Partnership Net Earned Income Issues

[Guest Doug Goelz]

Issue 1:

I would like to know if anyone has any experience dealing with net earned income calculations for large partnerships that have numerous partners that extend their personal tax filings.

As a result of the tax filing extensions, the amount of unreimbursed partnership expenses claimed by some partners is not available in some cases until very late in the year. Since these deductions are taken into account by Schedule SE before calculating the 1/2 self employment tax deduction, the whole NEI process appears to be stalled -- which in turn delays the contribution allocation and testing. This delay in the contribution determination then causes complaints by the partners that do want to file their returns early.

Assume that there are partners that make under the compensation cap and that there is not a single accountant that prepares all the personal tax returns for the partners as well as the Form 1065 filing for the partnership.

Does anybody have a workaround methodology that somehow sidesteps this unreimbursed partnership expense issue that has been reviewed by the IRS?

Issue 2:

What is the proper way to allocate a defined benefit plan contribution deduction to the individual partners. Based on the following sections taken from Sal Tripodi's ERISA Outline Book., there seems to be some issues that will need to be considered to properly make this allocation. It seems as though there is no common-law employee contribution deduction, and the entire contribution to the defined benefit plan is allocated to the partners based on the same proportion as the partners' profits interests, regardless of whether the contributions are made to fund benefits for the common law employees or the partners (even though some partners may be older than the others and more of the contribution costs are needed to fund these partners' benefits).

The author of the FSA referenced by Sal analyzes Treasury Reg. section 1.404(e)-1A(f)(2) which was promulgated under a Code subsection that was repealed by TEFRA. However, since the subsection did not specifically address allocations the FSA author concludes that the rationale remains applicable. Treasury Reg. section 1.404(e)-1(e), effective for tax years prior to 1974, was the operative regulation for partnership allocations of partner’s retirement plan deductions without distinguishing between defined contribution or defined benefit plan contributions. Treasury Reg. section 1.404(e)-1(e) is substantially similar to Treasury Reg. section 1.404(e)-1A(f)(1) which is effective for tax years after 1973 but with specific reference to defined contribution plan deductions. Treasury Reg. section 1.404(e)-1A(f)(2) was added specifically addressing defined benefit plan contribution allocations to partners.

Treasury Reg.1.404(e)-1A(f)(2) provides in part:

In the case of a defined benefit plan, a partner’s distributive share of contributions on behalf of self-employed individuals and his distributive share of deductions allowed the partnership under section 404 for such contributions is determined in the same manner as his distributive share of partnership taxable income….

Except for the applicability of this regulation, the general statutory scheme of IRC 704 would allow for the partnership agreement to be drafted to try and make the economics of funding a defined benefit plan deduction match the allocated cost of the defined benefit plan for that partner. The FSA author also concludes that the defined contribution plan deduction for all partners should be shared by all partners in accordance with their interests in the partnership. However, this interpretation conflicts with Treasury Reg. 1.404(e)-1A(f)(1).

Considering the plain language of Treasury Reg. 1.404(e)-1A(f)(2) requiring defined benefit plan deductions to be allocated consistent with the partner’s computation of his distributive share of partnership taxable income, is there a way around this requirement to allow for matching the partner’s defined benefit plan deduction with his economic cost?

[mwyatt]

Intriguing that the regs say to split DB contribuitions on partnership interest (try explaining that to the 60 year old partner and the 30 year old partner BTW), rather than on what develops from the actuarial valuation (of course you're dealing with a large partnership that probably uses a funding method other than Individual Aggregate). Would you also use this strategy in a cross-tested DC plan, ignoring what each partner actually received? I can see allocating cost of non-partner participants on partnership percentage, but in the DB world allocating costs strictly on partnership interest doesn't make a tremendous amount of sense (or will cause the wars between young and old partners to move to WMDs).

[David MacLennan]

Issue 1: No workaround possible, since it is simply data that must be acquired, right?

Issue 2:

Are you are saying that Treasury Reg. section 1.404(e)-1A(f)(2) does not permit any allocation of deduction in a DB plan other than one based on partnership percentage? If so, I would disagree. The section goes on to say "see section 704 . . . and the regulations thereunder." I interpret this to mean that one can avail oneself of the rules under 704, but that if the partnership agreement does not address the allocation of DB plan deductions, then the default is the partnership percentage. Another (well respected) actuary has told me that in his experience IRS auditors have taken this interpretation (I looked, but couldn't find anything in the Examination Guidelines).

If instead you are saying you want to be able to allocate the deductions in a different way other than by partnership percentage, and you don't want to modify the partnership agreement, the only justification I can think of is that the Sch K-1 instructions seems to suggest that DB deductions be allocated based on the "amount of benefit for the current tax year" - sufficiently vague to allow for many interpretations. Certainly this is clearly inconsistent with the Regs and maybe therefore allows one to be able to argue any reasonable method.

