Creating ability to make 401K contribution

[Guest forohonek]

I read about this in a just published book and would like some citations to either support or challenge the concept.

Facts: Sole proprietor, materially participating, no employees. The trade or business has a good gross income level but he expects to have little or no net taxable income on his Sch C for the year, yet he wants to maximize his solo-401K/ProfitSharingPlan contribution.

Solution: form a SMLLC Single-member LLC and have the 1st Sch C "hire" the SMLLC (a 2nd Sch C) to preform administration/management services.

End of year: Sch C #1 has a $200,000 loss (including the fees paid to the SMLLC)

Sch C #2, The SMLLC (Sch C #2), has a $200,000 profit (solely from the fees paid to it by Sch C #1). Taxpayer establishes a solo-401K/ProfitSharingPlan for the trade or business represented by the SMLLC.

He is now able to pay in the maximum for the year based on the $200,000 net income shown on Sch C #2.

The book's author claims that the key here is that the Sch C #2 is represented by a SMLLC (rather than simply a non-entity trade of business filing a Sch C).

If this "works" why does it "work" only with an SMLLC Sch C but does not "work" with a non-entity trade or busienss Sch C?

Any authoritave citations (pro or con) will be appreciated.

[Alf]

Why 200K? Not that any of this would fly, but wouldn't you just use $42K?

[Blinky the 3-eyed Fish]

I can say it doesn't work on just a Sch C because you can't deduct any more than the SE income. With no positive Sch C income your deduction would be $0. I don't know enough about the scheme proposed to comment, other than it seems suspicious.

Alf, what is the significance of $42k? Remember the deduction rules will require higher compensation to get to that level of contributions.

[Guest forohonek]

I can say it doesn't work on just a Sch C because you can't deduct any more than the SE income.  With no positive Sch C income your deduction would be $0. 

That statement is not quite correct. The law is that you can't deduct any more than the adjusted SE income from the particular trade or business that is associated with the plan. Whether there is positive net SE income from a group of Sch C's has no bearing on the allowability of the deduction based on ONE of the Sch C's.

[mbozek]

Foro: Can you explain the ultimate tax benefit of this transaction? Ignoring the question of whether the services paid to the SMLLC are reasonable comp it seems that there is no economic purpose to the creation of the LLC other than to generate a tax loss to the sole proprietor who owns the sked C business. Under the Tax law signed in Oct. there are increased penalties for tax avoidance transactions that are entered into just to generate tax losses including penalites of 75% or more plus interest. You really need to consult a tax advisor not just read books. By the way what is the name of the book?

[Blinky the 3-eyed Fish]

That statement is not quite correct. The law is that you can't deduct any more than the adjusted SE income from the particular trade or business that is associated with the plan. Whether there is positive net SE income from a group of Sch C's has no bearing on the allowability of the deduction based on ONE of the Sch C's.

Can you provide a cite?

Anyway, what about the 415 limit? 415 compensation is aggregated amongst the related employers and your net comp would be $0, resulting in $0 allowable annual additions.

[Guest forohonek]

Can you explain the ultimate tax benefit of this transaction? Ignoring the question of whether the services paid to the SMLLC are reasonable comp it seems that there is no economic purpose to the creation of the LLC other than to generate a tax loss to the sole proprietor who owns the sked C business.

Of course the price paid for the services must be reasonable.

There is no net, net tax loss generated... if one Schedule C has a $200,000 deductible fee paid... The Schedule C that receives the $200,000 has taxable income... dollar-for-dollar.

[Guest forohonek]

Can you provide a cite?

2003 returns IRS Publication 560 section 4, "contributions" "Self-employed individual. You can make contributions on behalf of yourself only if you have net earnings (compensation) from self-employment in the trade or business for which the plan was set up..."

IRS Code § 401. Qualified Pension, Profit-sharing, And Stock Bonus Plans

IRS Code §401(d) Contribution Limit On Owner-employees.--

A trust forming part of a pension or profit-sharing plan which provides contributions or benefits for employees some or all of whom are owner-employees shall constitute a qualified trust under this section only if, in addition to meeting the requirements of subsection (a), the plan provides that contributions on behalf of any owner-employee may be made only with respect to the earned income of such owner-employee which is derived from the trade or business with respect to which such plan is established.

