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Deduction for Keogh contribution


Guest Diane DuFresne

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Guest Diane DuFresne

I am currently in a debate with a a well know administration firm. They are computing an integrated calculation for a self employed individual with two employees. Their allocation to the self employed individual is in excess of 20% of net self-employed income (Schedule C less 1/2 of self employment taxes and EE contribution). I'm suggesting to them that is not recommended as any contribution in excess of the 20% limit is subject to the excise tax for nondeductible contributions. They are refusing to budge indicating:"the limit is 25% of all compensation, and since the plan is integrated, the self-employed individual is entitled to a higher percentage above the 20%." Is anyone ever allowed a deduction in excess of 20% of net-self employment income? The net self-employement income for the individual is below the $245,000 limit. Can anyone tell me where I am going wrong? Am I all wet?

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I think they may be correct. Section 415 limit isn't 25 % of comp up to $30,000 anymore. Now it is 100% of comp up to $50,000. And section 404 says that deductible amount is 25% of total comp of everyone eligible. So I can imagine an employee getting a 30% contribution in a cross tested plan.

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Guest Diane DuFresne

The 404 deduction limit seems very clear in that a self-employed individual is only allowed a deduction of 20%. In preparing the tax return for the self-employed individual, I cannot take more than 20% as a tax deduction. Where am I going wrong?

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The 404 deduction limit seems very clear in that a self-employed individual is only allowed a deduction of 20%. In preparing the tax return for the self-employed individual, I cannot take more than 20% as a tax deduction. Where am I going wrong?

It's not a SEP (where 25% is actually the 415 Limit and the Deduction Limit). Being a qualified plan, the deduction is 25% of all compensation, but the resulting compensation after all contributions to the owner is added to the total employee compensation for calculating the 25%. Remember, the 415 limit goes to 100% of compensation in a qualified plan. You would be entirely correct if it were a SEP, but the TPA is correct for the qualified plan.

The 20% is merely an algebraic method of getting to the 25% limit. You should never mistake 20% written as a rule. If Net Schedule C is $100,000 and the owner receives a contribution of $20,000, then Earned Income is reduced from $100,000 to $80,000. $20,000 is 25% of $80,000. There is nothing to preclude the owner from receiving $30,000 (and having earned income reduced to $70,000), if that $70,000 (when added to the Compensation of all other "eligible" employees) keeps overall contributions less than 25%, then you're fine.

What MAY also "blow your mind" is that the owner's elective deferrals and "employer contributions" are deducted on the same line on the Form 1040.

Don't worry, this situation burns everyone; got me 10 years ago ;)

Good Luck!

CPC, QPA, QKA, TGPC, ERPA

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We prepare tax returns as well. You will not be able to use the tax software to calculate the tax deduction amount if you have other employees who are participants and the allocation is integrated or cross tested. I have to explain this all the time.

My way to understand is 404 determines the limit of the contribution but does not govern how the contribution will be allocated.

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Guest Diane DuFresne

Thanks to everyone who replied. You learn something new everyday..... Now on to thanking the benefit administration firm for being so patient with me!

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The 404 deduction limit seems very clear in that a self-employed individual is only allowed a deduction of 20%. In preparing the tax return for the self-employed individual, I cannot take more than 20% as a tax deduction. Where am I going wrong?

It's not a SEP (where 25% is actually the 415 Limit and the Deduction Limit). Being a qualified plan, the deduction is 25% of all compensation, but the resulting compensation after all contributions to the owner is added to the total employee compensation for calculating the 25%. Remember, the 415 limit goes to 100% of compensation in a qualified plan. You would be entirely correct if it were a SEP, but the TPA is correct for the qualified plan.

The 20% is merely an algebraic method of getting to the 25% limit. You should never mistake 20% written as a rule. If Net Schedule C is $100,000 and the owner receives a contribution of $20,000, then Earned Income is reduced from $100,000 to $80,000. $20,000 is 25% of $80,000. There is nothing to preclude the owner from receiving $30,000 (and having earned income reduced to $70,000), if that $70,000 (when added to the Compensation of all other "eligible" employees) keeps overall contributions less than 25%, then you're fine.

