401k profitshare allocation in an unequal partnership

[N. Wood]

Situation: husband and wife are co-owners of an LLC taxed as a partnership. They take draws, not W2s, and there are no other employees. LLC Operating Agreement splits income 10/90 between the two. They set up solo401k.

Question: if the partnership contributes 20% of its profits to 401k, does it split up the contribution between the partners 50/50 (if that's what in operating agreement) or 10/90 according to the partnership share?

Is there a problem if income is shared 10/90 but partnership contribution to 401k is split 50/50?

[jpod]

What does the plan say?

[N. Wood]

Nothing. But since this is a solo401k, it can be amended at any time.

[401king]

Does the document have an allocation formula for profit sharing contributions?

[N. Wood]

It's a standard E-Trade solo401k plan, available here: https://content.etrade.com/etrade/estation/pdf/401kPlanDescriptionBooklet.pdf

E-trade Plan Adoption agreement says "Employer Profit Sharing Contributions Employer Profit Sharing Contributions, if any, will be allocated to all Qualifying Participants pursuant to the pro rata allocation formula described in Plan Section 3.04(B)(1)."

Plan description section 3.04(B)(1) says "Unless otherwise elected in the Adoption Agreement, Employer Profit Sharing Contributions will be allocated to all Qualifying Participants using a pro rata allocation formula. Under the pro rata allocation formula, Employer Profit Sharing Contributions will be allocated to the Individual Accounts of Qualifying Participants in the ratio that each Qualifying Participant’s Compensation for the Plan Year bears to the total Compensation of all Qualifying Participants for the Plan Year. The Employer Contribution for any Plan Year will be deemed allocated to each Participant’s Individual Account as of the last day of that Plan Year. Notwithstanding the preceding, Employer Profit Sharing Contributions and Employer Money Purchase Pension Contributions will be allocated to the Plan on behalf of each Participant who has incurred a Disability and who is a non-Highly Compensated Employee if so specified in the Adoption Agreement and without regard to any allocation conditions"

Since compensation for partners is net income minus self-employment tax, that seems to suggest contribution in the 10/90 ration?

What if the plan document is amended and says compensation is 50/50 for co-owners (or in "equal share")?

[jpod]

Two things to suggest.

1. If you are talking about the contributions for 2015, you're stuck with your 2015 facts and the pro rata allocation formula.

2. If you are talking about 2016 and beyond, does the Adoption Agreement allow for an "each participant in his/her own group" allocation methodology? If so, and given that you say there are no employees, that would seem to be where you should be headed.

[N. Wood]

No, this is for 2016 and beyond.

The Adoption Agreement merely references Plan Description (see post above). Plan Description is less than helpful.

[Mike Preston]

The client adopted a simplified plan. It was inexpensive. Live with the results or pay some money to get a more flexible plan.

[N. Wood]

Adopting a new plan or even switching to a new provider is not a problem (and it looks like that's what needs to happen). I am wondering if there will be an issue with changing profit sharing allocation not tracking distributive formula.

[Mike Preston]

Please rephrase your second sentence.

[Bird]

Backing up a little, and sensing that something might be a bit "off" -

do they want to split "profit sharing" (i.e. optional plan contributions) 50/50, or do they want to split "profits" (business profits after draws and expenses) 50/50?

I'm a bit curious and skeptical about a business agreement that specifies how plan contributions are to be allocated. Especially for husband and wife.

I agree that any plan contributions under the existing plan should be allocated pro-rata on income.

[N. Wood]

No, we are not talking about optional plan contributions - if you mean employEE's elective contributions. We are talking about employER (partnership's) contributions to 401k, which is limited to 20% of the partnership's income ("profitshare"). They would like those split 50/50, while the ownership interest and the income in the partnership is allocated 10/90 ("profits") per operating agreement. See original post.

I am wondering what is prompting the skepticism?... Especially for husband and wife?...

[jpod]

You can find a prototype or volume submitter that allows you to accomplish what you wish to accomplish, but in the end the amount contributed for the 10% partner could be subject to a big haircut due to that partner's 415 limits and tax deduction limits.

[Mike Preston]

I'm not skeptical at all. I see all kinds of crazy crap. This is just another one.

