Partnership Earnings

[Oh so SIMPLE]

This is a question about determining the earned income of a partner. The partnership has determined that the partners do not actively participate. They meet from time to time as a board to discuss and decide issues that have come up in the partnership's business. The partnership reports on K-1's the income to its owners as passive, not subject to self-employment tax.

One of the partners reports on his 1040 that he materially participates in the business of the partnership for the year and pays self-employment tax, so that he could accrue a plan benefit. The other partners report the K-1 income as passive on their 1040s and do not pay self-employment tax.

The partnership does not take into account as plan compensation what it reported to any of the partners on the K-1's as passive income.

The partner that claimed material participation and paid self-employment tax wants his income to be earned income under 401© and considered as plan compensation so that he can accrue plan benefits. He points to some proposed regs that show as an example that attending regular business meetings of the partnership meets the de minimis activity level required.

The other partners are concerned that if the plan were to accommodate him, it would call into question their treatment of the K-1 amounts as passive income and trigger self-employment tax for those other partners. Some of them spent more time attending to the partnership's business (i.e., attended more of the management meetings) than did the partner that chose to pay self-employment tax.

The partner that paid the self-employment tax insists that if he is not allowed to accrue a plan benefit, he will file amended returns to claim a refund of the self-employment tax and that could be what triggers an audit of the partnership and the partners on that issue.

As the plan administrator, the partnership must decide if the partners' earnings are "with respect to a trade or business in which personal services of the taxpayer are a material income-producing factor". IRC 401©(2)(A)(i).

What should the partnership, which is controlled by the 'passive' partners, do?

[K2retire]

Sounds like an excellent question for the partnership's ERISA attorney!