What MAY also "blow your mind" is that the owner's elective deferrals and "employer contributions" are deducted on the same line on the Form 1040.

Don't worry, this situation burns everyone; got me 10 years ago ;)

Good Luck!

That not the way the IRS calculates the amount of the deduction. See Pub 560 P 22 for deduction worksheet for self employed.

Under your example $100,000 of net earnings from SE (step 3) would be multiplied by the maximum rate of 20% (step 4) for a deduction of $20,000 (step 5).

P 23 rt column under Rate table for self employed contains the following * comment under plan contribution rate of 25% which corresponds to a deduction limit of 20%:

"* the deduction limit for annual employer contributions (other than elective deferrals) to a SEP, a profit sharing plan or a money purchase plan cannot be more than 20% of your net earnings (figured without deducting contributions for yourself) from the business that has the plan. "

IRC 401©(2)(A)(v) provides that in computing the earned income of a SE person, employer contributions on the owners behalf must be deducted. If $30,000 is contributed for a self employed person with sked C income of $100,000, the earned income will be reduced to $70,000 and the contribution % would be 43% (30/70) which exceeds the maximum 25% allowed under the IRS table.

Also the deductions for employee contributions is taken on Schedule C of the 1040 which reduces net income from SE whereas the owner deducts his contributions on line 28 of the 1040 after doing the calculation on P 22. The contributions are not combined. See P 16, col 1 of Pub 560.

mjb

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Are you saying the max deductible applies differently to schedule C businesses as opposed to all other forms of entities?

Austin:

I have explained the IRS methodology for a self employed person claiming a deduction for a contribution to his pension plan under IRC 401©, pub 560 and the 1040. However I do not prepare tax returns and a taxpayer needs to consult with his or her tax advisor.

What I can say is the rule of aggregating the deductions for owners and employees under 404/415 applies if the plan sponsor is a corporation and the owner is an employee. What seems to be overlooked is that when Congress allowed self employed persons to participate in qualified plans 50 years ago it created a separate structure for taking deductions in 401© to limit tax avoidance which is distinct from the rules which govern deductions of contributions for owners who are corporate employees.

mjb

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Now curious how all perceive the following that has been presented to me, a DC plan with discretionary ER contribution only.

A self employed individual has earned income in excess of 1,000,000. The SE income will be the maximum under compensation rules, 245,000. The SE also has an eligible employee who earns 30,000.

Would the overall tax deduction limit be 68,750 ((245,000 + 30,000) * .25)?

The allocation to the SE would be limited to 49,000 under 415.

The allocation to the EE could be up to 19,750 assuming the Plan allows amounts in excess of the maximum permissible amount to be allocated to other participants.

The 49,000 would be deducted on page 1 of the SE Form 1040 and the 19,750 deducted on Schedule C.

Any thoughts.

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Now curious how all perceive the following that has been presented to me, a DC plan with discretionary ER contribution only.

A self employed individual has earned income in excess of 1,000,000. The SE income will be the maximum under compensation rules, 245,000. The SE also has an eligible employee who earns 30,000.

Would the overall tax deduction limit be 68,750 ((245,000 + 30,000) * .25)?

The allocation to the SE would be limited to 49,000 under 415.

The allocation to the EE could be up to 19,750 assuming the Plan allows amounts in excess of the maximum permissible amount to be allocated to other participants.

The 49,000 would be deducted on page 1 of the SE Form 1040 and the 19,750 deducted on Schedule C.

Any thoughts.

Need to check the terms of the plan but under IRS rules max 25% deductible contribution would be:

7500 for employee (25% of 30k)

49k for owner (25% of 196k) because under 401©(2) the contribution for the owner must be subtracted from his 245k earned income from SE

mjb

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So Bird, you are saying that the deduction rules do apply the same way to Schedule C's as they do to corporations? Mbozek seems to think otherwise?

