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Andy the Actuary

DB Contribution Exceeds Schedule C

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A self-employed individual makes a required DB contribution that exceeds his Schedule C. The individual intends to take the nondeductible portion against future Schedule C. However, the individual quits working altogether so there is no future Schedule C. The Plan is terminated.

In looking at this, it appears you consider the individual as employer and also as an employee. As an employer, he has made a nondeductible contribution so tough. As an employee, he receives a totally tax deferred distribution.

Question 1: Is anyone aware of an exception that would deem the portion of the distribution attributable to the nondeductible contribution as nontaxable, so the individual would not be taxed twice on the same monies? I.e., he would roll part to an IRA and take part in nontaxable cash.

Question 2: How should the contribution in excess of Schedule C income be reported on 1040? Do you report a contribution to the extent of Schedule C (less 1/2 ss) or do you report the entire contribution?

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Q 1. To my knowledge, the nondeductible portion is still taxable when distributed. It does not create basis.

Q2. You only report the deductible contribution on the 1040, ie. net Sched C - 1/2 SET.

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I'd agree with D Syrett as that's my general "understanding" as well, though I must say I've ever seen a cite for this per se.

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Guest mjb

Q1- IRC 402(a)

Q2 IRC 172(d)(4)(D)

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402(a) does not describe the real tax issues, which are found in IRC 72, where basis in a contract is discussed.

There are non-taxable distributions from plans, so 402(a) is not even close to covering the topic.

Examples: PS 58 costs, non-deducted IRAs, Roth contributions, previously taxed loan proceeds.

IRC 172 (concerned about net operating losses) points out the fact that pension contributions are not deductible as business expenses if they cause a loss. But they might be deductible elsewhere as a non-business deduction. And, if they are not deductible, the payments are attributable to the person. I suspect that meets the classic definition of contributed investment in the contract, discussed extensively in Section 72.

I am willing to consider other arguments here, but they need to reflect the provisions of IRC 72.

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Guest mjb

Socal: 402(a) describes the taxation of distributions of benefits from a qualified plan. PS 58 is the taxation of the economic benefit of LI, Roth contributions are exempt from taxation of distributions as an after tax employee contribution under IRC 402A unless earnings are taxable under 402(a), non deductible IRAs are not distributions from a Q plan hence are taxed under 408(e) and (o), not 402(a). Loans that do not meet the requirements of IRC 72(p) are treated as imputed income in a distribution, not an employer contribution. The Q was what IRC provision requires taxation of non deductible employer contributions to a qualified plan (which would also include contributions made by non profits, govt er and excess employer contributions that exceed the 404 limits) for which the applicable IRC section is 402(a), not why employee contributions, IRA distributions or disqualified loans are not taxed upon distribution.

I dont see anything in IRC 72 which provides authority to convert a non taxable contribution by an employer to a Q plan into non taxable basis for each participant. If you can find an IRC section that converts non deductible contributions to after tax employee basis (e.g., similar to employee after tax contributions to purchase stock under IRC 402(e)(4)(A)) which are not taxed on distribution please cite it.

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402(a) describes the taxability of benefits under a qualified plan.

But I cited several examples where distributions have a tax basis. So it is clear to me that not all distributions are taxable.

172 describes the rules for net operating losses. In this example, a contribution that would otherwise be deductible under 404 would exceed the business income. By reading this more carefully, I note that the excess of contribution over business income is not deductible as a business expense, and the deduction (if any) flows to the individual's tax status. The question then arises, to wit: under 172, if a self-employed individual cannot make a deductible business expense, then the individual can take the deduction elsewhere. But if no such deduction is available, then the contribution is not granted any tax-favored status.

Section 72 describes the fact that distributions from annuity contracts, including qualified plans among others, must consider the after-tax investment in the contract. If the funds came into the contract on a tax favored basis, they do not count as investment in the contract, but if they came in without a tax-favored treatment, the owner has a tax basis. Those principles look like they would apply here. Does anyone have a cite showing that the IRS has denied this logic in the Code or Regs?