I may be overtired, but should I know what "FSA" stands for? (other than Fellow of the Society of Actuaries, or Funding Standard Account)

[Guest Doug Goelz]

A couple of things:

mwyatt: I think it is clear from the regs that each partner's actual allocation under a DC plan is what is deducted for that partner [see 1.404(e)-1A(f)(1)], and I don't see how the plan satisfies the nondiscrimination rules would change this. Therefore, cross-tested plans are handled no differently than any other DC plan.

David: FSA as I used it stands for Field Service Advice issued by the IRS National Office during the course of a plan audit. I agree with what you say. My intent in posting the message was to find out if anybody had something of substance (say something else from the IRS) that could be used as a solid counter against the FSA.

Sal states in his book, "There are no regulations that require an allocation of defined benefit plan deductions different from a partner's interest in other partnership items and Treasury Regulation 1.404(e)-1A(f)(2) specifically prohibits a special allocation of the defined benefit plan deduction. Although that regulation was issued under a now-repealed tax code section, the IRS feels the underlying rationale remains applicable."

Attached is the FSA in a Word document.

Partnership_NEI_DB_Deduction_FSA_1992_0626_4.doc

[David MacLennan]

I was wondering, from a legal point of view, whether IRS Instructions to a tax form provide any reliance. It seems clear that the K-1 instructions state that the DB deduction is NOT to be allocated based on the partnership percentage, but rather on some measure of the benefit given to the partner. I have not seen any disclaimer statement on IRS form instructions that says: "where the code or regs differ from these instructions, the code or regs must be followed." Anyone thought about this before?

Doug: Thanks for the FSA. I've added it to my reference collection.

[mwyatt]

Hey Doug:

What I was getting at was more the point of allocating DB contributions based upon the costs incurred by the underlying partners. Let's say you had 3 equal partners, 1 60 years old, and 2 30 years old. Clearly a DB plan would more than likely have a tremendous cost being developed for the 60 year old partner and nominal amounts for the 2 younger partners. Really wouldn't make a tremendous amount of sense to me to split the aggregate cost in equal thirds.

[E as in ERISA]

On issue one: Be careful that plan accruals are not being affected by aggressive individual tax strategies. Just because they're deducting it on their individual returns doesn't mean it's really "an expense of the partnership" that should be considered for plan purposes. According to the Schedule E instructions, the partner may only deduct "unreimbursed ordinary and necessary expenses" paid on behalf of the partnership if the partner was "required to pay these expenses under the partnership agreement." Some partners are a little aggressive in claiming unreimbursed expenses on their returns. They may throw any expenses remotely associated to the partnership on their return just to reduce their taxes (e.g., automobile expenses, equipment, entertainment, etc. that the partnership doesn't require the partners to actually incur). You could ask the client to verify with its tax counsel which expenses should be considered as partnership expenses for purposes of the plan accruals.....

[mwyatt]

An epiphany just struck me:

Switch to a beginning of year valuation. I'm assuming in your pool that you have diligent people, as well as those folks who like to ride on the "double secret probation" edge up to 10/15. You're doomed to failure if you're counting on the procrastinators to get their act together. Move to a beginning of year valuation, and regardless of how this argument of divvying up costs plays out, at least you know what is going on before the fiscal year is over...

[Mary Kay Foss]

I have a client who is the "young" partner in a three person partnership. The other two partners are each 10 years older than she is. The partnership had a DB plan, the contribution for the older two was (of course) much larger than the one for her. The preparers of the partnership return allocated the contributions based upon how much was put away for each partner. Since the partnership itself paid the contributions for all three partners as well as the other five employee, my client was paying 1/3 of the expense and not getting to deduct 1/3 of the total cost.

We provided the FSA mentioned above to the return preparers that agreed they had made an error. They amended the partnership return and I amended my client's return and she got a tax refund.

One of the other two partners was extremely unhappy about this result. They no longer have a DB plan.

[Mike Preston]

One of the key provisions of the FSA is: "The partnership agreement makes no provision for allocations of Keogh plans different from the partners' profits percentages. "

The partnership clearly needs to understand its own partnership agreement. That is not the province of the actuary or the third party administrator. It wouldn't surprise me if somebody tried, some day, to hang their plan advisor for their own failing of not having a properly drafted partnership agreement. I would hope that since plan advisors have historically never, ever provided advice as to how partnership agreements are structured the responsibility would end up where it always has been: with the drafter of the partnership agreement.

[Mike Preston]

Doesn't the FSA also presume that the partnership in question is subject to the same share requirement? Whether such a requirement applies to a given partnership, is advisable to be applicable to a given partnership or can/cannot be avoided with respect to a given partnership is another item that is not the purview of typical discussions between a plan sponsor and its ERISA advisors. Instead it is properly the responsibility of its attorneys.