"Earned Income" of a Partner

[J Simmons]

P-ship issued a K-1 to P1. It showed an amount in excess of the compensation limit for 2007 ($225,000). On that basis, TPA tested an allocation of employer contributions for P1, in the P-ship plan’s nondiscrimination testing, using the $225,000 amount for her compensation.

P1 did not roll the income from the K-1 into Line 17 of her Form 1040 via Line 28 of Schedule E. Instead, P1 brought the K-1 income into a Schedule C (with the resulting amount from the Schedule C ending up on Line 12 of her Forms 1040). Due to expenses claimed and deducted by P1 on the Schedule C, the end result amount from the Schedules C onto Line 12 of the Forms 1040 was $85,000.

P1 has notified the P-ship that her earned income was $85,000, not $225,000.

My question is not about the appropriateness of what P1 did (i.e., running the K-1 ordinary income through Schedule C rather than Schedule E).

My question is whether for purposes of the P-ship's plan, is P1's compensation for 2007 the $225,000 as more than that was reported as her ordinary income from the P-ship on the K-1? Or is it the $85,000 that she's notified the P-ship about, and requiring that it recompute the nondiscrimination test--and reduce her allocation from P-ship contributions?

If the $85,000 must be used in a recompute of the nondiscrimination testing, and thus part of her employer contribution taken from her benefits, it would appear such would have to be re-allocated among other employees and could not be returned to the P-ship under a 'mistake of fact'. Even with the reduction in P1's compensation, the total employer contribution would yet be deductible. Agree/disagree that the extra would have to be re-allocated among other participants rather than returned to the P-ship?

[BeckyMiller]

This whole question about business expenses paid by the partner, rather than the partnership and their impact on plan compensation has been bouncing around for years without any clear resolution. In today's world of preparer obligations under new IRC Section 6694 and the need to conclude at a more likely than not standard, for the person preparing this partner's tax return, I would say that they have a real issue. The statute says that for a self-employed person, compensation is their "net-earnings from self-employment" for the venture sponsoring the plan. I don't see that putting the expenses on Schedule C, rather than claiming them against Schedule E income changes what really is "net earnings from self-employment" with respect to the partnership. (Obviously, there is the whole question about whether or not such expenses really are legitimate expenses to be deducted against partnership income or are they really personal business expenses that are only deductible on Schedule B.) BUT, if they are bona fide business expenses deductible from partnership income, they would reduce this partner's income under IRC Section 401©(2)(A) and as such eligible compensation for plan purposes.

However, I have never seen this requirement - to get partners to report their net earnings from self-employment as reported on THEIR tax return - enforced in any IRS examination of a partnership plan. When the non-discrimination regulations were updated after the 1986 act, this question was specifically raised and the IRS chose not to take action.

SO - what is the answer? There is the technically correct answer and there is what most everyone seems to do. Even under the new penalty provision, the preparer gets the out if they have a reasonable basis for believing that a certain result would be more likely than not to succeed. Can we say that an undocumented non-enforcement pattern creates such a reasonable expectation? Don't know, we just have proposed regulations on Section 6694 at this time and they offer little help on this thorny matter.

[J Simmons]

Thanks, Becky. Your thoughts not only validated but further fleshed out some of my own thinking on this issue.

[Bird]

I ignored this as "too messy" the first time I saw it, but since it has reappeared I'll comment for the sake of discussion.

I don't think I would necessarily accept the partner's assertion that her earned income is $85,000. Her approach of running the partnership income through a Schedule C is probably inappropriate, and while it's not my place to tell her she can't do it, it's my place (as the TPA working for the partnership) to say that her Schedule C is irrelevant for my plan calcs. There are certain expenses that can be claimed by a partner, and we ask for them (or, more typically, find that they are not significant enough to reduce comp below the limit). If they are properly claimed and reported to us we'll use them. If not, well, that's not the plan's problem.

[QDROphile]

I second Bird.