I don't know who to believe!! Two reliable sources with contradicting answers :(

Austin Powers, CPA, QPA, ERPA

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Are you saying the max deductible applies differently to schedule C businesses as opposed to all other forms of entities?

The IRS pub is wrong and a distraction from this discussion.

What substantial authority do you have for concluding that it is wrong?

mjb

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So Bird, you are saying that the deduction rules do apply the same way to Schedule C's as they do to corporations? Mbozek seems to think otherwise?

I don't know who to believe!! Two reliable sources with contradicting answers :(

I'm saying it does. The rule for deductibility (as we all know) is 25% of eligible 415 compensation. 415 Compensation for a Self-Employed individual is "Earned Income". Earned Income is reduced by contributions made to the plan. While the "Employer" Contributions to the employee are taken as an expenses on the Schedule C, the Employer Contributions to "EACH OWNER" is used to reduced "THAT INDIVIDUAL OWNER's" Earned Income. This resulting amount is that individual owners 415 Compensation.

Now, if this were a SEP (Just think about what the Pub 560 talks about), then the owners 415 Limit is actually 25% of Compensation. There is no aggregation of income.

Therefore, when we are discussing these matters, it's important to distinguish qualified plans from SEPs, because the actual 415 limits are different.

Good Luck!

CPC, QPA, QKA, TGPC, ERPA

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Yes, but do you reduce earned income starting at 245K, or do you reduce it at the uncapped figure. That appears to be the question.

FWIW, I refuse to reduce from the capped figure because I am sure I would be the only one doing so :). Well, it wouyld be and mbozek!

Austin Powers, CPA, QPA, ERPA

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In my experience the worksheets in Pub 560 are limited in scope and probably only work for a sole prop with no employees. I have not found any authority which states that the deduction and allocation rules are different for SEIs and Corps. Nor for the idea of capping earned income before applying the deductions, etc.

PensionPro, CPC, TGPC

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In my experience the worksheets in Pub 560 are limited in scope and probably only work for a sole prop with no employees. I have not found any authority which states that the deduction and allocation rules are different for SEIs and Corps. Nor for the idea of capping earned income before applying the deductions, etc.

"Like"

Okay, maybe this is getting a little old, but Benefitslink could really use a like button.

Austin, you use the original figure (i.e. $1 Million) and then begin to reduce. You would, then, cap the final amount to the 401(a)(17) limit.

Good Luck!

CPC, QPA, QKA, TGPC, ERPA

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Now curious how all perceive the following that has been presented to me, a DC plan with discretionary ER contribution only.

A self employed individual has earned income in excess of 1,000,000. The SE income will be the maximum under compensation rules, 245,000. The SE also has an eligible employee who earns 30,000.

Would the overall tax deduction limit be 68,750 ((245,000 + 30,000) * .25)?

The allocation to the SE would be limited to 49,000 under 415.

The allocation to the EE could be up to 19,750 assuming the Plan allows amounts in excess of the maximum permissible amount to be allocated to other participants.

The 49,000 would be deducted on page 1 of the SE Form 1040 and the 19,750 deducted on Schedule C.

Any thoughts.

Need to check the terms of the plan but under IRS rules max 25% deductible contribution would be:

7500 for employee (25% of 30k)

49k for owner (25% of 196k) because under 401©(2) the contribution for the owner must be subtracted from his 245k earned income from SE

Isn't his earned income, after taking into account the retirement plan deductions, se tax adjustment, etc. in excess of 245,000? Then you reduce the earned income to the maximum allowed by law 245,000, and that amount is used ultimately to determine the 404 deduction limit (25% of 245,000)?

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In my experience the worksheets in Pub 560 are limited in scope and probably only work for a sole prop with no employees. I have not found any authority which states that the deduction and allocation rules are different for SEIs and Corps. Nor for the idea of capping earned income before applying the deductions, etc.

