Deduction for Sole Proprietor

[flosfur]

Husband and Wife opearte a Sole Prop business and file separate Sch Cs.

Total net Sch C for the business is $100k which is split 50/50. Therefore, net Sch C for each owner is $50k and 1/2 FICA is $3,500 (rounded for illustration). The sum of their Sch Cs less 1/2 FICA is $93,000.

Total plan cost is $90k say, which is less than the $93k in total Sch C less 1/2 FICA. Actuarially allocated costs are: $55k for husband and $35k for wife (computed individual costs under the Ind Agg method or allocated under the EAN or FIL methods using a reasonbale approach).

Scenario #1 - A joint income tax return is to be filed.

What can be deduced for the pension plan: full $90k or $81,500 (Husband's Sch C less 1/2 FICA of $46,500 plus $35k for the wife), carrying foward a loss of $8,500?

Scenario #2 - Separate income tax returns are to be filed.

What is the deduction for pension plan for each of them: $46,500 for husband and $35k for the wife or can the pension plan be split 50/50 and $45k deducted by each?

(they each have a higher Hi 3 average established in the past so current year eligible compensation does not affect the cost).

[flosfur]

Hey, folks any comments on my post?

I am surprised no one has any comments given this issue must come up frequently when dealing with sole props & partnerships or am I making a mountain out of a mole hill?

Desperately seeking comments [topic related, of course ].

Thanks in advance.

[Blinky the 3-eyed Fish]

My understanding is that in a related business scenario where both companies adopt a plan, one company can deduct contributions attributable to the other company's employees. This appears to be a similar situation, so I certainly believe that the the contribution can be split so that none of the contribution is nondeductible regardless of how the tax return is filed.

[David MacLennan]

I think the tax approach is improper. Two schedule C's are for two businesses, not one. IRS rules ascribe all the earned income in a sole proprietorship to one spouse, whoever carried on the business to the greatest extent, based on facts and circumstances. Only one spouse should be filing a Schedule C. If the other spouse wants to participate in a pension plan, he/she needs earned income, and you must form a partnership or pay him/her a W-2 from the sole proprietorship. You seem to have a partnership and they should be filing a 1065.

Given a partnership form, there are no regs to my knowledge that address how to allocate the deduction. I think the IRS would find acceptable any reasonable method, as long as it is followed consistently from year to year. Allocation based on earned income, or the normal costs, would be my suggestions.

[Mike Preston]

David, are you referencing 1402(a)(5)(A)? (As an aside, it is so politically incorrect that clients have a hard time believing it.) That section says that, if the income is subject to community property laws, you treat it all as being attributable to the husband, unless the wife "exercises substantially all of themanagement and control of such trade or business". In that case, you attribute it all to the wife.

Note, however, that the section in question appears to apply only in states which are community property states. Flosfur appears to be in such a state.

I agree that this whole issue seems to go away if there is only one Schedule C.

Which leaves open the original issue, if not for the original poster.

[flosfur]

Dave and Mike:

1. Well my client's CPA thinks he can allocate the total earnings any way he wants and, to boot, the allocation ratio from one year to the next does not have to be the same - go figure! Whatever legal backing he has for his position, I do not know - and should I care? The client is in Oregan.

2. I have come across quite a few husband/wife Sole Props - in & outside California. Obvioulsy their CPAs & tax advisors don't think there is anything wrong with husband/wife being a Sole Prop and don't advise them to form a Partnership.

3. Mostly, people (& their CPAs) go to a great length to avoid allocating income to both spouses so as not to pay FICA for both. The fact that CPAs are willing to split the earnings may have some legal backing? I have no idea.

I was told by one CPA why should the IRS cares how earnings are split as long as the tax liability - which it is, if there was pension plans involved.

As far as I am concerned, I don't understand why they all don't incorporate, especially at some of the income levels I see - one husband/wife sole prop had earnings of $9 million.

And for DB plans cost calculations, I would rather have them all as Corp, failing that Sch C for one spouse and W2 for the other is preferred.

Back to the problem at hand:

It may not (& does not) matter how the plan cost is split between spouses if they file jointly since all of the cost gets deducted on the single 1040.

What if they were filing separately - wouldn't the cost split matter?

In a non-spousal Partnership, the cost split "does matter" to each partner since each partner files his/her own tax returns.

To highlight the issue I raised, instead of husband/wife Sole Prop, consider a non-spousal partnership with two K-1s of $50k each.