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Guest mjb

You are ingoring the difference between taxation of the benefits paid to a participant which includes a self employed person (SEP) under IRC 402(a) and taxation of the SEP as the employer who contributes to a qualified plan under IRC 402©. As a participant, the benefits paid to a SEP can include after tax amounts for Roth 401k and imputed income for loans in default.

However under IRC 401©(4) and ©(5) the SEP is also the plan sponsor subject to the limits for taking deductions. " As an employer you can deduct contributions you make to a qualified plan " Pub 560 P 11-12. "An individual who owns the entire interest in a unincorported business shall be treated as his own employer." IRC 401©(4). "The term contribution on behalf of an owner-employee includes a contribution under a plan by the employer for the owner-employee." IRC 401©(5). Therefore contributions made by the SEP to his own account are subject to the same rules for distributions as any other plan sponsor for contributions that are not deductible even though the contrbutions are deducted on his own return. If what you say is correct then all contributions made by non profit employers and and all non deductible contributions allocated to a plan would not be taxable upon distrbution because there is no tax favored treatment for the contribution incurred by the employer.

The deductiblity of contributions by a self employed person is limited to net earning from self employment (less 1/2 Fica tax) which is consistent with the limitation on deductions to a DB plan by a S corp shareholder to the amount of the shareholder's basis (interest ) in the S corp even though the all benefits will be taxed under IRC 402(a).

Since you researching anomalities in the tax code, where is the IRC provision that does not allow a capital loss on the sale of residential homes even though profits are taxed as capital gains?

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You are ingoring the difference between taxation of the benefits paid to a participant which includes a self employed person (SEP) under IRC 402(a) and taxation of the SEP as the employer who contributes to a qualified plan under IRC 402©. As a participant, the benefits paid to a SEP can include after tax amounts for Roth 401k and imputed income for loans in default.

However under IRC 401©(4) and ©(5) the SEP is also the plan sponsor subject to the limits for taking deductions. " As an employer you can deduct contributions you make to a qualified plan " Pub 560 P 11-12. "An individual who owns the entire interest in a unincorported business shall be treated as his own employer." IRC 401©(4). "The term contribution on behalf of an owner-employee includes a contribution under a plan by the employer for the owner-employee." IRC 401©(5). Therefore contributions made by the SEP to his own account are subject to the same rules for distributions as any other plan sponsor for contributions that are not deductible even though the contrbutions are deducted on his own return. If what you say is correct then all contributions made by non profit employers and and all non deductible contributions allocated to a plan would not be taxable upon distrbution because there is no tax favored treatment for the contribution incurred by the employer.

The deductiblity of contributions by a self employed person is limited to net earning from self employment (less 1/2 Fica tax) which is consistent with the limitation on deductions to a DB plan by a S corp shareholder to the amount of the shareholder's basis (interest ) in the S corp even though the all benefits will be taxed under IRC 402(a).

Since you researching anomalities in the tax code, where is the IRC provision that does not allow a capital loss on the sale of residential homes even though profits are taxed as capital gains?

The non-profit employer and the real estate issues ... what do they have to do with this discussion?

My basic point is this:

In a DB plan, there are plenty of distribution issues that do not result in taxable income, because they have already been taxed to the individual recipient. In addition to taxed loans and insurance premiums and rollover of after-tax IRAs, this includes non-deductible employee contribution. All of these are investment in the contract (IITC).

At issue here is the tax question - if the self-employed individual made a contribution exceeding the allowable deduction, then it is not a business deduction, so does it become IITC?

If it is IITC, then under IRC 72 it is not taxable when distributed.

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The answer to the residential real estate trivia question, I think, is the IRS' and the courts' longstanding interpretation of Section 165© (and its predecessors). A bad interpretation, maybe, but Congress has not seen fit to overall it either.

