Carrying forward deductions - DB and now DC plan

[TPAnnie]

I apologize in advance if this is not the right forum...

I'm so confused by this issue, I'm not sure where to turn. The employer is a sole proprietor, no other employees. He had a DB plan which was terminated at the end of 2005. For a few years, 2003-2005, the contributions required to meet the DB minimum funding standards exceeded the amount that was deductible, so he was making required contributions that weren’t deductible (for a sole proprietor, the maximum deduction is limited to earned income minus ½ se tax). He was able to deduct some of those contributions in subsequent years, subject to the deduction limitation in those subsequent years. After the 2006 tax deduction, he still has about $60,000 of contributions that were made that have not yet been deducted. He now has a 401k profit sharing plan. For 2007 he has earned income minus ½ se tax of about $200,000. He’d like to get the maximum deduction possible, using both as much of the $60,000 plus as much current 401k and profit sharing contribution as possible.

The question is, can he deduct some/all of the $60,000 PLUS make deductible 401k and profit sharing contributions for 2007? If so, how much? Or, if he makes the maximum $50,000 401k/profit sharing contributions (he’s over age 50), is that $50,000 the maximum deduction allowable for 2007, and he’ll have to continue to carry forward the $60,000 for deduction is some future year? Or is the deduction subject to the DB/DC combined plan deduction rules, even though the DB is not currently in existence and there is no current contribution to the DB.

Thanks in advance for any insight!!

[tymesup]

You might get some help on this forum.

The plan was terminated in 2005. You mention he took deductions in subsequent years, implying the plan continued for more than a year.

Was the plan truly terminated? Normally, distribution must take place within a year of the termination.

Were the assets of the trust distributed?

[Guest Sieve]

I don't want to rain on your parade, Annieruok, but I fear that the excess contributions made in 2003-2005 above the individual's earned income are not deductible at all, even if carried over into future years. I think you have more serious issues to deal with than how much can be currently deducted.

Look at IRC Section 404(a)(8)©. That says that the contributions made "on behalf of" a self-employed individual "shall be considered to satisfy the conditions of section 162 or 212" to the extent those contributions do not exceed earned income. The provision does not say that such excess amounts simply are not currently deductible in that specific year, but that the excess will not be considered to satisfy IRC Section 162 or 212. (You said that this sole proprietor has no employees, so the entire contribution has been made "on behalf of" the self-employed individual.)

In order to deduct a contribution to a qualified plan, the contribution must first be deductible elsewhere in the Code other than IRC Section 404: "If contributions are paid by an employer to . . . a pension . . . plan . . . such contributions . . . shall not be deductible . . . ; but, if they would otherwise be deductible, they shall be deductible under this section [404], subject, however, to the following limitations as to the amounts deductible in any year . . ." (IRC Section 404(a), language before 404(a)(1).) The regs are more specific: "In order to be deductible under section 404(a), contributions must be expenses which would be deductible under section 162 (relating to trade or business expenses) or 212 (relating to expenses for the production of income) if it were not for the provision in section 404(a) that they are deductible, if at all, only under section 404(a)." (Treas. Reg. Section 1.404(a)-1(b), emphasis added.)

Since IRC 404(a)(8)© says that the contribution on behalf of a self-employed individual that does not exceed earned income is treated as satisfying Section 162 or 212, then amounts in excess of earned income will NOT satisfy either 162 or 212. In that case, under what other section of the Code would such a contribution be deductible? Remember, the legitimacy of the deduction is found elsewhere in the Code (such as Section 162, "ordinary and necessary" business expenes), while the amount and timing of the deduction are found in Section 404. Although Section 404(a)(1)(E) allows carryover for amounts exceeding the maximum deductible amount for that year, those succeeding years' deductions still must be deductible under IRC Section 404, and IRC Section 404(a)(8)© considers those excess amounts to be non-deductible.

Others may disagree, and I'm sure they'll say so, but this is how I interpret the rules. Pray to the audit gods that this plan is not audited by the IRS. (And make sure you get your own professional advise before resolving this particular issue--don't rely solely on this post, by any means.)

[Belgarath]

This is a question I've wrestled with as well. Sieve's interpretation represents one side of the debate, while others take the opposite view, contending that the contribution, while not deductible FOR THAT YEAR under 162, is nevertheless "deductible" under 162 as an ordinary and necessary business expense, and can therefore be carried over. I've never seen any definitive IRS guidance, although I have seen 1 audit where such a carryover was not not challenged. Doesn't mean that this is the IRS position!!

I've got a question for the CPA types - specifically with regard to S/E, are there NON PENSION ordinary and necessary business expenses under 162 where a carryover is allowed, for deduction purposes in a future year? If there are, then I think this would strengthen the argument that the pension contribution may be carried over. If there are no such carryovers for non-pension expenses, then it would strengthen the opposite view.

[Guest Sieve]

Assuming you get beyond the initial deductibility issue discussed above, so that you are convinced that a carryover deduction is permitted, then the best you can do--since the $60,000 exceeds 25% of compensation (on a net basis)--would be to take a deduction equal to the DB contribution plus 401(k) deferrals plus a psp contribution up to 6% of earned income. (IRC Section 404(a)(7)©.)

Again, assuming that the excess contribution is deductible at all, I think you can take a carryover deduction even though the DB trust may no longer be exempt as a result of the plan's termination (and distribution of all assets) based on Treas. Reg. Section 1.404-3(a): "In order to be deductible . . . contributions to a pension trust must be paid in a taxable year of the employer which ends with or within a year of the trust for which it is exempt under section 501(a). Contributions paid in such a taxable year of the employer may be carried over and deducted in a succeeding taxable year . . . in accordance with sectin 404(a)(1)(D), whether or not such succeeding taxable year of the employer ends with or within a taxable year of the trust for which it is exempt under section 501(a)." (Emphasis added.)