Sched C with negative comp

[austin3515]

So the EOB is pretty clear that where a W-2 employee has no comp, it is "probably" to aggressive to include as a zero in the ADP test (0 / 0 is either imaginary math or 100%, but probably not zero). It does not address a Schedule C though, which I think is a little bit different as the individual had no control over the outcome. Anyone have any thoughts about whether or not they would include as a zero in the ADP test?

[Lou S.]

Pretty sure self-employed with income of $0.00 or less s/b thrown out of testing.

[Tom Poje]

Of course there are no guidelines, so one has to follow a good faith effort. I had always learned 0 comp = no opportunity to defer, therefore exclude from test. However, The preamble to the 401k regs contained the following comments. based on this comment, I'd hold the IRS says, yes, the person 'exists'. he can defer, even before knowing what the final comp will be, just that, when all is said and done, he can't exceed the 415 limit. well, with 0 comp you exceeded the 415 limit, and the regs (1.410(b)-3(a)(2)) says if someone who hits the 415 limit is still treated as benefiting. Of course, it is not specific if that refers to deferrals, but it does apply to defined contribution plans.

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.

[Belgarath]

My own feeling is that it is a stretch to get from this comment to the conclusion that a S/E with zero comp should be included in testing. I honestly don't think that was an intended consequence of the comment.

'Twould be nice if the IRS would settle this issue once and for all. In the meantime, we all have to give it our best shot. Austin, FWIW, I'd exclude the S/E from the test in this situation. I might be WRONG, but that's what I'd do.

There's one thing about it - if you go to jail, you'll have a lot of company on this!

[austin3515]

Am I alone, that when there is an absence of guidance, and a reasonable interpretation exists (even though it may not be your BEST interpretation), that it would be worthwhile to take advantage of the flexibility?

Imagine a plan for example where there is S/E individual and a non-owner HCE making $130K and who contributes 10% of pay. Imagine further that the NHCE's contribute 3% of pay, placing the limit at 5% of pay. Do you a) tell the non-owner that he gets back a refund of $6,500 because "there is no specific guidance and this is "probably" to aggressive; or do you say "there is no guidance and this is at least one interpretation that is reasonable, and therefore you can keep your money in the plan and will have a decent shot at retiring when you want."

This is a very realistic set of circumstances. Another variation which is essentially the same is if it is the owners kids, or even the spouse. Why kick them when they're down? Does that serve the common good??

Am I alone here in the land of reason? (sounds like Tom might be with me, and Belgarath seems to think I'll have good company, which is a consolation)

[MoShawn]

Present both options, with pros and cons. Get a decision in writing.

I had a similar question recently. I just cannot get beyond the math. 0/0 does not = 0. As you said, it is imaginary math.

[BG5150]

To me, it's not zero deferrals, it's the null set, as there is no opportunity to defer. There simply is no denominator.

I look at it this way:

Will the IRS take a second look if you took the person out of the test? Probably not.

Will they take a second look with an all zeros test? Maybe.

Do I want to take that chance? Do I leave it up to the Client?

To be honest, I've done it both ways, under client direction.

[Belgarath]

Well, I said you'll have lots of company. I didn't say it would be GOOD company...

[austin3515]

^{But there is safey in numbers}

[Tom Poje]

At the ASPPA Conference 2008, the following was asked

A 401(k) plan disregards commissions as compensation for plan purposes. One employee has only commissions, therefore could not defer. Assuming the compensation definition satisfies 414(s) testing, is this person included in the ADP test as a 0%, or would they be excluded from the test completely since they have no compensation for plan purposes?

If the person is excludable, does the answer change if, for purposes of testing, the plan included all compensation (including the commissions) for ADP testing purposes?

Answer:

Refer to Treas. Reg. §1.401(k)-2(a)(3)(i), last sentence, which requires that you include all eligible employees in the testing. What is an eligible employee? Per Treas. Reg. §1.401(k)-6, it is someone who is directly or indirectly eligible to make a deferral for the year. Is this guy eligible? Yes, you must include him as 0%..

The ASPPA folks asked for more research on this.

Recall, any comments from the IRS don't necessarily reflect an actual Treasury position. What I find interesting is that it seems everyone is willing to go by a response from years ago that said treat them as 0, but now when they say something different people 'grumble'.

but anyway, if you go by the response at the Conference, was the person in question directly or indirectly eligible to defer?

e.g. on January 31 he takes a draw. could he defer? I would say yes. The IRS would say yes, but make sure you have enough at the end of the year for any limitations. so he is at least indirectly eligible to defer.

so if you feel comfortable to say: there are no guidelines.

At ASPPA 2008 they said include the person.

In a good faith effort, I included him.

let's suppose the person took a draw and deferred $5000. you reach the end of the year and determine he has negative comp. is it possible to treat that $5000 as a catch up since he exceeded the 415 limit? good grief, we can get a lot worse than any 0/0 argument

[austin3515]

So Tom, you're suggesting that Q&A supports including a zero comp participant who is still active in the ADP test?

That just reminded me that Relius always brings in those zero comp people with no term dates. Perhaps that suggests Relius would agree? For example, people on a leave of absence. They are "indirectly eligible" because the only reason they can't is that they had no comp?

[of course if we were talking about NHCE's don't be surprised if I use the 0/0 rationale for excluding them - I am such a two-face!]

[Tom Poje]

I believe Relius brings them in as a warning you need to possibly investigate further, not to indicate "yes, you include them"

if someone was on a leave of absence all year and performed no service I would not include them.

I'm not suggesting anything about the Q and A other than what it says, which is

include as 0%

again, some folks at ASPPA asked for further/future discussion.

but my point is, in the past at one Conference (maybe more?) they said don't include them, so now the question is which answer is correct (or perhaps, does the current opinion expressed carry more weight than the past, or, at least from my point of view, why does the prior opinion carry more weight than one expressed in the past)

[Belgarath]

Speaking only for myself, the prior opinion makes more sense. When you have a person who had no compensation from which to defer, couldn't possibly defer a penny, then I think your testing results can get badly skewed, particularly in a small plan.

Since neither answer from the podium constitutes official guidance, and not necessarily even standard IRS thinking, then I choose to go with the interpretation that seems more sensible.

That's my story, and I'm sticking to it!