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Guest mjb

In order to exclude the portion of the distribution attributable to non deductible employer contributions from taxation as you believe there must be a statutory provision authorizing such exclusion. The NP employer and excess contribution examples are analogous to the question you have raised- in both cases the employer receives no tax benefit from its contribution made to the plan but the plan participants are still taxed on the full amount of their distribution from the plan attributable to such contribution b/c there is no exemption from the taxation of the benefits under IRC 402(a). There is a difference in the IRC between taxation of the distribution to a plan participant (402(a)) and how much of a contribtuion can be deducted by the employer (404(a)) and there is no proportionality in the IRC between the amount of the contribution claimed as a deduction and the amount of the distribution included as taxable income. The portion of the after tax distribution from a plan is based solely on the interest in the plan contributed by a participant, e.g., Roth contributions, after tax employee contributions or loans in default which are investments made by the employee, not by a self employed person contributing to the plan in the capacity of the employer as required under IRC 401©(4) and ©(5) for deduction purposes under IRC 404(a). The fact that the same taxpayer is both a participant and the employer does not result in the conversion of a portion of the distribution to a non taxable investment in the contract merely because the entire amount could not be claimed as a deduction on an individual tax return.

The reference to residential real estate is revalent because similar questions are often asked as to why cant a loss can be claimed in the sale of residential RE since profits in excess of the statutory exclusion are taxed as gains. The answer is no because there is no separate provision in the IRC for claiming a loss for property that is not used in a trade or business.

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Your argument is interesting. My position comes in part from a discussion that Larry Starr developed some years back, so I'm still inclined to believe that you have IITC, but I'm willing to continue discussing it.

Could you also explain the importance of the wording in IRC 172 that moves the excess contribution to the personal tax return? Does this now become a 1040 Schedule A deduction? What other meaning could that section imply?

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Guest mjb

You need to find a cite that allows a conversion of after tax employer contributions into an after tax benefit which is not attributable to the employee's contribution. Under IRC 72© excess employer contributions are not defined as an investment in the contract exempt from taxation under IRC 72. I am not aware of a provision that allows for such recharactization. You need to discuss this with an acountant.

IRC 172(d)(4)(D) prohibits a self employed individual from using contributions to the plan which exceed sked C income as a net operating loss on line 12 of the 1040 to reduce taxable income. Where would the excess contribution fit as an itemized deduction? According to the 1040 instructions it not permitted under line 27 as other misc deductions.

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My basic point is this:

In a DB plan, there are plenty of distribution issues that do not result in taxable income, because they have already been taxed to the individual recipient. In addition to taxed loans and insurance premiums and rollover of after-tax IRAs, this includes non-deductible employee contribution. All of these are investment in the contract (IITC).

At issue here is the tax question - if the self-employed individual made a contribution exceeding the allowable deduction, then it is not a business deduction, so does it become IITC?

If it is IITC, then under IRC 72 it is not taxable when distributed.

SoCal, just wanted to voice my agreement with your analysis. In fact I had posted on this thread that this meets in general the "investment in contract" discussion in IRS publication 575. However, as about 5 people immediately took issue, rather than waste the breath arguing I simply deleted my post. But now that you've provided the proper section, IRC 72...

To quote pub 575 "This includes the amounts your employer contributed that were taxable to you when paid." Since MJB established above that the IRC says the self-employed person is treated as his own employer (and since he established that IRS pubs are valid citations by using one himself), then we can conclude from what we are told by IRS code and sources that since the person had to pay tax on the contribution (because it wasn't deductible) then it counts as investment in contract.

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Well if we must pick sides I'm with mjb on this one, though I'm appreciative of the fact this discussion is continuing on quite professionally with no snide comments (very refreshing). I thought mjb's point about non-profit entities participants' don't have any tax basis in their non-deductible contributions was a good practical point. It seems hard to believe that absent clear guidance (which appears a bit lacking) the IRS interpretation of existing laws would allow the cumulative combination of the Sole Prop to stuff in large contributions, potentially way beyond the current net Schedule C (say by using a high-3 year comp formula based on prior higher comp years) and let these contributions generate the extra tax deferred earnings in the plan as non deductible, and allow the contribution to automatically become an "employee" cost-basis by saying there is no bright line dividing employer and employee taxation issues, and continue to allow the normal exemption from the 10% penalty tax on non-deductible contributions on unincorporated entities. Don't get me wrong, I like the result, but it seems potentially abusive and a bit too good to be true.

