DB Deduction

[Christopher Wilson]

Hello everyone,

Hope you all and your loved ones are safe. My three questions pertain to the extent to which contributions to a defined benefit plan are deductible by individuals with earned income from a sole proprietorship, partnership or LLC taxed as a partnership. In my situation, I have a defined benefit plan for which the members want the maximum contribution. The plan was effective in 2015 and the definition of average compensation is the highest average of three consecutive years.

Year                 Member 1      Member 2

2015                 $265k             $104k

2016                 $160k             $35k

2017                 $230k            $130k

2018                 $5k                 $99k

High-3 Avg      $218,333       $89,667

Each of the two members of the LLC have equal ownership and have earned income (K-1 ,Line 14A) of $276k. When I run the valuation using zero compensation for the members, I'm getting minimum and maximum contributions of $216k and $620k, respectively. Intuitively, however, I don't think the members can contribute $620k because their earned income isn't sufficient. I believe the maximum db contribution is $528,618:

Earned Income: $276,134

- SE Tax Deduction: $11,825

- 50% of Staff Cost: $8,394

= $255,925

$255,915 x 2 = $511,830

$511,830 + $16,788 = $528,618

Am I correct that the maximum deductible contribution cannot exceed $528,618? My actuary says that we shouldn't opine about the whether the $620k is deductible because there may be circumstances where the deduction could be higher than the net K-1. Whether the $620k is deductible is a question for the client's accountant. However, the accountant is asking me to verfity whether or not the $620k is deductible. I'm stuck in the middle, so that's why I'm reaching out to you.

My second question is if the members were to increase their earned income to $322k each, could they then contribute $620k?

 Earned Income: $322,000

- SE Tax Deduction: $12,439

- 50% of Staff Cost: $8,394

= $301,167

$301,167 x 2 = $602,334

$602,334 + $16,788 = $619,122

My last question is if the client wants a contribution greater than $620k, then wouldn't the earned income have to be significantly higher to increase the average compensation to generate a higher benefit?

[Lou S.]

Unless there is some accounting trick I'm unaware of, I don't see how you can deduct more than your net earnings from self employment income.

[C. B. Zeller]

I will remind clients in this situation that we are not tax experts and we can't in good faith provide them with tax advice. Our valuation report has a line that says something along the lines of, "This is the maximum deductible contribution under IRC sec. 404, but we can not confirm that this amount is deductible for federal income tax purposes, check with your tax advisor or accountant."

That said, I agree with Lou's understanding, I don't think there is a way to deduct an amount that would cause a loss. If they contribute the amount anyway, they have a non-deductible contribution which is subject to excise tax. There is an exemption to the excise tax for the amount necessary to satisfy minimum funding.

To your second question, the deduction is not based on average comp. It is based on the sum of the funding target plus target normal cost plus cushion amount over the market value of assets. If the plan's benefit formula is based on average comp, then the funding target and target normal cost could be affected by a change in average comp, but given the very low 2018 comp for #1, I expect it's going to be hard to get an appreciable increase in the average for 2019, especially considering 401(a)(17) limits.