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Partner Compensation


Guest derek
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Previously, I asked a question about compensation and limits for LLC/LLPs and partners. I now have a more specific question....If a partner receives two types of compensation from a partnership (in particular a LLP), what compensation is used for their SEP contribution limit. In my case, the partner receives a W-2 with significant compensation, as well as a K-1 from the partnership as a limited partner (with some self-employment or "flow-through" earnings). Does the partner get to receive a contribution on the W-2 compensation - or is it limited to the SE Income from the actual partnership operations? I realize on the SE Income (absent the W-2 compensation) that the employee/partner is subject to the "circular" formula for contribution limit purposes.

[This message has been edited by derek (edited 12-07-98).]

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Any good suggestions on finding this answer? I have tried a number of sources and bulletin boards and have no responses. I am getting desperate!!! Perhaps this is just a dumb question and it should go without answering.

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Guest Paul McDonald

You say the "limited partner" receives compensation as an employee in the form of "significant" W-2 earnings and also receives K-1 as a limited partner. I would be concerned that the IRS would allow the SEP contribution on the W-2 income only, as this income sounds like it is based on the actual work the person does for the partnership to produce income for the business. The K-1 earnings for a limited partner could possibly be then treated as un-earned or investment income from the business. I believe this has always been the concern of LLCs that the limited partners income would be dependant on what they actually do for the business.

So IMHO, the W-2 based contribution would be a safe bet and the K-1 based circular formula a big MAYBE.

Anyone else have thoughts on this?

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It would be wonderful to have a definitive answer on this. W-2 is not a completely safe bet. If the IRS decided that some K-1 income was includable in income for SEP purposes, the SEP contribution would not be correct for that partcipant. The compliance risk arises either way - overinclusion or underinclusion. Qualified plans have the same problem in determining eligible income. But they can define income however they want, subject to discrimination rules.

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In the case of an LLC/LLP an owner employee's compensation is their earned income _plus_ any W-2 income. Thus, both are considered. The W-2 income has an effect on the amount of self-employment tax that reduces the earned income component for calculation purposes. If you are using QP-SEP Illustrator software, use the noncorporate version (KEO-SAR); enter the earned income in column "W;" enter the W-2 compensation in column "AY" to be considered for SE tax purposes (the reduction) and again in column "BB" to be treated as plan compensation (since entity is a single/controlled business). The circular and interdependant calculations are all handled automatically; that is "instant answers" with no math!! The 1998 and 1999 versions of that software are available by calling (317) 846-7704 (during business hours).

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But what is earned income from an LLC? Assume that no member is considered to be an employee (no W-2). Member #1 contributed no capital to the LLC, but performs services. Presumably all LLC distributions are earned income (compensation). Member #2 contributed $$$ to the LLC and performed no services. Presumably no LLC distributions are compensation. Member #3 contributed $$$ and performs services. Does the either the LLC accounting or the K-1 break down the distribution between compensation and noncompensation distributions? Does the IRS distinguish between the two? If so, is there an objective rule for allocating between the investment return portion of the distributions and the compensation portion? Or does the LLC or individual allocate between the two?

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All W-2 compensation (wages) are considered. In the case of a partner or sole-proprietor, only earned income from personal services (including guaranteed payments) are considered. [iRC Section 401©(2)] The IRS has always believed that they have the right to recharacterize amounts to reflect economic reality. I am not aware of a any objective standard. Perhaps an expert in partnership taxation will have additional thoughts. You might wish to read _Durando v US 19 EBC 2191 (8th Cir 1985). In Durando, an S-Corp, tried to base its plan contribution on what appeared to be dividend income (which is reported on Schedule he K-1). The taxpayer lost. The tax return preparer (accountant) would generally make this determination. Hope this helps.

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