Distribution to Self-Employed Participant from DB Plan that has non-deducted contributions

[kpension]

I have a self-employed client with a Defined Benefit Plan that has been contributing the minimum required amount for the past several years. In the past 3 years, those contributions have not been deducted, since there were no self-employment earnings in those years, (business actual experienced losses). It is expected that 2019 will also be a loss and that the business will no longer exist since the client has retired. I am aware that the contributions avoid the penalty tax under IRC § 4972 due to the special rule under IRC § 4972(c)(4). However, I cannot find anything that addresses how these non-deducted contributions are treated when they are distributed. Distributions, (MRDs) have been made as required by IRC § 401(a)(9) and they were fully taxed on the presumption that the contributions would eventually be deducted .Since there is no expectation of future self-employment earnings it would seem that there is a tax basis recovery of cost (investment in the contract) that should be considered on future distributions. The plan will likely terminate, to eliminate future non-deducted contributions.  Upon termination and after payment of the MRDs the plan would distribute lump sums, which would be directly transferred to IRAs. If the accumulated non-deducted contributions were treated like employee after-tax voluntary contributions then they would be excluded from the rollover and refunded to the participant, which would be the best possible outcome. Assuming  that these are nondeductible contributions for all purposes except IRC § 4972, then it seems that they are not eligible for rollover treatment. One fact that I have left out is that the client’s wife is the only other plan participant receiving a minimum benefit that was fully funded before the plan was improved to generate contributions for the self-employed participant. Has anyone had a similar situation; and how was the tax reporting done on the final lump sum distribution?

[Belgarath]

Without doing any research whatsoever, my off-the-cuff opinion is that there is no basis generated due to the nondeductibility in this situation, and the distributions are an eligible rollover distribution to the extent they exceed RMD's. Again, I caveat this heavily that I haven't actually done any research to back up my thoughts.

[Luke Bailey]

I don't know the answer. I'm sympathetic to Belgarath's position, but it may be worth your or someone else's doing some basic research into how clear (if it's clear at all) it is that a sole proprietor's business activities (i.e., sponsoring and contributing to plan) are separate from his individual activities (being a participant in plan). There may be some uncertainty in this regard. After all, Schedule C is just a form that's part of the 1040, not a separate taxpayer.