the basic rules for determining the compensation for self-employed individuals: sole proprietors, partners, and LLC members treated as a partnership.
While it may seem obvious, under IRS Publication 560, not every individual who has net earnings from self-employment for purposes of Social Security tax payments is considered self-employed. For example, common law employees who are ministers, members of religious orders, full-time insurance salespeople, and U.S. citizens employed in the U.S. by a foreign government are not considered self-employed for retirement plan purposes and cannot establish their own retirement plans, even though their income is treated as from self-employment.
For qualified retirement plans, IRC Section 401(c)(1) treats partners in a partnership, LLC members of an LLC treated as a partnership, and sole proprietors as employees. If the individual is a sole proprietor or partner, he or she is also an owner-employee under IRC Section 401(c)(3). Either way, they cannot establish their own retirement plans to the exclusion of other employees or partners.
When an entity contributes to its retirement plan on behalf of a self-employed individual, that individual must have self-employment earnings. Under IRC Section 401(c)(2), the individual’s earnings from self-employment must be from a trade or business in which the individual’s services are a material income-producing factor. For example, if the individual is a partner who only contributes capital and not services, he/she cannot participate in the partnership’s retirement plan.
In an entity’s retirement plan, the earned income of a self-employed individual is his/her net earnings from self-employment as defined under IRC Section 1402(a). Under this section, net earnings from self-employment are the business’ gross income less allowable deductions from that income. This amount can be further adjusted by:
- Excluding items not includable in gross income, such as foreign earned income exempt under IRC Section 911 and deductions allocable to this income.
- Including gains—other than capital gains—on property sales created by the individual’s personal efforts, such as an artist’s income.
- Including earnings of certain classes of individuals exempted from self-employment tax as described above.
- Excluding deductions to a qualified retirement plan allowed under IRC Section 404 and 50% of the self-employment tax paid under Section 164(f).
For a partnership (other than limited), self-employment net earnings include the person’s distributive share of partnership income or loss, other than separately computed items such as capital gains and losses and guaranteed payments from the partnership. For a limited partner, net earnings from self-employment include only the guaranteed payments received for services rendered to or for the partnership.
Partners or LLC members treated as partnerships often defer salary contributions during a plan year based on their guaranteed payments. They then may discover after the end of the plan year, assuming the plan and partnership have the same year-end, that the partnership or LLC has a net loss. Accordingly, they do not have earned income for purposes of the retirement plan and cannot make any salary deferral contributions or receive any employer contributions. Thus, it becomes preferable for self-employed individuals to confirm they will have sufficient earned income before having contributions made on their behalf to a plan in years where they may potentially have a net loss from the partnership or the LLC. This could also apply to a sole proprietorship. Salary deferral contributions to a 401(k) plan on behalf of a self-employed individual may be made after the end of the plan year, provided that the election to defer the compensation is made prior to the end of the entity’s tax year.
Common issues that occur in reporting earned income for retirement plan purposes to an entity’s third-party plan administrator include failing to:
- Net guaranteed payments with the partner’s or LLC member’s share of the distributive income or loss.
- Report the net income from all related entities that participate in the retirement plan. This can occur when related LLCs and members receive income or losses from more than one of the entities, and these amounts are not netted for determining earned income of their retirement plan.
- Have related self-employed businesses adopt the retirement plan so that earned income from all businesses is considered for the plan.
Self-employed individuals need to correctly calculate their earned income for purposes of any qualified retirement plans in which they participate. This does not usually present a problem for sole proprietors unless they have multiple businesses reported on separate Form 1040 Schedules C. It is imperative partnerships and LLCs consult with their third-party administrators so that they understand what and how income for partners and members should be calculated for their retirement plans. Without the proper approach, they might either under- or over-contribute to the retirement plan, both of which can trigger IRS penalties.