IRS Code §404(a)(8) Self-employed Individuals

IRS Code §404(a)(8)© the contributions to such plan on behalf of an individual who is an employee within the meaning of section 401©(1) shall be considered to satisfy the conditions of section 162 or 212 to the extent that such contributions do not exceed the earned income of such individual (determined without regard to the deductions allowed by this section) derived from the trade or business with respect to which such plan is established, and to the extent that such contributions are not allocable (determined in accordance with regulations prescribed by the Secretary) to the purchase of life, accident, health, or other insurance; and

IRS Code §404(a)(8) Self-employed Individuals

IRS Code §404(a)(8)(D) any reference to compensation shall, in the case of an individual who is an employee within the meaning of section 401©(1), be considered to be a reference to the earned income of such individual derived from the trade or business with respect to which the plan is established.

IRS Regs § 1.401-10 Definitions relating to plans covering self-employed individuals.

IRS Regs 1.401-10(b)(2) If a self-employed individual is engaged in more than one trade or business, each such trade or business shall be considered a separate employer for purposes of applying the provisions of sections 401 through 404 to such individual. Thus, if a qualified plan is established for one trade or business but not the others, the individual will be considered an employee only if he received earned income with respect to such trade or business and only the amount of such earned income derived from that trade or business shall be taken into account for purposes of the qualified plan.

Anyway, what about the 415 limit? 415 compensation is aggregated amongst the related employers and your net comp would be $0, resulting in $0 allowable annual additions.

IRS Regs § 1.401-10 Definitions relating to plans covering self-employed individuals.

IRS Regs 1.401-10(b)(2) If a self-employed individual is engaged in more than one trade or business, each such trade or business shall be considered a separate employer for purposes of applying the provisions of sections 401 through 404 to such individual. Thus, if a qualified plan is established for one trade or business but not the others, the individual will be considered an employee only if he received earned income with respect to such trade or business and only the amount of such earned income derived from that trade or business shall be taken into account for purposes of the qualified plan.

[austin3515]

Does the use of the term "trade or business" put the kabash on any of this? We can all see right through what's really happening. The "business" includes the management company because every business must have management. I could see if they were paying an unrelated 3rd party, but everything here is coming back to the same guy...

The additional tax deduction generated from this scheme (thereby making it possibly subject to the avoidance penalties) would be the PS contribution itself.

[Guest forohonek]

Does the use of the term "trade or business" put the kabash on any of this?  We can all see right through what's really happening.  The "business" includes the management company because every business must have management. I could see if they were paying an unrelated 3rd party, but everything here is coming back to the same guy...

The additional tax deduction generated from this scheme (thereby making it possibly subject to the avoidance penalties) would be the PS contribution itself.

I'm looking for citations to either attack the concept written up in the tax book or to support the concept.

Any verifiable citations, pro or con, will be appreciated!!

[GBurns]

What is the name of this book and how can I get 1??

I do not think that anyone should either attack or support any concept until after the promoter of that concept proves that the concept. It is for the promoter to cite and relate etc nor for us to speculate. The speculation, criticism or support should come after disclosure, explanation and proof.

[austin3515]

Sure, but gosh it's fun to talk about this stuff...

[Guest Robin S. Vatalaro]

Going back to the original post, how would you prep the 1040? An individual with two Sch C's is going to have the bottom line's of those two Sch C's aggregated during 1040 preparation for purposes of computing Sch SE (self employment tax). In the original scenario, net earnings from SE is 0. So there is no "comp" on which to base any contribution. Sch C for a sole member LLC is no different than Sch C for a sole prop. A sole member LLC is a disregarded entity for tax purposes. All the tax software programs would get a bad case of the hiccups trying to compute a retirement contribution based on the scenario in the original post.

[jquazza]

Foronek,

I think with unrelated entities, you wouldn't have a problem. The fact that the individual is the sole member of both LLCs makes them a controlled group and therefore treated as a single employer for pension purposes. I will have to agree with Blinky, it smells fishy (and Blinky knows about fish.)

Sure, but gosh it's fun to talk about this stuff...

Austin, I think you need to get out more often...

[Guest forohonek]

Going back to the original post, how would you prep the 1040?  An individual with two Sch C's is going to have the bottom line's of those two Sch C's aggregated during 1040 preparation for purposes of computing Sch SE (self employment tax).  In the original scenario, net earnings from SE is 0.  So there is no "comp" on which to base any contribution.  Sch C for a sole member LLC is no different than Sch C for a sole prop.  A sole member LLC is a disregarded entity for tax purposes.  All the tax software programs would get a bad case of the hiccups trying to compute a retirement contribution based on the scenario in the original post.

