Parnter Forfeits

[austin3515]

So I have a client who (without my "permission") paid out a terminated partner as though he was 100% vested when in fact his PS money was just 60% vested. I explained that this was wrong and they said, "that's ridiculous, it's money that came out of his pocket" which is true inasmuch as it was a reduction directly to his capital account. I told my client that it was really an excellent question and I would look into it...

Has anyone ever run into this before? I have a theory that the appropriate way to handle is obviously to forfeit the nonvested portion but perhaps increase his capital account by the amount of the forfeiture.

Any cites (though unlikely?) would be appreciated...

[masteff]

How are forfeitures used in that plan... to fund future employer contributions or allocated to the other participants?

[austin3515]

Well of course in a discretionary PS plan like this one, the point is moot. But let's its allocated out to remaining participants. Again, though, obviously the money should have been forfeited, blah blah blah. So in my plan, the employer could excercise its right to declare a lower contribution than it might have, yada yada yada...

I'm really more focused on the fact that the partner did fund his entire contribution from his own capital account, and the uniqueness related to that.

Hey I broke 1,000 posts! Do I get a certificate or anything????

[Bird]

I'm really more focused on the fact that the partner did fund his entire contribution from his own capital account, and the uniqueness related to that.

I don't think it matters - the plan doesn't care where the money came from. The "fair" thing to do, well, to have done, would be to pay out the vested amount and then increase his capital account to make it up.

[JanetM]

How about a gold star? How many participants in this plan. Is plan small enough that one term triggers 100% vesting?

[masteff]

I gave this some thought overnight. My thought is the partner took a tax deduction for the full amount of the contribution so he doesn't have a taxable loss to recognize. Also, by virtue of it being a forfeitable amount, there's no grounds to adjust his capital account. Further, since it occurs in the Plan, the forfeiture is not an accounting transaction on the partnership's books (at least not that I can find) so again no grounds to adjust his cap acct. The remaining partners however might gain an economic benefit if they reduce future PS contributions by the amount of forf allocations. If they are so inclined to make the ex-partner whole for that, then they should add the amount to the partner's buyout (after he returns it to the plan).

Tax effect of adding to capital account: Money goes back to plan. Amount is added to capital account. Partners increase payout. The amount added to cap acct is ordinary income, probably subject to SE tax. Tax and taxable income go up.

Tax effect of not adding to capital account: Money goes back to plan. Partners increase payout. This increases ex-partner's proceeds from sale of partnership interest. The proceeds are capital gain income. Tax and taxable income go up.

So it's either ordinary income or capital gain income. I personally would prefer cap gain income (and I think that's the more proper method).

Of course if the partners don't increase the buyout by the amount of the windfall, then the ex-partner simply has a non-taxable loss (because he previously took a deduction for the contribution).

[MARYMM]

I'm really more focused on the fact that the partner did fund his entire contribution from his own capital account, and the uniqueness related to that.

I don't think it matters - the plan doesn't care where the money came from. The "fair" thing to do, well, to have done, would be to pay out the vested amount and then increase his capital account to make it up.

I've worked at a firm where this was came up fairly regularly. We paid out/rolled over the vested amount but the "make up" was not to the capital account since a distribution from capital would not be taxed. We paid the forfeiture amount to the ex-partner as earnings for the year of termination. It was included in his k-1 for that year so it offset the tax deductions that had been taken when the contributions were made.

[J Simmons]

The partner is an HCE. Outside the plan, the ER (the P-ship) is making up the forfeiture inside the plan by a payment to the HCE, a make up payment that the ER does not make for NHCEs due to what they forfeit inside the plan. Does anyone know if the IRS has any problems with what amounts to a vesting requirement on NHCEs that effectively does not apply to HCEs that are partners? or is the IRS okay with it since the make-up is outside the plan and doesn't have the tax advantages of being inside the plan?

[austin3515]

Thanks MaryMM!

There is no way you can discriminate in favor of an HCE IN a qualified plan through something that takes place OUTSIDE the plan. As long as you operate the plan in accordance with its terms, your OK in my book.

[Bird]

We paid out/rolled over the vested amount but the "make up" was not to the capital account since a distribution from capital would not be taxed. We paid the forfeiture amount to the ex-partner as earnings for the year of termination. It was included in his k-1 for that year so it offset the tax deductions that had been taken when the contributions were made.

I agree and stand corrected. Not being an accountant, I should have added "or whatever" or something to my suggestion.

And FWIW, I agree that there should be no discrimination concerns wrt making up the forfeiture outside of the plan.