This Issue Snapshot will discuss the calculation of plan compensation for partnerships that maintain qualified retirement plans under IRC Section 401 and SEP IRA plans under IRC Section 408(k). IRC Sections and Treas. Regulations IRC Section 164 IRC Section 401 IRC Section 404 IRC Section 415 IRC Section 701 IRC Section 703 IRC Section 705 IRC Section 707 IRC Section 1402 Resources Publication 560, Retirement Plans for Small Business (SEP, SIMPLE and Qualified Plans) Form 1065, U.S. Return of Partnership Income Schedule SE (Form 1040), Self-Employment Tax Schedule E (Form 1040), Supplemental Income and Loss Schedule K-1 (Form 1041), Beneficiary's Share of Income, Deductions, Credits, etc. LaFlamme v. Comm'r, T.C. Memo 2012-36 Analysis Earned Income: For self-employed individuals, IRC Section 404(a)(8)(D) provides that "earned income," as defined in IRC Section 401(c)(2) (Earned Income), must be used in place of "compensation" when computing the deductible limit under IRC Section 404(a)(3). Generally, while Earned Income is attributable to the individual's personal services in conducting a trade or business, "compensation" is remuneration for an employee's personal services received in the course of employment by an employer. Self-employed individuals are usually sole proprietors or partners. Under IRC Section 404(a)(8), contributions to a qualified plan made on behalf of a self-employed individual (including a partner) are considered to satisfy the requirements for deductibility under IRC Sections 162 and 212 to the extent those contributions do not exceed the Earned Income of the individual (determined by increasing that amount by the deductions allowed under IRC Section 404) and are not allocable to the purchase of life, accident, health, or other insurance. Earned Income is used to apply rules to plans covering self-employed individuals in the following plan areas: allocations, accruals, deductions, IRC Section 401(a)(4) nondiscrimination, and IRC Section 415 Limits. Earned Income is also relevant for purposes of computing the limit under IRC Section 401(a)(17). For purposes of applying some of these rules, adjustments specified in the IRC and Treas. Regulations are made to a self-employed individual's Earned Income. Partner's Earned Income: A partnership, unlike a sole proprietorship, is a separate legal entity that reports its income on Form 1065. However, the partnership does not pay taxes. Instead, the partnership items are divided among the partners (according to the terms of their agreement) and reported on Schedule K-1 and on the partners' individual tax returns. See IRC Section 701. The partnership is the employer for retirement plan purposes and sponsors the retirement plan for the organization. The partner is treated as the employee-participant in the plans. See IRC Section 401(c)(3) and (4). Contributions made by the partnership to a pension plan on behalf of a partner are reported on box 13 of Schedule K-1 (Code R), and are reported on Schedule 1 (line 16) to Form 1040 as self-employed retirement plan contributions. Definition of Earned Income If none of the adjustments under IRC Section 401(c)(2)(A)(i) through (iv) apply for a taxpayer who is a partner, the taxpayer's Earned Income is equal to: Net Earnings from Self-Employment (NESE) (IRC Sections 401(c)(2) and 1402(a)) Adjusted under IRC Section 401(c)(2) by subtracting 1/2 Self Employment (SE) tax paid (IRC Section 164(f) deduction) Adjusted by subtracting the partner's deduction for contributions to the plan on his or her own behalf A partner must separately calculate Earned Income for each trade or business. IRC Section 401(d) states that a plan covering owner-employees (including partners) must provide that contributions on behalf of an owner-employee may be made only with respect to the Earned Income of the owner-employee that is derived from the trade or business with respect to which the plan is established. Partner's net earnings from self-employment IRC Section 1402(a) generally defines the term "net earnings from self-employment" as the gross income derived by an individual from any trade or business carried on by such individual, less certain deductions which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in IRC Section 702(a)(8) from any trade or business carried on by a partnership of which he is a member, with certain enumerated exclusions. Not all partners will have NESE, and a partner who does not have NESE does not have Earned Income for retirement plan purposes. A contribution to a qualified plan made by a partnership on behalf of a partner is deductible by the partner (subject to applicable limits), but is not an expense of the partnership that is included in the partner's distributive share of partnership deductions. Therefore, a partner's NESE reflects the partner's distributive share of deductible contributions to a qualified plan made on behalf of the partnership's employees, but does not reflect any subtraction for contributions made on behalf of partners. (LaFlamme v. Commissioner, T.C. Memo 2012-36) Partners with NESE compute SE taxes on Schedule SE. General partners pay SE tax on their 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 that are derived from a trade or business, less certain deductible amounts reflected on Form 1040, Schedule E, line 28 (such as certain unreimbursed partnership expenses paid by the partner). Distributive shares are reflected on Schedule K-1, box 1 as Ordinary Business Income (or loss). Limited partners pay SE tax on guaranteed payments for services rendered to or on behalf of the partnership. However, whether a partner qualifies as a limited partner for purposes of SE tax depends upon whether the partner meets the definition of a limited partner under IRC section 1402(a)(13). A partner's SE Earnings are shown on Schedule K-1, box 14 Guaranteed payments Guaranteed payments are payments made to a partner throughout the year to compensate that partner for personal services or for the use of capital. If paid for services, they may be thought of as a "salary equivalent." Unlike the distributive share reported on Box 1 of Schedule K-1, the amount of a guaranteed payment is determined without regard to partnership profits. Guaranteed payments made to a limited partner are included in NESE only to the extent they are made for services the limited partner actually rendered to, or on behalf of, the partnership. Thus, for example, guaranteed payments that are made to compensate a limited partner for the use of capital are not included in the limited partner's NESE, even if the limited partner also receives guaranteed payments for services rendered to the partnership. A general partner's receipt of guaranteed payments does not ensure the partner will have positive Earned Income for the year. See IRC Section 707(c).
