How to prevent partnership from DQ'd CODA?

[J Simmons]

As to partnerships and LLCs that sponsor cross-tested plans that do not identify allocation groups, what practical steps are you taking to assure that the employer contributions for partners and LLC members do not rise to the level of a disqualified CODA? I.e., what practical steps are you taking to dispel the notion that partnership contributions that vary in amount among partners is not the result of their individual choice? Treas Reg sec 1.401(k)-1(a)(6)(i).

What factors does the IRS look to in this regard on audit?

This seems particularly tricky given that the deduction for the employer contributions made for a particular partner or LLC member are allocated to him or her rather than treated as a partnership (entity) expense as is the case for contributions to a DB plan. Treas Reg sec 1.404(e)-1A(f). This takes from the rest of the partners any financial incentive not to allow the individual partner to make the decision of how much will be contributed by the partnership for that partner.

I've prepared written partnership and LLC resolutions that state the partnership contributions are decided by the partnership and not the individual partners, but such seem quite self serving (and vulnerable by reason of such).

[buckaroo]

John,

This is a question that has been bantered about for quite a while. I think from the lack of responses that no one has come up with anything more that you have already stated. We have done exactly as you have stated in you e-mail. If anyone had anything else, I would be happy to hear about it.

[ak2ary]

So, if one partner wanted to significantlt increase his contributions from prior years and it would cause a failure of the test absent a significant increase in staff contributions, he could make the increased contribution and the rest of the partners would have no choice but to fund the staff? No, I think not. I think the partnership would tell him, well we understand you want to put more away but it would be exorbitantly expensive for commensurate staff benefits and so you CAN'T have the higher contribution. And since the partnership has the right to nix the ideas of any partner...it is not a CODA

Based on the IRS' current ridiculous interpretation of what an definitely determinable allocation formula is; these plans are legal. It kills me that the people that benefit from the promotion of these plans are the first ones to say publicly (and continuously ) the "We all know these are just CODAs in disguise." They are NOT and we should stop talking that way.

There are limits that actually do get enforced from time to time by the partnership or the firm's executive committee or whatever the management group of the firm is called. The fact that the exec committee takes into account the goals of the partners in making contribution decisions is allowable and admirable, but taking into account the wants of certain individuals is not ceding contribution discretion to them. If the firm was having a rough year and the exec committee didnt think the firm should fund any staff contributio other than top heavy....BOOM every partner just goit knocked down to 9%...the discretion belongs to the firm not the partner...it aint a CODA.

Has anybody had one of these challenged and lost?

[J Simmons]

Ak2ary,

My concern is grounded more in allocations that vary significantly between partners, all the while the cross-tested plan is satisfying nondiscrimination with nothing more than 5%-of-pay gateway for non-partners, not a situation where a spike in contributions for a partner will necessitate any greater contribution for the non-partners.

Suppose a partnership of A and B. Partner A has earned income of $150k and Partner B has earned income of $150k. The partnership makes a 5%-of-pay gateway contribution for all non-partner employees. Partner A makes a $15,500 401k elective deferral. Partner B makes zero elective deferrals. The partnership makes a contribution of $25k more for Partner A, all of which is deductible by Partner A. Partnership makes no contribution for Partner B. On the demographics, cross-testing passes with no more than the gateway contributed for the staff, so Partner B does not care how much the partnership contributes for Partner A.

Are there any practical steps that can be taken to shore up the claim that the partnership, and not just Partner A, made the decision to make the contribution it did for Partner A?

[Tom Poje]

this will always be an issue until the IRS invents some type of guidelines. I'd lean toward the burden of proof being on the IRS. lets suppose in your example partner B was excluded from the plan, but had his own plan with no other participants.

now would you have an argument against him receiving 0 some years? the end results are the same.

in fact, take it one step further. how come a one person plan (strictly profit sharing - no 401(k)) - how come that is not deemed to be a CODA since the person decides each year how much to put in?