Using the DB plan cost allocation method used in the past, partners' costs are $55k & $30k. Obviously, under this cost allocation, the partner with $55k allocated cost cannot deduct more than $46,500 ($50k less 1/2 FICA, rounded), leaving $8,500 undeductible. Can the other partner use this undeductible and deduct $38,500 on his return - I think not?

(Of course this does not answer the frequently asked question by the partners: We are equal partners, why our cost is not the same? But that's another Post).

[David MacLennan]

Mike, I wasn't really referencing that code section re community property. Mostly my argument is based on what I see as a logical approach (perhaps I'm too logical!), and on what I've read in IRS publications. Many years ago I did look into this issue as thoroughly as I could, as often a DB plan sponsor will want to include the spouse to increase deductions or get out of overfunding. Publication 533 on SE tax states:

Husband and wife partners. If you and your spouse join

together in the conduct of a business and share in the

profits and losses, you have created a partnership. A

partnership must report business income and expenses on

Form 1065, U.S. Return of Partnership Income, along with

Schedules K–1 showing each partner’s share of the earnings.

Both of you must report the earnings on Form 1040

and file a separate Schedule SE (Form 1040) to report

your individual SE tax.

However, if your spouse is your employee, not your

partner, you must withhold and pay social security and

Medicare taxes for him or her. For more information about

employment taxes, see Publication 15.

I think that we all know that spouses often participate in a sole proprietor's business, but the FICA tax can be reduced, so the result is that it is ascribed to one spouse as a practical matter rather than forming a partnership. I seem to recall this was stated in the instructions to the Sch SE many years ago, but the 2002 instructions only make reference to this under the community property section. I think the IRS really wants spouses both with earned income to report it as such, but to do so really means you have a partnership. Two Schedule SE's attributable to the same business? Again, to me this just means you have a partnership. Two Schedule C's for the same business - to me that is really an untenable practice. Sure you can do it, and I suppose the IRS will never know it's one business, and may not even care, etc.

Is that CPA based in Eugene OR? If so, he may be an anarchist.

[David MacLennan]

I had stated above that I was not aware of any regs that specifically addressed how to allocate the a DB deduction among partners. I was reading the instructions to Form 1065 today and, low and behold, found this statement:

• Payments for a partner to an IRA,

qualified plan, or simplified employee

pension (SEP) or SIMPLE IRA plan. If a

qualified plan is a defined benefit plan, a

partner’s distributive share of payments is

determined in the same manner as his or

her distributive share of partnership

taxable income. For a defined benefit

plan, attach to the Schedule K-1 for each

partner a statement showing the amount

of benefit accrued for the tax year.

This relates to line 11 of the Sch K-1. However, the partner's deduction is taken on Form 1040 item 31, so this may not be a definitive answer to the question. Allocating the deduction via the partnership share percentage does not always make the most sense. Not sure how Line 11 is used and if it logically follows to use this on the 1040 (and don't really have the time to look into it right now). Comments anyone?

[Blinky the 3-eyed Fish]

How about this memo created by Pricewaterhousecoopers?

1. Under Code section 62(a)(6), the deduction from gross income for a self-employed individual (Code section 401©(1))is the deduction allowed under Code section 404. Regulation section 1.62-1T©(7) limits the deduction under Code section 62(a)(6) to the deduction under section 404 for contributions "on behalf of" a self-employed individual.

2. Where the deduction under Code section 404 is not for a contribution "on behalf of" a self-employed individual, it is a trade or business deduction under Code section 62(a)(1).

3. Code section 1402(a) and Regulation section 1.1402(a)-1(a) define net earnings from self-employment as gross income minus trade or business deductions. Thus, the deduction under Code section 404 and Code section 62(a)(1) reduces net earnings from self-employment. But the amount that is deductible under Code section 404 and Code section 62(a)(6) does not reduce net earnings from self-employment.

4. Under Code section 404(a)(8), for purposes of contributions to retirement plans, a partner is treated as an employee and a partnership is treated as the employer.

5. Under Regulation section 1.404(e)-1A(f)(1), a partner's distributive share of the deduction under Code section 404 for contributions to a defined contribution plan is the contribution made "on his behalf". It is accounted for separately under Code section 702(a)(8). A partner's distributive share of the deduction under Code section 404 for contributions to a defined contribution plan for employees is determined under Code section 704.

