K-1, Comp definition

[Guest m.n.ouellette]

Guys, I've been told by someone in my office that K-1 income can not be used in a person's wages for purposes of a retirement plan; that I can only look at W-2 wages. This client is an LLC and the partners receive mostly K-1 income, and very little W-2.

Please help... what is the answer? Can I use K-1 in addition to W-2 wages? The document says 415 comp, and for a SE individual - their Earned Income.

Thanks.

[Belgarath]

I'm not sure you are going to get a concrete answer on this one.

Generally, if an LLC is taxed as a partnership, then it would be reasonable to assume that the K-1 "earned income" would be the appropriate income to consider for qualified plan purposes. I would note, by the way, that if you had an S-corp, then you clearly cannot use K-income - for an S-corp it is W-2 only.

Every reasonable discussion that I have ever been able to have on this subject ends with only one thing on which there is general agreement - that it is highly unusual at best, and likely incorrect, to have an individual be both a "Partner" and an Employee of the same LLC for income tax purposes. Revenue Ruling 69-184 reaches the conclusion that the same individual cannot be both a partner and an employee, but this was probably before LLC's were around...

I think you would normally have to rely on the written instruction of the Plan Administrator/client, who should be intructing you on how to proceed based upon the advice of their own tax/legal counsel.

[John Feldt ERPA CPC QPA]

Good question. Compensation is one of the most commonly messed up factors for retirement plans.

That someone in your office may be confusing the K-1 for an S-Corp with the K-1 for a partnership. K-1 income from an S-Corp never counts as earned income for plan purposes.

From your statement, the LLC partners receive mostly K-1 income. An LLC is either treated (taxed) like a corporation, a partnership, or sole prop. If yours is taxed as a partnership, then the K-1 might be ok to use.

Might be ok? If the person receiving the K-1 is not materially participating in the creation of the income, they are only receiving passive income (like investment income), then they are not working there. Only wages from work (earned income) will be allowable for plan compensation purposes. Even a Sole Prop's schedule SE income could be considered passive income if they are no longer involved in making that business run.

W-2 is by default employee wages and thus earned income. 415 comp would include the earned income (non-passive income) of a partner. So, you will have to determine whether or not any of the K-1 amounts are non-passive earned income.

[Guest m.n.ouellette]

I think I got it. Y'all are great. This client IS operating as a partnership. Therefore, we only look at K-1 (they are materially contributing), and NOT W-2 at all, or can I combine the two?

I will talk with their CPA too; I just didn't wanna look like an idiot...

Thanks.

[Belgarath]

That's the crux of the question. If forced to opine, then I'd say you could not use the W-2, but this really is a decision to be made by the client on advice of his CPA. (And to cover your tail, make sure they instruct you in writing.)

[John Feldt ERPA CPC QPA]

To get both a W-2 and a K-1, perhaps they were not partners for the entire year, then they could get a W-2 for some of the year as an employee and then a K-1 for their share of the company earnings for the rest. Or the company could have changed from an corp (or LLC-Corp) to an LLC-partnership during the year.

Other than that, getting both a W-2 (with wages) and a partnership K-1 seems a bit odd.

[Bird]

They're not supposed to get W-2 income at all; it is, after all, a partnership. But it is, apparently, one of those "everybody's doing it" kind of things, and so far I haven't heard that the IRS cares. From a tax standpoint it makes no difference; I think it's just easier to do payroll withholding than estimated quarterly payments.

Anyway, we will use both W-2 and K-1 income. It's not all that easy because the W-2 income does NOT need adjustments for SE tax, and the K-1 DOES, and partnership calcs are bad enough without that complication, so you hope that they're over the limit and don't have to worry about it too much.

[jpod]

As someone already pointed out, the k-1 income must be "earned income" within the meaning of IRC Section 401©(2). If the p/s is throwing off income that is not "earned income" (and, therefore, not subject to the self-employment tax), it is reported on the k-1 but it cannot be counted for qualified plan purposes. I have seen cases where business owners and their accountants tried to have their cake and eat it too, by characterizing p/s income as other than "earned income," while thinking that the income can support a retirement plan contribution.