CG compensation: sole prop loss and s-corp in same year

[AlbanyConsultant]

Have a client that is a sole prop, but added an s-corp in at the beginning of the year (calendar year 2019; sole prop was left open through 2019) and the employees were transferred to the s-corp as of 1/1/19.  It's a controlled group, and the s-corp adopted the plan 1/1/19.  The sole prop (which has only the owner, no employees) is booking a bunch of losses, so the net comp is going to be about -$5K, and the owner's s-corp W-2 is going to be $100K.

What's the best way to determine the owner's compensation?  Is it $100K?  $95K?  Something else?  Thanks.

[Luke Bailey]

I'll vote for 100k.

[chc93]

This might help.  HKSUN suggested treating each source of income as two different entities, then combine the resulting contributions for each entity.  Mike Preston agreed...  So if I understand this correctly, $100K for s-corp with corresponding contribution, and $5K loss for sole prop and no contribution.

 

 

[Luke Bailey]

chc93, maybe that's right, but in the end the guy (or gal) got $100k in comp on his/her W-2, and it sounds like even though for 2019 the sole proprietor was an adopting employer, along with the S corp, all of the non-owner employees were paid through the S Corp. Unless the plan document provides explicitly that in this case you net the Schedule C against the S corp W-2, it seems to me he or she still has $100 k comp. Unlike an unincorporated business, a corporation can pay comp to its owner even if the business is losing money, because it can pay from capital or borrowed funds. The usual comp definition says that comp = W-2, and in the case of a self-employed person you look at SE income. I guess you can interpret that as saying that if you have both, you add or, if a loss, net, but I don't know that you would have to interpret it that way. Of course, we do not know what the plan language here says.

I just checked (pretty quickly, so maybe I missed something and if so I hope someone points it out), but 1.415(c)-2(b) does not seem to require netting where the participant has both types of comp and the SE is a loss, while it would support adding where both were positive.

[chc93]

Luke... thank you very much for your research and detailed response.  In the recent case that I had (sole prop, W-2 c-corp compensation, no employees) I calculated the profit sharing contribution separately for each source, then added the contributions for the total.  Also, others have indicated that there didn't seem to be specific rules for such situations.

[Bird]

12 hours ago, chc93 said:

This might help.  HKSUN suggested treating each source of income as two different entities, then combine the resulting contributions for each entity.  Mike Preston agreed...  So if I understand this correctly, $100K for s-corp with corresponding contribution, and $5K loss for sole prop and no contribution.

That's not how I read Mike's answer and I disagree with your conclusion.  I believe when he said "combine the amounts" he was referring to compensation.

If you are calculating contributions separately and combining contributions, when there is a $0 contribution for the sole prop due to a loss, it would be very easy to manipulate losses and W-2 to generate a deduction when there shouldn't be.  For example, let's say someone owns two businesses that combined have $0 net revenue - the corp has $100K of W-2 for the owner and the sole prop has a loss of $100K.  (IMO) you can't say "oh the corp can make a $25K contribution, the sole prop has a loss so $0 contribution, add them together and do $25K." 

If the sole prop has a profit, then I think, in a scenario with no employees, that calculating contributions separately and adding them will give the same results as adding compensation before calculating contributions, but with employees, and/or a loss in the sole prop, I think there are a bunch of reasons you need to add comp and then calculate contributions - 415 and various non-discrimination tests.  

Of course calculating comp for the sole prop could be (more than) tricky but so be it.  Simplicity is not a valid reason to do something incorrectly.

[Calavera]

From the original post it is not clear if there are two separate line of businesses, or if Sole-Proprietorship essentially got incorporated. If it is the continuation of the same business, I would vote for $95K.  If this would be a clear case of two different businesses, I would vote for $100K. Sal Tripodi in his ERISA Outline book discussed Earned Income under Important Definitions, covering the change in the form of entity during year as well. See if you have access to it for more details.

[Luke Bailey]

Note that for all we know the S corp itself had a loss on the K-1, but as long as (from capital or borrowed funds) the owner can pay him- or herself $100k on a W-2 and that is reasonable for the work done, that is his or her 415(c) comp.

[Mike Preston]

I agree with Bird and disagree with Luke.

[Lou S.]

I agree with Mike & Bird

[Luke Bailey]

In the absence of evidence to the contrary, I still agree with me.

[Bird]

20 hours ago, Calavera said:

or if Sole-Proprietorship essentially got incorporated.

what does that mean?

[Bird]

18 hours ago, Luke Bailey said:

Note that for all we know the S corp itself had a loss on the K-1, but as long as (from capital or borrowed funds) the owner can pay him- or herself $100k on a W-2 and that is reasonable for the work done, that is his or her 415(c) comp.

No problem at all with the S corp having a loss but don't see how that is relevant or makes a case either way.

In case it wasn't clear, what you are saying is that this scenario is ok:

• sole prop has $0 profits but plenty of cash
• decides to pay an S corp owned by himself $125K for consulting, creating a loss of $125K
• S corp pays him a salary of $100K and takes a $25K PS deduction

That creates a $25K deduction from nothing.