[ak2ary]

Jsimmons

Your example makes precisely my point. The PARTNERSHIP decided to make a contribution of 5% of pay for staff. The Partnership could just as easily decided upon 3% or 0%. Lets assume that the partnership had decided upon a 2% of pay contribution for staff. Partner A still wants the 415 limit, but the PARTNERSHIP will not allow him to have it. Again, there is nothing wrong with the PARTNERSHIP taking into account an individual partner's desires, but the PARTNERSHIP has final say over the contribution.

Even in your example where the 5% contribution is already decided. Assume Partner B for some reason based on their long and stormy relationship, doesn't want Partner A to be able to shelter the contribution from taxes (or from creditors)...perhaps Partner B is one of Partner A's creditors... if partner B doesn't sign off on the contribution for Partner A (assuming they are 50-50 partners), Partner A cannot have that contribution...it simply is not his ultimate decision...he gets to weigh-in, but he doesn't get to decide.

Having said all that, there are some practical steps

-- plan document should clearly define how the contribution is determined (e.g. by resolution of the executive committee of the partnership)

--the partnership should actually do what the plan doc says in terms of declaring the contribution

-- there should not be an election form for the partners to choose how much they are going to contribute

--the email trail soliciting partner input on contribution levels should not reference "how much do you elect to contribute?" or anything like that

--the partners should be aware that they do not get to decide their own contributions, that it is a partnership decision, although the partnership will take into account theiir desires to the extent possible

-- at the end of the day, while I think the deemed CODA concept is overhyped, at best it is a potential operational error. And the best way to avoid operational problems is to follow the plan document. Don't tell the client that each partner gets to pick his own contribution every year..rather explain that the level of contribution for each partner is a partnership decision and while there is year to year flexibility in the contributions, before changing the contribution level for any partner the partnership will have to look at the impact on the discrim tests and other factors, but most times partners' needs can be accomodated.

[J Simmons]

Ak2uary,

Thanks for your bulleted list.

In the particular circumstance that has prompted my concern and OP, a partnership check was written and signed alone by Partner A (Partners A and B each have individual signing authority) to make the contribution in question. Partner B has been completely indifferent to what amount Partner A put into the plan, since it is all allocated to Partner A--in the plan and in the partnership flow-through. Partner A seems equally indifferent to the fact no contribution is made for Partner B.

In the future, I'll instruct them to take the precautions you mentioned and to have B sign the partnership check for A's contribution.

[Belgarath]

Let me ask for a bit of discussion on the issue where it is a sole prop rather than a partnership. There are some peoiple who believe it is perfectly acceptable to have the sole prop in a group all by themselves. Have any of you ever requested a determination letter or had an audit in such a situation? How did it go?

[J Simmons]

Good morning, Belgarath,

I have received favorable d-letters for the sole proprietor X-tested plans where the sole prop is in a grouping all by him/herself.

[K2retire]

I've also had quite a few.

[Belgarath]

Thank you both. Our problem with this is that in order to get approval of our VS document, the IRS forced us to put this in the adoption agreement in the section where the employer designates the groups:

"...In the case of self-employed individuals (i.e. sole proprietorships or partnerships), consider the requirements of IRS reg. § 1.401(k)-1(a)(6) so that the allocation method does not result in a cash or deferred election being created for any self-employed individual..."

So I guess we could remove this language and file for a d-letter on each such plan, to see how it goes. I suppose that raises another question - does the IRS consider this an operational issue rather than a language issue, so that the d-letter doesn't provide any protection upon audit? Seems like it would be rather unreasonable for them to argue this.

[TPA Bob]

We have taken a different approach, which does not solve the AB example above but gets closer. All of these arrangements are safe harbor with QNEC, with the cross tested profit sharing to maximize contribution. We tell our clients (yes, law firms) that each partner gets to elect whether or not they will contribute 401(k) (22,000 of the equation) but they will not have the ability individually to say if they will get the profit sharing piece - that is a Partnership decision. The end result is A gets his/her 54,500 for 2009 and B will receive 32,500. Or A gets 29,350 (22,000 plus 3% 7,350) and B gets 7,350. Anything outside of this we advise against. And if they ignor they do at their own risk (knowing the exposure). Without any guidance one can argue the issues.

