Deferrals made on negative Sch C income

[Guest fiddler]

A sole proprietor client deposited deferrals throughout the year in 2008. We just received his 2008 Sch C from his CPA and he has negative net income! How do we treat his deferrals? Can we consider this as violating 415 and therefore, we can distribute his deferrals back to him? or since he has no income, are we to consider that we can't even call these deferrals and therefore we forfeit the amount and reallocate?

[Below Ground]

I would "vote" for the 415 Excess in this case.

[Guest fiddler]

That's the stance I was leaning towards. However, we did post this to another discussion site and were told that because there is no income, we can't even consider the deposits as being deferrals, and there the only remedy is to forfeit them. They said you can consider it a 415 violation ONLY if there was positive income. If anyone has a citing I can use to hang my hat on, I would be very appreciative.

[Tom Poje]

The preamble to the final 401(k) regs says:

One commentator asked for clarification of the interaction between these timing

rules and the rule under the regulations that treats a self-employed individual’s earned

income as being currently available on the last day of the individual’s taxable year and

whether this last day rule precludes a partner from making elective contributions during the

year through a reduction in the partner’s draw. The restriction on the timing of contributions

is not intended to prevent a partner from deferring amounts that are paid to the partner

throughout the year on account of services performed by the partner during the year, and

the final regulations have been modified to clarify this point. However, self-employed

individuals who take advantage of this opportunity to defer amounts during the year must

make sure that the amount contributed during the year will not exceed the limits (such as

the limits of section 415) that will apply to the individual, based on the individual’s actual

earned income for the relevant period. [emphasis mine]

that might be as close as you can come to finding a comment on the issue. certainly the comment implies there can be a violation of the 415 limit, but doesn't addrees the issue of negative income.

lets suppose the indivudual in question deferred $5000 and instead on negative income had $1 in positive income. Is the implication from the other commentator means that because the individual has positive income then 4999 can be treated as 415 violation? I'm personally a bit uncomfortable in saying that because the person had $1 instead of negative income it changes everything.

[Bird]

We've treated these are 415 excess. I'm not sure if that's right and don't have a cite, but I'm not sure why someone would say you have to have positive income to call them deferrals.

[david rigby]

Might the terms of the plan already anticipate this problem?

[Guest fiddler]

Thanks everyone. Your comments help. Tom, I thought of the same thing: if he had only $1 of net income, then according to the other source, it would be considered a 415 violation. I'm going to handle it as a 415 violation and put it to bed.