Pro:

You need to disabuse yourself of the notion that the little you know is all there is to know about the deduction and allocation rules for SEIs in qualified plans. There are three IRS regulations 1.401-11 to 13 which set out special rules for participation of SEI in qualified plans which are different than the rules for corporate emplyees..

For example, reg. 1.401-11(b)(3) does not permit the allocation of forfeitures to a SEI's account which is clearly different than the rules for corporate employees. As stated in the regulation, the legislation allowing qualified plans for self employed persons "extended SOME of the tax benefits allowed to common law employees who participate in qualified plans. However the tax benefits allowed an SEI are restricted by limits which are placed on the deductions allowed for contributions on such individual's behalf."

Thus the IRS recognizes that there are many differences in how a SEI treated under a qualified plan.

mjb

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You need to disabuse yourself of the notion that the little you know is all there is to know about the deduction and allocation rules for SEIs in qualified plans.

Rude and incorrect, wow.

The reg cited is from 1963, before parity of self-employed individuals which came with TEFRA in 1982. I will not waste my time finding cites but I am sure that reg is superseded or otherwise inapplicable now. The IRS pub makes no mention of not allocating forfeitures to self-employeds, therefore there are no restrictions since that is the ultimate authority.

Ed Snyder

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You need to disabuse yourself of the notion that the little you know is all there is to know about the deduction and allocation rules for SEIs in qualified plans.

Rude and incorrect, wow.

The reg cited is from 1963, before parity of self-employed individuals which came with TEFRA in 1982. I will not waste my time finding cites but I am sure that reg is superseded or otherwise inapplicable now. The IRS pub makes no mention of not allocating forfeitures to self-employeds, therefore there are no restrictions since that is the ultimate authority.

Birde:

You keep insisting that everything I cite is incorrect but you "will not waste your time" to come with any authority for your position that the IRS calculation in Pub 560 for determining how a self employed person can claim a deduction for contributions to a qualifed plan is wrong. I think you are dancing in the dark.

I cited reg. 1.401-11 specificially to demonstrate that under the legislation enacted to allow SEI to participate in qualified plans, Congress intended that different rules would apply to deductions and allocation of benefits than the rules which aply to employees. Saying that you are sure that a reg is superceded or inapplicable is not substantial authority which a client can rely on. If TEFRA had intended parity of of all provisions for Qualified plans of SEI, Congress would have repealed 401© and (d) and the deduction rules of 404(a)(8) which apply only to SEI. Since those provisions exist the distinctions in qualified plans for SEI continue to apply.

mjb

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Now curious how all perceive the following that has been presented to me, a DC plan with discretionary ER contribution only.

A self employed individual has earned income in excess of 1,000,000. The SE income will be the maximum under compensation rules, 245,000. The SE also has an eligible employee who earns 30,000.

Would the overall tax deduction limit be 68,750 ((245,000 + 30,000) * .25)?

The allocation to the SE would be limited to 49,000 under 415.

The allocation to the EE could be up to 19,750 assuming the Plan allows amounts in excess of the maximum permissible amount to be allocated to other participants.

The 49,000 would be deducted on page 1 of the SE Form 1040 and the 19,750 deducted on Schedule C.

Any thoughts.

Need to check the terms of the plan but under IRS rules max 25% deductible contribution would be:

7500 for employee (25% of 30k)

49k for owner (25% of 196k) because under 401©(2) the contribution for the owner must be subtracted from his 245k earned income from SE

Isn't his earned income, after taking into account the retirement plan deductions, se tax adjustment, etc. in excess of 245,000? Then you reduce the earned income to the maximum allowed by law 245,000, and that amount is used ultimately to determine the 404 deduction limit (25% of 245,000)?

For the purpeses of a deduction as a SEI, his compensation is his earned income within the meaning of IRC 401©(1) which is 245k minus the contribution made on his behalf (49k) or 196k, not 61.25k (25% of 245k). IRC 404(a)(8).

mjb

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