[RatherBeGolfing]

 

On 8/25/2020 at 9:03 AM, Bird said:

Simplicity is not a valid reason to do something incorrectly.

Agreed, but can you point to something that says it is required? Code, reg, or guidance?

If it is not specified in the code or regs, then it comes down to whether it is a reasonable interpretation rather than correct/incorrect

FWIW, there was a JPB article a few years ago that mentions that the IRS has informally stated that in situations where you have earned income from more than one entity, you can treat negative earned income for an entity as zero, and allocate based on the entity with positive earned income.  I don't think the negative earned income and W-2 scenario is that different

[Bird]

33 minutes ago, RatherBeGolfing said:

Agreed, but can you point to something that says it is required? Code, reg, or guidance?

That particular comment was not about a situation with negative earned income, but...no, I can't point to anything.  I gave a scenario where things could be manipulated and I think it was compelling from a logical standpoint.  I'd be one of the first to say that logic has nothing to do with retirement plan rules, but in the absence of clear-cut guidance I think that can and should be a form of "internal" guidance.  (Nobody asked but I'll go off the deep end here and say I think we have too many regs...not necessarily from the standpoint of complexity [which is of course a valid point] but from the standpoint that, as exhibited here, there is a sense that if the Code and regs don't prevent something it must be ok.  I'd be happy with "don't be a freakin' pig" and people would probably self-limit; of course there would be the need for some court cases for egregious piggery.  Oh well, sorry to digress and I don't know where that came from!)

1 hour ago, RatherBeGolfing said:

FWIW, there was a JPB article a few years ago that mentions that the IRS has informally stated that in situations where you have earned income from more than one entity, you can treat negative earned income for an entity as zero, and allocate based on the entity with positive earned income.  I don't think the negative earned income and W-2 scenario is that different

Yeah, well maybe that's why there is a feeling it is ok.  I'm no guru but I've seen enough cases where I absolutely positively know that the IRS wasn't thinking things all the way through...e.g. ASPPA Q&A sessions, especially towards the end when they take new Qs that haven't been pre-vetted.  (But if informal guidance agrees with my position I'll take it! ?)

[RatherBeGolfing]

51 minutes ago, Bird said:

That particular comment was not about a situation with negative earned income, but...no, I can't point to anything.  I gave a scenario where things could be manipulated and I think it was compelling from a logical standpoint.  I'd be one of the first to say that logic has nothing to do with retirement plan rules, but in the absence of clear-cut guidance I think that can and should be a form of "internal" guidance.  (Nobody asked but I'll go off the deep end here and say I think we have too many regs...not necessarily from the standpoint of complexity [which is of course a valid point] but from the standpoint that, as exhibited here, there is a sense that if the Code and regs don't prevent something it must be ok.  I'd be happy with "don't be a freakin' pig" and people would probably self-limit; of course there would be the need for some court cases for egregious piggery.  Oh well, sorry to digress and I don't know where that came from!)

Yeah, well maybe that's why there is a feeling it is ok.  I'm no guru but I've seen enough cases where I absolutely positively know that the IRS wasn't thinking things all the way through...e.g. ASPPA Q&A sessions, especially towards the end when they take new Qs that haven't been pre-vetted.  (But if informal guidance agrees with my position I'll take it! ?)

I really don't disagree with you, but I think you can make a reasonable argument in support of Luke's position as well.  Netting them out is just a more conservative position IMO.  

[Luke Bailey]

8 hours ago, Bird said:

No problem at all with the S corp having a loss but don't see how that is relevant or makes a case either way.

Bird, I think it is tangentially relevant to the policy issue. I was merely pointing out that because the Code fully respects the S corp employer/employee relationship for a sole owner-employee, it enables the situation where the owner of the business may be entitled to a qualified plan contribution even if the business loses money. Therefore, the fact that in this case the business may have been conducted, for 2019, by two tax vehicles, a sole proprietorship and an S corp, and on the whole they were less profitable to the owner than his or her W-2 would appear to indicate, seems a little less of an anomaly. But I agree that is certainly not a dispositive legal argument.

[Calavera]

On ‎8‎/‎26‎/‎2020 at 9:37 AM, Bird said:

what does that mean?

What I was trying to say that if a sole proprietor, decided to continue his business as a corporation, I would treat it as a continuation of the same business and add earnings together. However if a sole-proprietor created a corporation for a different line of business, I would account for income separately and use 0 if there is a loss. 

[AlbanyConsultant]

Thanks, everyone, for your input.  These are a lot of the same discussions we were having internally (thanks, @RatherBeGolfing - we knew we had heard about that 'informal guidance' before, but hadn't been able to put our fingers on it!).  Thankfully, in this instance, the negative amount is small enough and we're only looking at the 3% safe harbor; I believe that the plan sponsor will be comfortable with the 'treat the negative as zero' line.