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Compensation Concerns for Sole Props and Partnerships
Norman Levinrad, EA, FSPA, MAAA
Summit Benefit & Actuarial Services, Inc.
The different types of Business Entities
C Corporations
S Corporations
Partnerships
Sole Proprietorships
Limited Liability Companies (LLCs)
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C Corporations
Profit taxed at corporate level at graduated rates (15% - 35%)
Exception for certain Personal Service Corporations - 35% from first dollar [IRC §§11(b)(2); 448(d)(2)]
Dividends taxed at shareholder level Owned by shareholders Liability separate from owners
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C Corporations
Deductions for contributions made on behalf of all employees (including owners) taken at corporate level
Deductions may cause losses resulting in carryback (2 years) or carryover (20 years)– May elect to waive c/b and instead just c/o
– Fiscal year PSCs may c/o only
– IRC §§172(b)(1)(A) / 172(b)(3) / 280H(e)
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C Corporation Loss – Example
Corporation expects taxable income of $0 in 2014 and $300,000 in 2015 (before any pension)
Cash from 2015 earnings will be available before 2014 tax return due
Max DB deduction $150,000/year based on age, etc.
Adopt DB plan in 2014 - fund $150,000 by due date
Creates loss of $150,000 in 2014 Fund plan for $150,000 for 2015 bringing 2015
taxable income to $150,000 (300,000 – 150,000) before NOL C/O– $150,000 NOL C/O from 2014 will reduce 2015– taxable income to $0 4
C Corporation Loss – Example
Accrual basis corporation has taxable income of $100,000 each in 2013 and 2014 but limited cashflow
2014 break-even but $200,000 excess cash flow due to collection of receivables
In 2014 adopt plan and create net operating loss of $200,000
Loss carried back to 2011 and 2012 and taxes paid during those years are recovered
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S Corporations
Profit “passed through” (taxed) to owners, taxed at individual level
Profits taxed proportionate to ownership interest (whether or not distributed)
‘S’ status is a tax election affecting only how corporation is taxed
– Liability still separate from shareholders– Owners treated as employees for plan
purposes
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S Corporations
Deductions for contributions made on behalf of all employees (including owners) taken at corporate level – IRS Form 1120S, line 17, “Pension, profit-
sharing etc. plans”.
Deductions may cause losses – usage depends on shareholder “basis”– Contributions to capital, shareholder loans to
corporation, undistributed prior earnings
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S Corporation Compensation
Compensation = W2 payroll
Shareholders have two forms of income:– W2 Payroll
– Pass-through (dividends) shown on K-1.
Pass-through income may not be recognized as compensation for plan purposes (Durando v. U.S., CA-9, 11/16/95; see IRS Fact Sheet 2008-25)
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S Corporation Health Insurance Benefits
Heath and accident insurance premiums paid on behalf of greater than two percent S corp shareholders are deductible and reportable by the S corp as wages for income tax withholding purposes on the W-2.
These benefits are not subject to FICA or FUTA taxes. The additional compensation is included in Box 1 (Wages) of the W-2 but would not be included in Boxes 3 and 5 of W-2.
Included as plan comp in all three standard definitions of comp.
What do you do to gather this info?
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Sole Proprietorships
Income taxed on personal income tax return - Schedule C
No separate liability from the owner
For plan purposes compensation for SE person is “earned income” – basically “net earnings from self employment” (NESE) as adjusted
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Sole Proprietorships and Plans
Deductions for contributions made on behalf of employees taken on Form 1040, Schedule C, line 19“Pension and profit-sharing plans”.
Deduction for contributions made on behalf of sole proprietor taken on Form 1040, line 28 “Selef-employed SEP, SIMPLE and qualified plans”.
If the deduction for the sole prop’s contributions are taken on the Sch C then this understates the SS taxes paid. Allocation between the two must be “reasonable”.
Check to Schedule SE however.
