401k Qualification/Passive Income Only

[Guest John Comelately]

I have a client that is a S corporation. The corporation has been in business for 14 years and has now sold most of its business assets. For this year and next year it expects to only have investment income (e.g. interest, dividends, passive real estate, etc.) and will not have active trade or business income. It has two employees who manage its investments, evaluate new business possibilities, manage corporate matters, etc.

For tax purposed, the investment income and related investment expenses (including employee costs) are passed through to the shareholders on Form K-1. The shareholders deduct the investment expenses as Miscellaneous Itemized Deductions on their individual returns, to the extent they exceed the limit.

I have two questions:

1. Can the S corporation, with only investment income, set up a qualified 401k profit sharing plan? If not, why not? (I can not find any authority prohibiting a corporation, with only investment income, from establishing a qualified retirement plan for its employees. However, there are limits on the corporate deduction for the employer contribution to the plan and a possible excise tax on a non deductible plan contribution.)

2. If the corporation can set up a 401k plan, is the employer contribution an expense that will pass through on the K-1 to the shareholders and be deductible as an investment expense under the Miscellaneous Itemized Deductions on the individual returns of the shareholders? If not, why not?

All ideas and comments are welcomed.

[Jim Norman]

If there are no wages paid, there are no contributions available. Deductible limit is zero, 415 limit is zero. Contributions cannot be based on s-corp pass-thru K-1 income, only wages. For reference, court case directly on point is "Durando", you can find it by googling.

[Guest mjb]

Q: who will participate in the plan? If it is the two employees who are paid wages then a Q plan can be adopted by the S corp and the deductions passed on to the shareholders. Under IRC 1366(d) the share holders can deduct the contributions to the extent of their basis (investment) in the corp.

[Guest John Comelately]

If there are no wages paid, there are no contributions available. Deductible limit is zero, 415 limit is zero. Contributions cannot be based on s-corp pass-thru K-1 income, only wages. For reference, court case directly on point is "Durando", you can find it by googling.

Hi Jim

Thanks for your interest.

The two employees are actually employees. They are paid W-2 wages for their services. The corporation maintains a workmans compensation policy. Even corporations that have only passive income (e.g., real estate, equipment leasing, day trading in stocks and bonds, looking for new business investments, etc.) need real employees.

So. What do you think? Can a S corp. with real employees, but only "passive income" set up a 401k plan for them?

[Guest John Comelately]

Q: who will participate in the plan? If it is the two employees who are paid wages then a Q plan can be adopted by the S corp and the deductions passed on to the shareholders. Under IRC 1366(d) the share holders can deduct the contributions to the extent of their basis (investment) in the corp.

Hi mjb

Thanks for your interest.

The two employees would participate in the plan. (They are actual employees with W2 wages.)

Do you have an authority for your conclusion that a corporation with only "passive income" can establish a qulaified plan?

Thanks

[Guest mjb]

What does passsive income have to do with establishing a plan? S corp are no different than C corp in being able to sponsor a plan. Non profit organizations with passive income can establish a Q plan for its employees. Passive income does not effect amount of benefit which is determined from comp paid and both participants receive W-2 income. Passive income will effect the amount of the deduction that can be claimed by S corp owner who will not participate in the plan since deduction by owner is limited to basis but that is an accounting Q.

[namealreadyinuse]

Doesn't this raise part of the old ERSOP issue about carrying on a business. If it is a legitimate business with employees, they should be able to sponsor a QP.