Deductibility of 3% SHK with DB

[Jed Macy]

FACTS: Sole Proprietor ("SP") has 1 employee ("EE"). SP makes about $120,000 of self-employment income and EE is paid $20,000 per year. SP is 52 and EE is 40.

ISSUE: Can SP set up a Defined Benefit Plan for 2002 that provides for the maximum benefit and also set up a safe harbor 401(k) plan, and deduct all of the contributions?

MY DISCUSSION: Assume that the DB funding is about $60,000 for SP and $5,000 for EE which is clearly more than the 25% limit imposed by §404(a)(7). (Also assume that the DB plan satisfies the top heavy minimum.) If EE elects to defer 8% to a 401(k) plan, then SP can defer $12,000. But if EE does not defer any, then SP can't defer unless he makes a safe harbor contribution of 3% for EE. It seems to me that deduction of this 3% safe harbor contribution would be prevented by §404(a)(7), but the deferrals (SP's and EE's) would be deductible under §404(n) that was added to the IRC by EGTRRA.

Can SP defer the $1,000 catch up regardless of any deferral by EE? Can the safe harbor plan use a matching contribution instead, and if EE does not defer, then have deferrals by SP as the only contributions (since the DB plan is satisfying the top heavy minimum)?

Thanks for your thoughts on these issues.

[AndyH]

You are correct about the 404 limits. The deductible limit is the greater of 25% of pay or the amount required to fund the DB. The deferrals are not counted in this, effective 1/1/2002.

I'm not sure about the catch up deferral, but I don't see why not.

[Richard Anderson]

If it is unlikely that the Ee will defer anything, use safe harbor match instead of the 3% non-elective. And have the safe harbor match contributed only for NHCEs. If the Ee defers nothing there will be no match required. And, if all other requirements are met (notice, ect.) the owner can defer the maximum. The $5,000 DB contribution for the Ee should easily satisfy top heavy minimum.

[Mike Preston]

I would encourage you to make sure your files are well documented as to the availability of the k plan, both as to deferrals and match, to the NHCE's. There is something that makes me think that, should the IRS look at this plan after it has been in operation 2 years, if there are truly no NHCE contributions, they will at least question things.

But with that said, even if there is a required contribution to the SH match, and even though it won't give rise to a deduction, as long as the contribution is less than 6% of pay, at least the employer is not stuck with the excise tax on non-deductible contribuitons.

See 4972©(6)(B).

[Blinky the 3-eyed Fish]

Mike, the exemption for there not being excise tax you speak of is only available if there are more than 100 participants.

[Mike Preston]

Blinky, my Code doesn't agree with you. The 100 participant requirement is specific to 4972©(6)(A) and doesn't have any bearing on 4972©(6)b).

Is my copy of the Code incorrect?

[Blinky the 3-eyed Fish]

Your copy of the code is not incorrect, but I your interpretation of it is. The "AND" at the end of (A)(ii) links the two subparts (A) and (B). I copied it for your convenience

(6) Exceptions.—

In determining the amount of nondeductible contributions for any taxable year, there shall not be taken into account—

(A) contributions that would be deductible under section 404(a)(1)(D) if the plan had more than 100 participants if—

(i) the plan is covered under section 4021 of the Employee Retirement Income Security Act of 1974, and

(ii) the plan is terminated under section 4041(B) of such Act on or before the last day of the taxable year, and

(B) so much of the contributions to 1 or more defined contribution plans which are not deductible when contributed solely because of section 404(a)(7) as does not exceed the greater of--

(i) the amount of contributions not in excess of 6 percent of compensation (within the meaning of section 404(a)) paid or accrued (during the taxable year for which the contributions were made) to beneficiaries under the plans, or

[Mike Preston]

Well, I stand by my original interpretation. The language says that folks have to pay excise taxes on non-deductible contributions except for a certain amount of non-deductible contributions. You determine that certain amount by adding the dollar values determined under (A) to the dollar values determined under (B).

The dollar values under (A) are only applicable if the plan has more than 100 participants.

The dollar values under (B) are applicable whether the plan has more than 100 participants or not.

You add up (A) and (B). If (A) is zero, you still get (B).

Whatever you get, that amount is not subject to excise taxes.

The linkage you identify by the 'AND" between (A) and (B) is the same as the plus sign in the equation:

X = ND - [(A) + (B)]

where X is the amount subject to excise taxes;

ND is the total non-deductible contributions

(A) is contributions identified with reference to subclause (A)

(B) is contributions identified with reference to subclause (B).

[Blinky the 3-eyed Fish]

I would welcome other opinions. Personally, when I studied for actuarial examinations, both problems on prior exams and multiple sets of study notes explicitly interpreted the excise tax exemption to be only available if greater than 100 participants.

[Mike Preston]

Maybe the flush language following (B) serves to make the study notes, and you, correct. Thanks for sticking with this.