Partners in 401(k) Plan receiving W-2's

[rblum50]

I just acquired a calendar year 401(k) Plan whose Plan Sponsor is an LLC electing to be taxed as a partnership. During 2014, there were two partners, along with staff, in the plan, one of whom (a long time participant in the plan) terminated his employment and partnership interests in June, 2014.

For 2014 and before, there were losses in the partnership. It is my understanding that when the earned income of a partner, which is composed of the partnership distributive share of earnings plus guaranteed payments, is negative, the partners cannot defer any amount into the plan nor receive any employer contributions. In this plan, only salary deferrals and a Safe Harbor match have ever been made.

Here's the problem: it appears that for years, the income being used for the partners was only their guaranteed payments which was given to them on W-2's. At this point, I don't know if the guaranteed payments were included on their K-1's.

For the plan point of view:

1. If the net partnership income is negative, the partners should not have deferred anything and, in turn, should not have received an employer match.

2. If this is the case, the company over-contributed and over-deducted these contributions to the plan. I believe, that this should require a resubmission of the partnership returns for the affected years as well as the personal tax returns for the partners involved. Am I correct on this?

3. To make matters worse, the partner that left in 2014 had most likely made his salary deferral and received matches for some time incorrectly and received his account balance from the plan during 2014.

This is obviously a mess. I will be meeting with the CPA and the client next week. The CPA has already dismissed these problems as minor and as "no big deal." As I see it, the plan has operational and/or qualification problems, over-deduction problems, distribution problems, etc., etc. and etc.

I am looking for some insights into:

1. Whether or not there might be other concerns that I haven't touched on and

2. how to go about repairing these problems, i.e., EPCRS.

Thanks, in advance, for any help.

[Bird]

At this point, I don't know if the guaranteed payments were included on their K-1's.

That's a pretty important point. I'd assume that the guaranteed payments were treated as wages on the partnership return, and that's why they are generating losses. Issuing W-2s to partners is not correct, but everyone seems to be doing it, and until I hear otherwise, it doesn't appear that the IRS cares too much - it does in fact sort out in the wash and they may be overpaying on self-employment taxes. "Proper" treatment, using these improper facts, would be to net the W-2 and the loss. If the losses aren't significant I'd be inclined to use the W-2s and move on.

[shERPA]

Lots of accountants do this so the partners can pay their income taxes via wage withholding (which is deemed to be paid ratably thru the year) rather than doing quarterly estimated payments. IRS seems OK with it even though written guidance says otherwise. Makes our jobs harder, but what else is new?

As Bird said, to get plan compensation you probably need to combine the K-1 losses with the W-2 wages, assuming the wages were expensed in the partnership (likely). Hopefully this will mostly solve the problem.

Since you mention the CPA, I assume your doing the plan administration, not the tax work. I recommend focusing on the plan operations and qualification issues first. If there are corrections needed, figure out what they are and present them. Let the CPA worry about whether or not tax returns need to be amended.