Calculating EBARs of the Two 50% Members of LLC

[Guest Dash04]

An LLC maintains a cross-tested & 401(k) plan. The LLC employs about 10 employees who are plan participants along with the two members, who are husband and wife and who each own 50% of the LLC ownership interests.

I would appreciate confirmation on the correct manner in which to calculate the two members' EBARs for calendar 2003. Specifically, I am questioning the "compensation" amount that should be used for the two members.

I suspect that I start off with each member's 50% distributive share of the LLC's income, as adjusted under Sec. 1402(a). Then, pursuant to Sec. 401©(2)(v) and (iv), I reduce this amount by:

(v) the deduction allowed for one-half the SE tax paid by each such member; and

(vi) the deductions allowed by Sec. 404 to the taxpayer.

Assuming this is correct so far, in arriving at "earned income," do I reduce the owner's distributive share of LLC income by the ENTIRE amount of deductible contributions made to the plan? OR only the amount that is allocated to each such member?

If the reduction is for the ENTIRE amount, does this include 401(k) deferrals?

RELATED QUESTIONS:

For purposes of the deductibility limitation of Sec. 404(a)(3), which limits the deductibility of profit sharing contributions to 25% of compensation paid to the participants ---

1. Does this same "earned income" amount get added to the compensation paid to the plan participants?

2. Are the LLC members subject to a separate deductibilty limitation equal to 25% of their individual "earned income" amount?

Thanks for the help. It's appreciated.

[Blinky the 3-eyed Fish]

Assuming this is correct so far, in arriving at "earned income," do I reduce the owner's distributive share of LLC income by the ENTIRE amount of deductible contributions made to the plan? OR only the amount that is allocated to each such member?

I didn't specifically look to see what you mean by your cites so I am not sure if you have the concept, but in determining earned income for a single member of the LLC you are only going to consider their share of the ancillary contribution and their allocation.

If the reduction is for the ENTIRE amount, does this include 401(k) deferrals?

No

1. Does this same "earned income" amount get added to the compensation paid to the plan participants?

Yes, earned income is compensation for self-employed persons. Just think as to what the answer would be if there were no ancillary employees. If you couldn't include the compensation, you couldn't have a retirement plan in that situation.

2. Are the LLC members subject to a separate deductibilty limitation equal to 25% of their individual "earned income" amount?

No, why would you think that?

[Guest Dash04]

Thanks for the reply ... and I like your answer, but ...

Sec. 401©(2)(v) provides that "the term "earned income" means the net earnings from self-employment, but such net earnings shall be determined ... with regard to THE DEDUCTIONS ALLOWED BY SECTION 404 TO THE TAXPAYER."

It does NOT say that "such net earnings shall be determined with regard to the deduction allowed by section 404 for contributions made with respect to the self-employed individual.

Is there any authority for your interpretation?

Thanks.

[Blinky the 3-eyed Fish]

The individual is the taxpayer in this case. Just think of how the LLC taxed as a partnership works for the LLC members. The income and expense of the entity is divided up appropriately and flows through to the K-1's, which are then part of the individual's tax return.

[Guest Dash04]

Thanks again for the reply.

I agree, the individual LLC member IS the taxpayer. Consequently, sec. 401©(2)(v) appears to me to require that that such member's distributive share of income be reduced by the total amount of the deductions allowed by sec. 404 to the taxpayer in arriving at the member's "earned income". At least arguably, this would include the deductible contributions made and allocated to the LLC's non-member employees, PLUS the deductible contributions made and allocated to the member taxpayer.

Stated differently, aren't the contributions made and allocated to the non-member employees of the LLC deductible to the member-taxpayer under sec. 404? If so, sec. 401©(2)(v) seems to require that these amounts be taken into account in order to arrive at the member-taxpayer's "earned income," which amount, so reduced, is presumably used in calculating the member's EBAR. Such a further reduction in "earned income," of course, would cause the member's EBAR to increase and would, therefore, make it harder for the plan to pass the discrimination testing on a cross-tested basis.

Sorry to be such a pain ... but I certainly don't want to disqualify the plan.

I look forward to your reply. Thanks.

[Blinky the 3-eyed Fish]

Stated differently, aren't the contributions made and allocated to the non-member employees of the LLC deductible to the member-taxpayer under sec. 404? If so, sec. 401©(2)(v) seems to require that these amounts be taken into account in order to arrive at the member-taxpayer's "earned income," which amount, so reduced, is presumably used in calculating the member's EBAR. Such a further reduction in "earned income," of course, would cause the member's EBAR to increase and would, therefore, make it harder for the plan to pass the discrimination testing on a cross-tested basis.

The ancillary employees' (you refer to them an non-member employees) contributions are just like other expenses within the partnership and they are divided up amongst the partners. This expense, like any other expense, reduces each partners' earned income.

As for the EBAR being reduced, first, if their net earned income is over the 401(a)(17) limit, then there is no effect. Also, writing off that business lunch is doing the same thing, so tell them to eat the costs if so concerned.

[mwyatt]

The plan contribution costs for the non-partners are split in determining each of the partner's net earned income. Remember that the conceptual map to follow is what you would be doing if this was a corporation and you were "back solving" to arrive at the salary. If you applied the entire non-partner deduction to each partner, you would be double counting the cost of the non-partners contribution which doesn't make alot of sense.