While I do agree with your characterizion generally of how some generic tax preparation software would respond, that is not how the law reads.

I gave the citation for this above. Here it is again:

IRS Regs § 1.401-10 Definitions relating to plans covering self-employed individuals.

IRS Regs 1.401-10(b)(2) If a self-employed individual is engaged in more than one trade or business, each such trade or business shall be considered a separate employer for purposes of applying the provisions of sections 401 through 404 to such individual. Thus, if a qualified plan is established for one trade or business but not the others, the individual will be considered an employee only if he received earned income with respect to such trade or business and only the amount of such earned income derived from that trade or business shall be taken into account for purposes of the qualified plan.

[Guest forohonek]

I think with unrelated entities, you wouldn't have a problem.  The fact that the individual is the sole member of both LLCs makes them a controlled group and therefore treated as a single employer for pension purposes.  I will have to agree with Blinky, it smells fishy (and Blinky knows about fish.)

You've touched on the main thrust of my inquiry... But first a correction: The scenerio in the book calls for one sole proprietorship Sch C and one SMLLC dsgrgarded entity Sch C both apprearing on the same form 1040 for a single unmarried taxpayer. The formation of the SMLLC is a key issue to make this work, says the book's author.

My question is: why does the use of the SMLLC come up with a different result than if it was simply two sole proprietorship Sch C's?

Further what would the correct result be with either: one SMLLC dsgrgarded entity Sch C and one sole proprietorship Sch C vs. two sole proprietorship Sch C's?

Cites needed to support any conclusions.

[GBurns]

Why do I get the feeling that we are being used by the plan promoter as a sounding board from which to get ideas that will be used to answer questions and to explain the scheme to potential clients and their advisors?

I get the impression that someone came up with the basic scheme but could not tie the pieces together themselves, not unlike some of the "double dipping" "419 VEBA" "132 Transportation" "COBRA" "BOSS""Split Dollar" etc etc schemes. The pieces work individually but not together.

I noticed that we still cannot get disclosure of the name of the book etc. Is someone afraid that someone reading the Forum might have specific input, comment or knowledge about the scheme which if identified might cause some embarrassing disclosure?

[mbozek]

Since the -10 reg has never been revised for the addition of the 415 limits, the controlled group rules and the application of the 415 limits to all members of the CG it is not controlling law on these issues.

[austin3515]

Can anyone define trade or business? Isn't this one trade or business? There must be some functional test and I can't believe this arrangement would ever be considered two separate trades or businesses. With that being said, I don't really know.

Jquazza, I definitely need to get out more... Although this is an all volunteer sight, so I doubt if I'm alone!

[Guest forohonek]

Since the -10 reg has never been revised for the addition of the 415 limits,  the controlled group rules and the application of the 415 limits to all members of the  CG it is not controlling law on these issues.

mbozek Would you please "translate" that a bit for me. I am a tax preparer but not proficient enough in this area to understand what was said.

[Guest forohonek]

Can anyone define trade or business?  Isn't this one trade or business? There must be some functional test and I can't believe this arrangement would ever be considered two separate trades or businesses.  With that being said, I don't really know.

I think the assumption here is that the two schedule C's are in fact separate and distinct trades or businesses...

BUT I think you have have just touched something there! Maybe the reason for (the importance of) the SMLLC is to assure that there is a distinct and separate deliniation between the trade or business #1 (let's call it the widget sales operation) and the SMLLC's trade or business of providing administrative services for hire.

Yes, I AM concerned that this SMLLC could be deemed an alter-ego of the owner, and thus be ignored by IRS. On the other hand, no taxable income is being understated per se, so what would IRS be looking to attack it for? On the other hand, perhaps the retirement plan division of IRS might have an issue with it. (BTW I've already discussed this with one of their attorneys and he did not like the way it smelled (who would?), but he could not offer a cite to attack it)

And finally, on the other hand, if it was not a SMLLC, but it was a solely-owned S-Corporation that was providing the administrative services, there clearly would be no problem at all, IMO.

To summarize, I am questioning the book's author's contention that an S-Corp (or some other qualifying entity) is not necessary, but rather a SMLLC is all that is needed to accomplish the same thing.

The REASON for using the SMLLC, rather than a different entity it seems is so the taxpayer has only one tax return to file (form 1040), rather than two (forms 1040 & 1120S).