6. Under Regulation section 1.404(e)-1A(f)(2), a partner's distributive share of the deduction under Code section 404 for contributions to a defined benefit plan is determined under Code section 704. Under Code section 704, in the case of a defined benefit plan, no contribution is identified as being made "on behalf of" the partner, and the deduction is determined under the rules for contributions made for employees of the partnership.

7. Therefore, in the case of a defined benefit plan (1) there is no deduction under Code section 404 for a contribution made "on behalf of" the partner; (2) Code section 62(a)(6) does not apply; and (3) Code section 62(a)(1) does apply. Thus, the deduction for contributions to a defined benefit plan reduce gross income to determine net earnings from self-employment.

[David MacLennan]

The regs under 1.404e-1Af2 appear to be the answer to my question on how DB deductions are allocated in a partnership - it is determined by their partnership percentage, unless the partnership agreement states otherwise. I spoke to another actuary today who conveyed this same opinion. He also said that he has heard that IRS auditors have been inflexible on this.

My first impression is that the conclusion from 6 to 7 is ridiculous. The argument says that because the words "made on his behalf" in the singular are absent from the f2 part of the reg, then it must reduce SE Income. It seems to me the intent of the reg is clear, even if it uses the plural "on behalf of self employed individuals" rather than the singular. But, if somebody wants to get out from paying SE tax on your DB contribution, I guess here is the argument to save for the auditor! I've seen many times sole props trying to sneak their pension plan contribution onto their Sch C, but I didn't know PWC was in on this too! Does anyone take this seriously? Maybe I'm missing something and the argument is more compelling than it appears.

[AndyH]

Because of all the effort already expended upon this issue, I am appending my question instead of starting anew.

DB plan for self employed person includes his wife (W-2) employee and a regular employee.

Assume DB minumum contribution is $300,000, $150,000 "on behalf of" the proprietor, $100,000 on behalf of the wife, and $50,000 on behalf of the employee.

Question #1: Is the contribution on behalf of the spouse treated like the contribution on behalf of the employee (Schedule C expense) or is the cost of the spouse treated as an addition to the cost for the proprietor?

Example, Ignoring the SECA tax, if the net Schedule C income after deducting the employee's and wife's cost is negative, is this loss permitted or does it become $0?

Thanks for any help.

[David MacLennan]

On Question 1, the spouse contribution is treated like an employee. I don't see how it can be otherwise, looking at the IRS instructions. Andy is there some inconsistency or problem you see in doing it this way?

Re Ques 2, I'm not a CPA, but I would think the loss would be permitted. The Sch C and IRS instructions give details on how to handle losses. On quick review of the instructions, it looks as though the loss is deducted on page 1 of the 1040, unless some of the investment in the business activity is not "at risk", in which case the loss is treated as deduction for the business in the following year.

[AndyH]

I was trying to determine if the prohibibition on a pension contribution on behalf of a sole proprieter creating a net operating loss could be sidestepped by shifting wages and thus pension accrual to a spouse. And if they are filing a joint return, could it then be used to offset other income that would otherwise be taxable?

Or, to put it another way, if a DB contribution is not fully deductible because it exceeds Schedule C income, can the spouse's contribution be effectively deductible by creating a loss and offsetting other income?

The second situation might occur accidentally.

[SoCalActuary]

Assuming that the spouse has wages and payroll tax withheld, then the cost of that employee belongs on the Sch C deduction. If this produces a loss, then the employer (the primary person conducting the business) pays no SE tax, and takes no deduction for pension on 1040 page one.

[AndyH]

But you would deduct the pension cost attributable to the spouse on Schedule C, just like as if it were wages, albeit on a different line, right?

[WDIK]

Schedule C, Line 19 (2003 Form)

[AndyH]

In the situation that prompted this question, the proprietor lost a major business contract, so his Schedule C drops substantially, to possibly $0 after deducting employee costs. If he has substantial investment or other taxable income, it might be worthwhile for him to continue the plan covering his wife only. Even though the resulting contribution would create a net operating loss, this loss would then be available to offset other taxable income. Or so it would appear.

I suppose one complication might be that the business must exist for the purpose of creating positive income. Maybe the wife's contribution would not qualify as an ordinary and necessary business expense?

Thanks for the feedback.

[SoCalActuary]

The business did exist. Revenues occurred. The expense of the employee (who happened to be a relative) was real, assuming it was paid & payroll taxes administered. Negative net revenue is only a problem if you risk running into the "hobby" rules for a sole-proprietor return. If there were profits in the last few years, the business is considered real.