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Well if we must pick sides I'm with mjb on this one, though I'm appreciative of the fact this discussion is continuing on quite professionally with no snide comments (very refreshing). I thought mjb's point about non-profit entities participants' don't have any tax basis in their non-deductible contributions was a good practical point. It seems hard to believe that absent clear guidance (which appears a bit lacking) the IRS interpretation of existing laws would allow the cumulative combination of the Sole Prop to stuff in large contributions, potentially way beyond the current net Schedule C (say by using a high-3 year comp formula based on prior higher comp years) and let these contributions generate the extra tax deferred earnings in the plan as non deductible, and allow the contribution to automatically become an "employee" cost-basis by saying there is no bright line dividing employer and employee taxation issues, and continue to allow the normal exemption from the 10% penalty tax on non-deductible contributions on unincorporated entities. Don't get me wrong, I like the result, but it seems potentially abusive and a bit too good to be true.

My problem with the non-profit reference is that the employer is a different entity from the recipient of the contract proceeds. The non-profit may not have a deduction, but the employee is being credited with tax-deferred income while participating in the plan. They are getting favorable tax treatment because the cost of the pension is not immediately taxable income.

Not so for the sole proprietor's required DB contribution. In the case of the sole proprietor, the person making the required non-deductible excess contribution is also the person receiving the benefits. There is no transfer of value between the employer and the recipient that qualifies as tax deferred income when the required contribution is deposited.

If the sole proprietor was only looking for tax deferral on the investment gain, they could put the funds into a deferred annuity contract where the tax basis is clearly defined, and the yield is not currently taxable. And there is no significant limit to the amount so deposited. This is the analogy that fits closest to the facts.

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SoCal, aren't they getting some tax advantages by virtue of the interest/gains earned on the non-deductible contribution ? Wouldn't that argue against having a cost basis ?

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My point is this: a deferred annuity contract has a non-deductible investment in the contract. When distributions occur, the non-taxable portion gets paid out without income tax assessed.

When a sole proprietor makes a non-deductible contribution to the pension plan, they are also making an investment in the contract. It should also come out tax free.

In either case, the investment gain within the contract would be taxed as ordinary income. The tax advantage in both cases is that the tax is deferred until the contract is paid out.

SoCal, aren't they getting some tax advantages by virtue of the interest/gains earned on the non-deductible contribution ? Wouldn't that argue against having a cost basis ?

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Guest mjb

Socal: the problem with your argument is that no matter how you analyze it, crediting the non deductoible contribution to the participant's account is still only a theory without any substantial authority under the IRC (more about that later) for the following reasons:

1. The non deductible portion is not a investment in the contract under IRC 72© which is treated a a non taxable amount

2. It is a contribution made by an employer as defined in IRC 401©(4) and (5) which subject it to the limitations on deductions under 404(a).

3. It is not a contribution made by the employee which is an investment in the contract under IRC 72©

Masteff: you referece to Pub 575 is misplaced. The "amounts your employer contributed that are taxed to you when paid" referred to on P 9 is for employer contributions to the plan used to fund LI premiums which are taxed to the employee as an economic benefit and are basis in the LI contract for tax purposes.

A taxpayer claiming a tax benefit that is not defined in the IRC needs substantial authority to avoid the tax penalties (up to 75% of the tax) that can be assessed if the taxayer lacks substantial authority for the tax benefit claimed.

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We should end this here.

The back and forth appears to hinge on whether one accepts that IRC 72 investment in contract should apply to the self-employed individual.

Both sides have stated their cases but neither side is willing to conceed key points.

Therefore, this will continue indefinitely as a ping pong match.

Let's agree to disagree, as we have given the original poster two lines of thought which he can provide to his client in question.

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