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Sole Proprietorships and Plans
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Self-Employment (SE) Tax
First multiply NESE by 92.35% Tax = 12.4% up to the Social Security taxable wage
base (TWB) for year ($113,700 for 2013; $117,000 for 2014; $118,500 for 2015) plus 2.9% of all NESE– Additional Medicare payroll tax of 0.9% on wages or
SE earnings above certain threshold, paid by employee, NOT employer
– Therefore does not affect ½ SE deduction or earned income for plan purposes
Outside W-2 income serves to reduce SE tax on NESE
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Example 1
Bette (age 51) has W-2 income of $60,000 from her regular employer
Bette also has Schedule C income of $150,000 from outside consulting
Bette has no employees
Bette wishes to maximize her contribution to a 401(k) plan
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Example 1 (cont’d)
Net earnings from SE $ 150,000
Multiply by .9235 138,525
Lesser this amount or TWB 113,700
Outside wages 60,000
Amount to tax at 12.4% 53,700
53,700 X 6.2% 3,329
138,525 X 1.45% 2,009
1/2 SE tax 5,338
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Example 1 (cont’d)
Net Earnings from Self Employment $150,000 ½ SE tax 5,338 Pre-pension Earned Income 144,662 Maximum PS (20% of
pre-contribution net) 28,932 Add 401(k) deferral 23,000 Total 51,932 Check PS:
$150,000 – 5,338 - $28,932 = $115,730$115,730 x 25% = $28,932
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Issues
Sch C “shared’ by spouses?– No such legal entity as a shared sole
proprietorship even if Sch SE splits the net income for SS tax payments.
– Important because you want them both to be eligible for the plan and past service may be an issue for a DB plan.
– Spouse must either be a sole proprietor with a separate Sch C, or a partner in a partnership, or a W2 employee.
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Issues
When is compensation paid to a sole proprietor? This is relevant in the context of a plan termination mid year. For example in a DB plan where the final year’s compensation affects the high 3 year average.– Is it paid on the last day of the year?
– Is it paid ratably through the year?
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Issues
The pension deduction cannot exceed the net earned income! No loss can be created in a sole prop via the pension deduction.
But….in a DB plan the minimum required contribution may exceed the net earned income.– There is no excise tax on the difference
between the required amount and the deductible amount.
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Example 2
John’s 2014 net Sch C income after the ½ self employment adjustment is $55,000.
The minimum required contribution for John’s DB plan is $70,000.
$70,000 is contributed, $55,000 is deducted. There is no excise tax.
What happens to the other $15,000? Can it be deducted in a future year? There is actually no statutory framework for this, but common sense says it has to be deductible.
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Issues – cont’d
EOY valuation for a DB plan sponsored by a sole proprietor is very challenging….you can’t quote a range between the min and the max since it will change the comp for plan benefits, change testing results etc..
BOY valuations are much easier – look back to prior year to determine plan compensation. No circular calc to run the BOY val.
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Partnerships
Profit passed through (taxed) to partners based on ownership % (or otherwise per partnership agreement)
General partner vs. limited partner – Income to general partners = earned income,
usually subject to SE tax
– Income to limited partners not earned income (not subject to SE tax).
Must be subject to SE tax to be compensation for plan purposes
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Type of Partnerships
An LLC is a limited liability company, sometimes referred to as a limited liability corporation, and an LLP is a limited liability partnership
LLCs and LLPs both provide personal asset protection from business debts and liabilities. However, in an LLC the members are not protected from the liability of another member, but an LLP does give this protection. For instance, if an LLC member in an engineering practice makes a client error that is legally actionable, the LLC and all of its members can be held liable. But if a partner in an LLP is legally liable for something, the other partners cannot be held jointly liable.
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Type of Partnership Both LLCs and LLPs can "pass through" earnings from the business
entities to the members or partners to avoid having to file corporate taxes on the earnings and paying personal income taxes on the same earnings, which is known as "double taxation." The difference is in how an LLC operates and the number of members it comprises. For instance, a single-member LLC is considered a sole proprietorship, and the IRS taxes the member as self-employed.
LLCs can be formed as S or C corporations and have to pay taxes on the same profits twice. However, LLP's are treated strictly as partnerships, and the partners pay taxes only on the earnings passed to them though the business.
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The Partnership Return
The partnership files an annual tax return (form 1065) to report revenue and expenses. The pension contribution for the employees is reflected like any other expense.
Sch K shows the income that are reported on the partner’s individual K-1’s.
The pension deduction for each partner is taken on their individual 1040 just like a sole proprietor.
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What do we calculate?
The amount of the employee contribution– We need to know how this is split between the
partners…you need to get this from them as it can change from year to year. It is not necessarily split on the basis of the partnership interests!
The ‘plan salary’ for each partner (their K-1 income less the ½ self employment adjustment less their pension contribution)
Again it’s a circular calculation.
