Self Employed With W2 Earnings and K1

[Guest Midas]

If an owner of a partnership receives regular earnings through payroll that generate a W2 and files a K-1 for his/her share of partnership income, do you add the W2 and K-1 together for plan compensation purposes?

It has been my understanding that a partner in a partnership should not have W2 earnings and it is their earned income from their K-1 that is used for qualified retirement plan purposes. Has anyone come across a partnership, or sole prop for that matter, that receives W2 income? And if so, what amount is used for compensation for plan purposes (i.e. testing, benefit calcs)

[Blinky the 3-eyed Fish]

Why did he get a W-2? Was it from another source other than the partnership? If so, is it a related entity? Was it a misclassification of his draws during the year or did he just become a partner during the year?

It's got to be one of those 3 I think.

[Guest Midas]

None of the 3. The owner was an owner for the entire year and received the w2 earnings directly from the partnership. I have a couple of self employed clients that have run draws through payroll, but the draws come through as non-taxable income and zeros out at year-end. Not the case here.

We spoke with the client's CPA. The accountant explained that he advises some of his clients that are in partnerships or sole props to put themselves on payroll for reasons than have nothing to do with qualified retirement plan purposes. The accountant explained that the practice of self employed employees adding themselves to payroll to take advantage of common law employee benefits is in practice in many CPA firms. So the accountant is advising that we add the w2 and k1 together. He said he understands that this is against everything written, but because it is becoming a common practice, he feels the practice would be accepted by the IRS. I have not had enough exposure to small self employed businesses to know if this is common practice. My gut tells me it is not and the w2 earnings should be disregarded for testing and contribution calcs.

[Bird]

My understanding is that a partner should not be getting any W-2 income (unless they became a partner sometime during the year).

Having said that - it's done already. Had the partner not received the W-2 income his profits would have presumably been higher. I don't think I'd ignore it. But then that part doesn't get adjusted for SE taxes.

[GBurns]

Midas,

I am confused by your terms:

"an owner of a partnership". How does a person get to own a partnership?

"I have a couple of self employed clients.." What is the relevance or similarity of what an SE can do with what a partner in a partnership can do?

"the practice of self employed employees adding themselves to payroll to take advantage of common law employee benefits" What does this have to do with partnerships?

"I have not had enough exposure to small self employed businesses to know if this is common practice" As before, but with the note that a small self employed business is not the same or close enough to a partnership.

I think that you are overlapping the 2 differently treated areas and ending up with a misundertsanding of what should be.

[wmyer]

The plan document will probably define compensation for self-employed individuals for allocation purposes. Without having read your document, I am nevertheless sure it won't mention W-2 earnings for partnership compensation, for allocation purposes.

[Guest Midas]

Bird - Thanks for the advice.

GBurns

When I refer to an owner I am referring to ONE of the owners in a partnership who should be filing a K-1 for his/her share of the partnership profits.

I really don't follow your next question. The partner adding himself to payroll is the issue I am trying to address. His accountant suggested that he add himself to payroll for such things as when he tries to get a loan he would have some sort of earnings to show. That is what I mean about one of the partners (owners) of the company wanting to go on payroll to have some of the "benefits" that common law employees traditionally receive by having regular earnings.

I apologize my termonolgy is not where it should be, but when a refer to a self employed entity I was trying refer to non-incorporated business such as a partnership or a sole prop.

My question boils down to bascially two questions: 1) Should a partner of partnership be receiving regular earnings through payroll instead of taking draws? And 2) If a parner of a partnership has decided to receive regular earning through payroll instead of taking draws and filing a k-1 to determine earned income, can the w2 earning be used as compensation for qualified retirement plan purposes?

Again, everything I read in the code, the ERISA Outline and other sources implies that self employed employee's compensation for plan purposes is defined as earned income from the k-1 or schedule c. Nothing speaks to w2 earning being treated as earned income.

[Bird]

GBurns-

A partner is a self-employed person for tax purposes. I think Midas has a good understanding of the issue and described it quite nicely.

wmyer-

Good point that the doc probably does not include W-2 income in the definition of earned income. But then the W-2 is just hanging there...if the individual had been an employee for part of the year, and became a partner during the year, you would add that W-2 income, right (carefully)? I'd treat this the same way - knowing that the way it was presented to me was probably wrong, but not being in a position to do much about it.

[Guest Midas]

wmyer - thanks for suggestion. you are correct. the basic plan document defines owner-employee's or self employed individual's compensation as earned income. No reference to w2.

Bird - Thanks Again.

I had thought about the situation of an employee changing status mid-year might be good to apply to this situation. My only concern was could I continually apply that method going forward every year as it seems the partner wishes to remain on payroll going forward?

Thanks for all the comments!

[mbozek]

In order to receive a w-2 a person must perform services as an employee and the comp paid must be reasonable. How do you determine that some services performed by a partner are the services of an employee and the comp is reasonable? Is there a written employment agreement? Partnerships usually have written agrements which may prevent a partner from performing services in any capacity other than as an owner.

I thought there has ben previous discussion that the IRS does not allow a partner to receive a W-2 and K-1 from the same entity except where there is a change of employment status in a tax year.

I dont understand how a practice that is against everything ever written would be accepted by the IRS because it has become a common practice.

[Blinky the 3-eyed Fish]

Midas, for the record, your situation is #2 of the items I listed. It's a misclassification of his draws.

I seem to recall a prior discussion on these boards on this topic. No time to search for it though. My take is that because the W-2 classification is clearly incorrect the plan should not compound the problem. Instead add the W-2 to the K-1, treat the whole amount as earned income and proceed as if the accountant had done things correctly in the first place.

[GBurns]

What I was getting at is that it is quite unlikely and unusual for a partner in a partnership to be an employee. If not an employee then the person cannot be on the payroll. Whereas in a SE, sole corp, dba or S corp etc the "owner" can be an employee and on the payroll.

[Belgarath]

Here's at least one prior discussion - may be others.

http://benefitslink.com/boards/index.php?s...t=0entry97481

[Guest Midas]

Belgarath - thanks for the threads!

[Blinky the 3-eyed Fish]

You sound like a hippie.

[Belgarath]

Feelin groovy...

[Blinky the 3-eyed Fish]

You sound like a dork.

(That of course was a joke. You are groovy!)

[Belgarath]

Not to worry. I wouldn't have been offended anyway. It's Friday afternoon, and like the song says, "I've got no deeds to do, no promises to keep..."

Since the Northeast is getting thumped with yet another major snowstorm, I refuse to work! I'm going to watch a little NCAA hoops on Saturday, and go x-country skiing on Sunday. How could life be better?

[Guest Midas]

Blinky - a little before my time, but I probably would have been. Thanks as well for your input.

Just as an update..., I ended up breaking down and speaking with a Benefits Attorney that is also a CPA regarding this issue. His stance mirrors many of the responses I received, that this should not be happening. If the partner is a self employed individual, W2 income should not be permitted. For this one year, he believes if we document the facts and have a conversation with the partner to take himself off payroll, that we could safely add the W2 amount to his K-1 line 14 before calculating the SE tax deduction. But going forward year to year, he did not believe it wise to continue to add the two together.

Thanks for all the input everyone.