Profit Sharing Plan for One Employee

[Guest inquiry2]

Small law firm has 2 partners, both highly compensated employees (X and Y), 1 attorney (Z), and 4 staff people. X and Y contribute to a SEP plan. X and Y pay Z and salary and issue a W2. X and Y pay Z a 50% commission on any business Z brings in and issue Z a 1099 for that commmission.

I understand there are issues with X and Y issuing both a W2 and 1099, but if Z pays both the er and ee portions of FICA, still a problem?

Also, Z had originally intended on making a contribution to a SEP plan. However, instead can Z can set up a profit sharing plan for Z only in 2003? Z's salary plus commission is currently less than $80K, but expected to grow. No staff ees nor X or Y are interested in participating in the profit sharing plan.

What issues with

-starting profit sharing plan at end of year?

-discrimination testing?

-contribution limits?

[Mike Preston]

I'm not an accountant, but if the generation of that commission income was based on effort while an employee (and not, say, while dining people on Saturday night) I'd say the 1099 concept would likely not fly on audit.

You make the point that, from a FICA tax perspective, all should be ok as long as all the income is reported and the taxes are paid. No argument there, although the employee's share is too high (he pays 7.65% too much, the employer doesn't pay enough).

But the real issue is one of discrimination as to compensation. Treat the 1099 as W-2, but exclude it from consideration under the plan(s) and see where you get. Maybe it would be ok because the only person benefitting under the plan is Z, an NHCE, which would be fine.

Now, assume Z is supposed to participate in the SEP. If the SEP contribution is based solely on the W-2 income the entire SEP is at risk because if the IRS determines that the 1099 income should have been W-2, Z didn't get the same percentage in his SEP as X and Y. So, I'd say that is a big problem.

Assuming a non-model SEP (or, maybe it would be better put to say "assuming a prototype SEP instead of a model SEP) and assuming the SEP is ok standing on its own, I believe there is no prohibition against the "small law firm" sponsoring a profit sharing plan. If that plan covered only Z, that would be fine because Z is an NHCE. The maximum contribution would then be 25% of W-2. If you want to go over that amount, you can include the other four employees to the tune of $1 each. Then the amount going to Z could be 25% of all compensation (other than X and Y) less the $4. The maximum amount going to Z would then likely be 100% of W-2 (something like W-2 of $40k and contribution of $40k).

But that is probably more complicated than you want to deal with in this situation.

So, why are x and Y the only participants in the SEP?

[Guest inquiry2]

Thanks for the information. I'll re-visit the 1099/FICA/W2 issue. X & Y have individual SEPs, and no other ee, other than Z, seems to be interested in deferring income.

[Mike Preston]

If I were you, I'd take a look at that SEP. It has rules that have to be followed, just like a qualified plan. And it sounds like you think those rules are based on how much money an employee wants to defer. That is not true. Unless it is a SAR-SEP, the amount of money being funded has to be the same percentage of pay for each participant. In this case, it sounds like you have at least two participants (X and Y), so at the least they each have to fund the same percentage of pay. Have they?

In all likelihood, though, there are other employees who are also supposed to be receiving contributions. The eligibility for a SEP can be a bit longer than the eligibility for a qualified plan, like 2+ years instead of 1, but once one satisfies the rules as established in the SEP document, there is a REQUIREMENT that the participant receive the exact same percentage.

Now, if it is a SARSEP instead of just a SEP (had to be in existence since 1996, I think, for the SARSEP rules to apply) then the plan can indeed accept deferrals. However, there is still an ADP test that must be performed and if the only people deferring are X and Y then the rules aren't being followed.