While I appreciate the steps provided earlier, the bottom line is that each partner's distributable share of income is not impacted by the election to contribute or not. And when this is the case I think you have a difficult time saying the contribution of 54,500 to one partner and 0 to the other partner, when not affecting overall distributive share of partnership income, was done at the partnership level.

[Tom Poje]

Belgarath:

Interesting. The language you were required to put in the adoption agreement comes from LRM 94.

I'll post it again, the particular verbage is in green.

[Belgarath]

Yeah, and although we tried to "push back" and not include it, the reviewer insisted. So I'm just wondering if folks who have received d-letters have this language in their documents? If not, we can try removing it, but it seems that when you highlight the removal, it might prompt a reviewer to give you a different result than if it isn't there to start with...

If they DO have this language, the it would appear that the IRS isn't enforcing this "rule" unless they view it as an operational issue, hence my prior question.

What a bore!

[Tom Poje]

so, they say you can put people in their own groups

and then say just make sure you don't operate so that in effect it becomes a CODA,

with the caveat added at one of the ASPPA conferences

"We will know abuse when we see it"

gotta love it.

(I'll give them credit for at least following the LRM!)

[J Simmons]

Belgarath,

I can certainly see the issue. I've also had some (but not great) success in pushing back on the prototype document review team before I get my opinion letter. However, in pushing back against the reviewers of d-letter applications, I've had good success.

For example, in the GUST II restatement period, I put in my X-tested amendments to the prototype a provision that after the year was ended, the employer could at the time of making a contribution declare by so labeling it a 'non-X-tested contribution' that would then be allocated per a permitted disparity formula. This was the fail safe. It was only used if X-testing did not look good for whatever reasons. If X-testing did look good, then per the same amendment the employer could declare it to be an 'X-testing contribution', and allocated per the rules set forth in the amendment for x-testing.

Each time one of my d-letter applications went to an IRS office that had not seen this before, I was told that we could not do that. I then had readied my analysis of the definitely determinable formula requirement, including what was called the Gold memo (internal at the IRS on the issue). A few times I got a call from the reviewer or a superior, and I just kept talking until the reviewer wanted off the phone. A few weeks later in the mail would come the d-letter, but as I mentioned, each time it was the first such application to an IRS office that had not seen this amendment before, we got static and we just pushed back until they issued the d-letter.

Now, for EGTRRA, they like language that permits post-year end determination of the rate groupings (even more liberal in light of the definitely determinable allocation formula requirement), even allowing it in prototypes. However, it is a bit more tricky now to get to use permitted disparity to demonstrate nondiscrimination if you have the LRM language for X-testing.

In any event, I'd be ready to push back with the IRS if you get any static. To date, I've not run into any such static over the clause you refer to with regards to an X-tested plan for a sole prop.

[12AX7]

In deference to LRM 94, could someone please explain how the deemed CODA is avoided for a Sole Prop where this person is in their own allocation group?

[J Simmons]

In deference to LRM 94, could someone please explain how the deemed CODA is avoided for a Sole Prop where this person is in their own allocation group?

The fiction of the Sole Prop wearing two hats, one as employer and one as employee, is elevated to its extreme. Otherwise, Sole Props would be limited to the 402g amount in benefit accruals, not the 415c limit which was intended to apply. Since there is no one else, and no grouping, to make the decision for the employer except the Sole Prop, the IRS choice is to truncate for Sole Prop's their 415c accrual limit to the lesser 402g limit or respect the two-hat fiction.

With a partnership, it is is different. The IRS does not have to defer to such a fiction. There is a grouping that is to make the decision for the individual. It is the partnership, not each partner, that is to make the decision as to the amount of the partnership, 'employer' contribution. If the circumstances suggest that the individual partners were each allowed to decide for the partnership what the contribution for that partner would be, that is clearly a disguised, disqualified 401k feature.

[12AX7]

Thanks for the explanation. The paradox will always be there.