Compensation in LLC under Plan

[Guest alifarr]

CLient is an LLC with many partners. Several of the partners (Safe Harbor plan) took W-2 sufficient to max their deferral for the year. At year end, several partners' active K-1 compensation (FICA Taxes paid on this comp) is so negative as to wipe out the entire W-2 compenation. Is total comp for these participants a negative number (therefore deferrals are exceeding the 415 limit), or should the W-2 be treated as compensation paid against which deferrals are allowed and the K-1 is considered as a separate issue?

Our office is divided on the issue - seeking additional justification for either side!

A. Farrin

[austin3515]

How do they have both W-2 and K-1, Box 14A income? That's really not supposed to ever happen. The two ideas are mutually exclusive. You are either a partner (receiving a K-1) OR an employee.

Are you sure this isn't a K-1 from an S-Corp?

[Bird]

I don't think there's any doubt that you have to net the comp.

I guess you could make an argument that if they paid FICA taxes on their W-2 comp, and can't and/or don't get that back as a result of the loss, that they should be entitled to make plan contributions on that basis. (But I don't think so.)

This whole business of paying partners on a W-2 is an irritation. Here's a thought; maybe the W-2 "wages" shouldn't count anyway...most plans will have a provision something like this:

For any Self-Employed Individual covered under the Plan, Compensation will mean Earned Income.

If the LLC partners are indeed Self-Employed Inidviduals, are the W-2 wages "Earned Income?" I'm not sure where I'm going with this...

[austin3515]

From the EOB:

8.Change in status from employee to partner. It is possible that, within a plan year, an employee might become a partner in the partnership that maintains the plan. As a result, the individual is an employee for a portion of the year and a self-employed individual for the rest of the year. In that case, the compensation taken into account under the plan will be the sum of the individual’s compensation as an employee plus his earned income as a partner. If the combined amount exceeds the compensation dollar limit prescribed by IRC §401(a)(17) (see the discussion in Section II of Chapter 3A), the combined amount is limited to that dollar limit.

8.a.What if the partner’s earned income is negative - does that offset the compensation received as an employee? The Joint Committee on Employee Benefits of the American Bar Association posed this question to the IRS. Suppose a participant works as an employee for part of the year, and then becomes a partner for the rest of the year. For the part of the year he is an employee, his compensation from the partnership is $40,000. Due to a one-time charge to the partnership, the participant’s earned income for the year is a $45,000 loss. What is the person’s section 415 compensation? The IRS says it is zero because the loss completely offsets the compensation. See 2001 Q&A-25 at www.abanet.org/jceb/2001/qairs.html. This is a surprising conclusion, since the individual nonetheless earns W-2 wages for that year as an employee. An opposing view is that the negative earned income is simply treated as zero and this person’s section 415 compensation for the year is $40,000. Proponents of this view argue that the W-2 wages paid as an employee are different from guaranteed payments, as described in 7. above, which are paid to the individual in his or her capacity as a partner and are subject to offset by partnership losses distributable to the individual. There certainly is room for disagreement here!

[Bird]

How do they have both W-2 and K-1, Box 14A income? That's really not supposed to ever happen. The two ideas are mutually exclusive. You are either a partner (receiving a K-1) OR an employee.

Austin, I agree with you, but this is being done all the time, and not as a mid-year change. It's easier for the accountants and partners to run their withholding through a payroll system than it is to make quarterly tax payments, or at least that's what I was told once, and that's the motivation.

[austin3515]

I guess that makes sense... I have run across it once or twice. If that's the purpose of it, then I agree with Bird that netting would definitely be required...