The added complication that I asked about was if 2 Sch C's can accomplish what normally (in my mind) requires a Sch C and a Sch E, then why is the SMLLC needed at all. And perhaps you hit that one on the head - to better assure a speparate and distinct trade or business that by State law (LLC being a formation under State law) can not be made a part of the operations outside of the SMLLC.

I think this may be what the author had in mind. But this is all supposition. I would like to locate cites to prove or disprove the viability of this SMLLC theory.

[Guest forohonek]

Why do I get the feeling that we are being used by the plan promoter as a sounding board from which to get ideas that will be used to answer questions and to explain the scheme to potential clients and their advisors?

I noticed that we still cannot get disclosure of the name of the book etc.

No I am not the promoter of this concept. Rather I am an advisor who does not believe that it is viable. After reading the book my client went to the promoter (who is happy to accept new clients, charge them to form the SMLLC and then prepare the ongoing annual income tax returns) and was assured that my expressed concerns were not valid.

No, I do not wish to promote sales of the tax advice book here or anywhere else. Other than those JK Lasser type tax books, I'm sure there's only been a handful of tax advice books out there with 2004 copyright dates so anyone could find it if they really wanted to go look for it.

[GBurns]

But still the question goes unanswered.. What is the name of the book?

In any case, you have fallen into the trap used by most tax shelter and scheme promoters. You are trying to get an answer to what you see as the questionable areas. You will never get the correct answers because all you have are your own answers to your own questions. Your questions are based on what you percieve as being the issues. What you see as being the issues might not be the issues. What you are doing is seeing issues and answering your own questions which might not even be relevant to what the scheme really is all about. What you think the promoter means might not really be so. Only the promoter knows what the promoter means and how the scheme is supposed to work. You cannot have a valid answer based on your own speculation of what the scheme is and how it works.

If you come back with negatives All the promoter has to do is to state that you did not look at the right things because you did not understand. The end result is that since you did not find anything wrong then it must be right.

It is for the promoter to provide understandable proof, not excerpted cites. It is for the promoter to show to the last detail why it works and how it complies.

It is for the promoter to answer the questions that have been raised and then it is for you to verify that the answers are correct.

[austin3515]

The IRS would take issue because you're creating fictitious income (in my opinion) so that you can take a tax deduction for the retirement plan contribution. Without this scheme, the retirement plan contriubtion and related deduction would be zero. Also, those contributions will grow tax deferred inside a qualified plan. So the government is indeed getting screwed by this scheme, in my opinion...

Can anyone site the defintion of trade or business?

[Guest forohonek]

The IRS would take issue because you're creating fictitious income (in my opinion) so that you can take a tax deduction for the retirement plan contribution.  Without this scheme, the retirement plan contriubtion and related deduction would be zero.  Also, those contributions will grow tax deferred inside a qualified plan.  So the government is indeed getting screwed by this scheme, in my opinion...

Can anyone site the defintion of trade or business?

Here is an excellent web site that covers the definition for "trade or business" http://www.toolkit.cch.com/text/P07_2100.asp and to expand a bit on the answer you gave me earlier see the link http://www.toolkit.cch.com/text/P07_2120.asp

Austin, I am now convinced that his reason for the disregarded SMLLC (rather than simply a 2nd sole proprietorship Scehdule C) is exactly what you suggested (or was it "stumbled on" ) before. See from the link above "These factors are quite vague and subjective, even for the IRS. The general idea, however, is that if you provide similar products or services to similar clients, you have a single business."

Because (as I think we all agree) you simply can not have one sole proprietorship Schedule C billing a 2nd sole proprietorship Schedule C and expect them to remain separate, this promoter's law department came up with the idea that by law the SMLLC is a separately organized entity, and I'm sure if this guy is on the ball he narrowly defines the business purpose of the SMLLC in its articals of organization to "provide back-office administrative services to the widget manufacturing indistry" or something similar. Therefore the two business operations "can not" (by state law) be combined under any alter-ego theory or other substance over form attack.

All this to avoid forming an S-Corporation!!! Well, thanks to everyone for all the input. I am satisfied now that I see his game. And no, I still do not "buy it" as we all know if it smells like a duck, it's gonna be a duck in the eyes of the IRS no matter how many convoluted arguments you present stating the SMLLC can not by law be combined with the sole-proprietorship.

What he misses is the IRS is not bound by State law. They can still use substance over form and attack the SMLLC under theories of self-dealing or step transaction doctrine or other tried and true attack mechanisms.