Compensation of Self-Employed Participants for Purposes of Qualified Retirement Plans
The use of limited liability companies (LLCs) has increased over the years as a form of doing business. These entities frequently elect to be treated as a partnership for tax purposes, and as such, we have seen confusion regarding what compensation is used to determine contributions to the company's qualified retirement plan on behalf of members of the LLC. Below is a discussion of the basic rules for determining the compensation for self-employed individuals (sole proprietors, partners in a partnership, and members of an LLC taxed as a partnership).
Who is Self-Employed?
Stating the obvious, under IRS Publication 560, a self-employed individual is one who is in business for himself or herself, and includes sole proprietors and partners. However, not every individual who has net earnings from self-employment for purposes of social security tax payments is considered self-employed. Specifically, 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 set up their own retirement plan even though their income is treated as self-employment income.
For purposes of participating in qualified retirement plans, Internal Revenue Code (IRC) section 401(c)(1) treats partners in a partnership (and LLC members of an LLC treated as a partnership) and sole proprietors as employees. If the individual is a sole proprietor or a partner, they are also owner-employees under IRC section 401(c)(3). In either case, they cannot set up their own retirement plan(s) to the exclusion of the other employees or partners (if in a partnership).
Net Earnings from Self-Employment
To have the entity make a contribution to the entity's retirement plan on behalf of the self-employed individual, the individual must have earnings from self-employment. 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 that only contributed capital and does not provide services to the partnership, he cannot participate in the partnership's retirement plan.
For purposes of the entity's retirement plan, the earned income of a self-employed individual is his or her net earnings from self-employment as defined under IRC section 1402(a) with several modifications. Under section 1402(a), net earnings from self-employment are the business' gross income less allowable deductions from that income. This amount is further adjusted as follows, if applicable:
- 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 sales of property created by the individual's personal efforts (for example, a sculptor's income from the sale of his sculpture or an author's net earnings under a royalties license).
- Including earnings of certain classes of individuals exempted from self-employment tax such as ministers, members of religious orders, full-time insurance salespeople, and U.S. citizens employed in the U.S. by a foreign government.
- Excluding deductions to a qualified retirement plan allowed under IRC section 404 and one-half of the self-employment tax paid under section 164(f).
For partners in a partnership (other than limited partners), net earnings from self-employment include the partner's distributive share of partnership income or loss (other than separately computed items such as capital gains and losses) and any guaranteed payments received from the partnership. This amount is reported on Form K-1, line 14 (code A). This amount is further reduced by the amount of the following items, if applicable:
- IRC section 179 expense deduction.
- Partnership expenses the partner paid personally and deducted on their Form 1040, Schedule E as unreimbursed partnership expenses.
- Oil and gas depletion.
If the individual is a limited partner, net earnings from self-employment include only the guaranteed payments the individual receives for services rendered to or for the partnership.
Not infrequently, partners or LLC members (of LLCs treated as partnerships) make salary deferral contributions during a plan year based on their guaranteed payments and then find out after the end of the plan year (assuming the plan and the 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. Therefore, it is generally preferable for self-employed individuals to wait until it is clear that they will have sufficient earned income before having any 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 principle could also apply to a sole proprietorship. It should be noted that 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.
Some of the more 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.
- Failing to report the net income from all related entities that participate in the retirement plan. This occurs, for example, when there is a structure of related LLCs for tax purposes and the members receive income or losses from more than one of the entities and these amounts are not netted for purposes of determining earned income for purposes of their retirement plan.
- Failing to have related businesses as determined under IRC sections 414(b), (c), and (m) [see our whitepaper on controlled groups] adopt the retirement plan so that earned income from all businesses is considered for the plan.
It is important for self-employed individuals to correctly calculate their earned income for purposes of any qualified retirement plans in which they participate. For sole proprietors, this does not usually present a problem unless they have multiple businesses reported on separate Forms 1040 Schedules C. For partnerships and LLCs, it is imperative that they consult with their third-party administrator so that they understand what and how income for partners and members should be calculated for purposes of their retirement plan. Otherwise, they could find themselves in a situation where they are under- or over-contributing to the retirement plan, both of which are unacceptable to the IRS and may be subject to penalties.