Compensation for employees is some variation of taxable wages reported on Form W-2. For allocation purposes, the employer or payroll provider downloads the census and compensation data based on the plan’s definition of compensation into a spreadsheet at the end of the year. It’s a little more complicated, of course, but let’s leave it at that for purposes of this post. But if you’re a sole proprietor, partner in a partnership, or member of an LLC taxed as a partnership, it’s definitely more complicated. Here’s why.
Instead of the appropriate variation of taxable wages, “Earned Income” is the basis for retirement plan allocations for sole proprietors, partners, and LLC members. It can be the Internal Revenue Code version of a Rubik’s Cube. Take a look at a standard retirement plan definition:
“Earned Income” means the net earnings from self-employment in the trade or business with respect to which the Plan is established, for which personal services of the individual are a material income-producing factor. Net earnings will be determined without regard to items not included in gross income and the deductions allocable to such items. Net earnings are reduced by contributions by the Employer to a qualified plan to the extent deductible under Code section 404. Net earnings shall be determined with regard to the deduction allowed to the taxpayer by Code section 164(f) for taxable years beginning after December 31, 1989.
There’s actually more to it than that so it’s a set of calculations best left to your accountant. But please keep reading, there are a few basics you should keep in mind.
1. The Internal Revenue Code considers sole proprietors, partners in a Partnership, and members of an LLC taxed as a Partnership as employees for purposes of participating in a retirement plan. This means even though in fact they are owners, they cannot establish their own retirement plans to the exclusion of other employees or partners.
2. Net earnings for these individuals include the partner’s distributive share of partnership income or loss (other than some separately computed items) and any guaranteed payments received from the partnership.
3. For the aforementioned limited partner, net earnings from self-employment include only the guaranteed payments the individual receives for services rendered to or for the partnership.
As third party administrators of retirement plans in which sole proprietor, partnerships, and members of LLCs participate, we offer up a few takeaways for you to consider.
401(k) Contributions Based on Guaranteed Payments. Partners or members of LLCs taxed as partnerships often make 401(k) contributions during the year based on guaranteed payments. But at the end of the year, they find out that the partnership or LLC has a net loss. Thus, they have no earned income for retirement plan purposes and cannot make any 401(k) contributions or receive any employer contributions. Sometimes it’s better to wait until the year-end to know that there will be sufficient earned income.
Related Businesses. Sometimes for tax purposes, there is a structure of related LLCs that participate in the retirement plan. Thus, members of the related LLC will receive income or losses from more than one. These amounts need to be netted for purposes of determining earned income.
Control Groups. On a related (pun intended) note, entities that are members of a control group must be taken into account irrespective of whether they are participating employers. Not only for purposes of determining earned income but also for the purposes of meeting ERISA compliance requirements.
So to avoid situations of under-contributing or over-contributing contributions to their retirement plans, sole proprietors, partners, and LLC members should always review their situations with their accountants.