Personally, I think you are mathematically challenged. $ to donuts that what you are thinking is 50/50 is actually pro-rata on comp, where comp is based on 90/10.

Give us a sample set of numbers that you think the client wants.

[N. Wood]

Mr. Preston,

I am an attorney and a CPA with more than a decade of practice. And when I say 50/50 split of the employer contribution, I mean exactly that, not pro-rata based on compensation. I posted here because I observed depth of expertise on this forum from reading the threads. All I am getting from you, however, is "skepticism." Do you actually have a citation to some reg that prevents clients from setting up their partnership and 401(k) plan in this matter, or would you like to insult me some more?

[Mike Preston]

Sounds like no donuts for me.

Nonetheless, because of the deduction for 1/2 FICA a 50/50 split will violate 415 based on 90/10 profit split.

Here's an example at $200,000.

Split profit sharing of 20% of net profits 50/50 when K-1's are split 90/10.

Gross profit 200000 A B

Profit distribution 180000 20000

FICA 9757.34 1412.96

Net 170242.7 18587.04

Net limited 170242.7 18587.04

Profit sharing 37765.94

18882.97 18882.97

Note that B's profit sharing exceeds 100% of net pay.

Whoever came up with this concept needs to sharpen their pencils.

[N. Wood]

I agree with you on the 415 problem. So it sounds like the recommendation would be to continue 401k based on compensation as currently written in the plan (aka, "stop with the crazy," with credit to Mr. Preston). Or, if the clients insist on 50/50 split, re-write the 401k plan with the language to reflect that, but with a modifier "not to exceed 415 contribution limits."

[Mike Preston]

You actually don't need to re-write the plan to reflect that because 100.0000000% of all plans already have that language. Take the case of the example above. If the contribution was voluntarily limited to $37,174.08 then both A and B would get 1/2 that and there would be no 415 violation. If the desire was to maximize the contribution and deposit $37,765,94 then the document would naturally limit B to $37,174.08 and the balance would be allocated to A.

I can see no justification for an individually designed plan. Just have them find a pre-approved plan that provides for individual allocation groups and then handle whatever manner of crazy by administrative action.

[Bird]

I am wondering what is prompting the skepticism?... Especially for husband and wife?...

Because we see a lot of confused non-pension people wander in here and butcher terminology, and because it seems a bit odd (to me) that they would split income 90/10 and have something specific in their partnership agreement about splitting retirement plan contributions 50/50...I can see splitting "profits" 50/50 after taking guaranteed payments but "profits" and "profit sharing contributions" are two different things. The term "profit sharing" should have been banned from our lexicon a long time ago, since plan contributions are no longer dependent upon profits.

But I'll take your word for it that you know what you are doing and trying to do, and others have pointed out the problems with limitations, so sorry for creating a distraction.

[jpod]

I am guessing that the 90-10 split is to minimize self-employment taxes in the aggregate, but that would just be a guess and the viability of that technique assumes that the pie being split 90-10 is big enough for the math to work out.

[N. Wood]

Mike Preston: thank you. Do you think the language quoted above from their E-trade plan is provides for individual allocation groups? It seems more like like a straight-forward pro rata based on compensation.

Bird: I believe they are trying to minimize one partner's income (they are married but filing separately for legitimate reasons). At the same time, they want to ensure that "profit" that does not hit the tax return, like the partnership's contribution to retirement plan, are split evenly. Unfortunately, minimizing one also affects the other because of 415 limitation. Both of them max out 401(k) elective contributions through other employers. If you have some creative suggestions, please let me know.

[Mike Preston]

It is pro-rata.

[Bird]

Bird: I believe they are trying to minimize one partner's income (they are married but filing separately for legitimate reasons). At the same time, they want to ensure that "profit" that does not hit the tax return, like the partnership's contribution to retirement plan, are split evenly. Unfortunately, minimizing one also affects the other because of 415 limitation. Both of them max out 401(k) elective contributions through other employers. If you have some creative suggestions, please let me know.

Ah, I get it.

As others have noted, it is no problem to have a "whatever we say" allocation "formula" in the types of documents we (the pension community) use. I doubt you'll find it in an E-Trade or similar document.

So...you either pay someone to provide pension services, including documents, or you try to find a document that lets you do what you want, or you just say "screw it, pro rata is close enough."