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Example
Partner 1 Partner 2 TOTAL
Net earnings prior to employee cost, self employment tax deduction, and personal cost - line 14a on K1 or net schedule C for self employed 738,166.00 386,081.00 1,124,247.00
Section 179 deducted - if 179 is on K1, get deducted amount from Sch. E (N/A for SE) (enter zero if no schedule C) 0.00
Unreimbursed partnership expenses from Sch. E (N/A for SE) 0.00
Oil & gas depletion expense-line 16d2 on K1 (N/A for SE) 0.00
employee pension expense allocation % 50.00% 50.00% 100%
employee pension expense (enter total in total column) 13,975.82 13,975.82 27,951.63
Income subject to self-employ tax 724,190.19 372,105.19 1,096,295.37
0.9235 668,790.00 343,639.00 1,012,429.00
wage base 102,000.00 102,000.00 204,000.00
w2 income subject to SS tax - - 0.00
net taxable wage base 102,000.00 102,000.00 204,000.00
1/2 self-employ tax 16,021.00 11,307.00 27,328.00
Personal pension expense 135,000.00 75,000.00 210,000.00
Plan Salary 573,169.19 285,798.19 858,967.37 29
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Reading the K-1
Generally line 14a (“self-employment earnings (loss)” is the amount of income for the partner to be split between the ½ self employment adjustment, their individual pension contribution and their plan salary.
Generally line 14a represents the sum of the guaranteed payment (the payment to them for their services separate from their partnership share of income or losses) in line 4 and their share of the partnership income or loss in line 1.
Its helpful to get a preliminary Sch SE for each partner.
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Adjustments
Section 179 deduction – if 179 is shown on the K-1 get the deducted amount from Sch E
Unreimbursed partnership expense from Sch E Oil and gas depletion expense – line 20 code T. Ask the CPA what these adjustments should be! Distributions are adjustments to the capital account and
is money previously taxed. It is not included in ordinary income for the year.
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Reading the K-1
We generally get preliminary K-1 amounts before the employee share of the contribution for each partner is determined.
When we tell the client and CPA the employee contribution, they then reflect that on the 1065 and the final K-1 amounts are net of the employee contributions.
So when we get final K-1’s, we need to make sure we do not back out the employee expense again! Doh!
What do you do when a partner is also issued a W-2?
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Types of partners
Partner may be individual or corporation
Corporate partner income passed through to corporation and then corporation pays W2 income and is taxed like other corporate income (could be S or C corporation).
Make sure all of these corporations jointly adopt the plan otherwise their employees are not participants in the plan!
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“Partnership of PCs”
Common in medical and legal practices Corporate Partner receives distributive share of
partnership earnings Compensation for corporate owner is payroll
received from corporation Affiliated Service Group and deductions are
taken at each entity level.
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Partnerships and DB Plans –Issues
Reg. section 1.404(e)-1A(f)(2) says a partner’s deductible share of a DB contribution is determined in the same manner as his distributive share of partnership taxable income.
Bit of a problem if not all partners are in the DB, hey?
Clearly partnership agreements should probably have a special allocation section when there are DB or CB plans involved.
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Partnerships and Plans – Issues
Allocation methodology when multiple principals?– Allocation on TNC or FT or PVAB or CB
account only works if no changes ever to the formula or no new principals enter
– Allocation on (FT + TNC) / ( Tot Ft + Tot TNC); or (Boy CB + CB credit) / ( Tot BOY CB + Tot CB
credit)
Works fairly for most every scenario.
Partnerships and Plans – Issues
When is the partnership income earned? For example a plan defines compensation in the year of entry from the entry date. Someone becomes a partner mid-year. How is their compensation determined?– All earned on the last day of year?
– Earned ratably?
– Who knows? I don’t!
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Valuation Date Issues
Same as with Sole Props….EOY vals take more work. BOY valuations eliminate the circular calc.
How do you establish the expected compensation for a sole/prop partner on a BOY val?
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Change in Entity
From Unincorporated to Incorporated– Corporation must formally adopt plan prior to end of
corporate fiscal year
– There must be a reasonable allocation of deduction between entitiesCould be based prorata on wages covered in entities
Could be based prorata on months sponsored by each entity
– Make sure plan language is consistent with administration, e.g., prior service grants.
Same issue for a plan jointly sponsored by a sole prop and a corp.
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