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Sole proprietor deferral election


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Sort of an Angels dancing on the head of a pin item here.

The 401(k) regulations are very clear that the sole prop (or unincorporated partner, for that matter) must complete a deferral election no later than the last day of their taxable year. Very common for such a deferral election, if it doesn't specify a specific dollar amount or percentage, to  say "maximum" or something similar.

Now, suppose a sole prop has an election where s/he specified "maximum." But once Schedule C income is known, s/he does not want to contribute the maximum, for whatever reason. Is this a problem? If instead, the deferral election said something more along the lines of, "an amount from zero up to the maximum allowed" or something along those lines, is this an acceptable election? Curious as to whether anyone has EVER seen or heard of the IRS opining on the issue - I have not...

And please don't beat me up with arguments about how stupid the regulations are on this - I absolutely agree that it is foolishness, but I don't make the rules - just try to play by them!

Thanks in advance for any thoughts.

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The intent of the regulation is to remove discretion after plan year end on the amount of the deferral, so having the self-employed specify a dollar amount or percentage of compensation parallels what a common law employee can do during the plan year.  You will find Slide 2 from this somewhat-aged and somewhat-amusing IRS presentation:

https://www.irs.gov/pub/irs-tege/forum08_401k.pdf

Several phrases come to mind:

  • let sleeping dogs lie
  • don't trouble trouble til trouble troubles you
  • don't poke the bear
  • tis a puzzlement

 

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Thanks Paul. The "real life" big difference being that a W-2 employee typically has a pretty good idea of the compensation they will be receiving, and also has the ability to cease at any time. And most plans allow modifications at points during the year. The sole prop can't do this, and frequently has very little idea of Schedule C comp until the CPA performs the financial alchemy after the close of the year.

I realize I'm preaching to the choir.

So, if faced with 100 lashes from a wet noodle for failure to give an opinion, which of the following options do you think is best, under the assumption that the sole prop really can't tell how much they will be able to defer so can't use a specific dollar amount or percentage:

Complete the form as "maximum" - and therefore MUST defer the maximum

Complete the form as "maximum" but then defer less if they so choose

Complete the form as "an amount to de determined, up to the maximum allowed - or some similar language, recognizing that this may fall afoul of the IRS interpretations.

Other?

I incline toward the second option, but there's lots of room for disagreement on all this excrement! I haven't ever developed a solid answer that covers reality and ensures IRS compliance. I'd LIKE to think that the IRS would accept reasonable good faith compliance, and perhaps they do, since I've neve heard of a situation where someone got stung if the election form was signed on or before the end of the year.

I wonder if this could conceivably be addressed in the Cycle 4 documents when they are submitted to the IRS? On the other hand, your warning phrases seem apropos, so probably better not to!

Thanks again.

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Perhaps a plan’s governing documents might not preclude an individual from specifying her elective-deferral election with conditions beyond those customary regarding an employee’s wages to refer to one or more business conditions.

For example, how about:  . . . ?

My elective deferral is the greatest amount that:

(i)   does not exceed the IRC § 402(g) limit (with the applicable IRC § 414(v) extension) and, counting the employer’s nonelective contribution, does not exceed the IRC § 415(c) limit;

(ii)  does not result in any contribution to the plan that otherwise would be deductible under IRC § 404 being nondeductible for 2024;

(iii) is limited such that Supportable Inc. does not breach any debt covenant;

(iv)  is limited such that Supportable Inc.’s net profit for 2024 is no less than $10,000; and

(v)   is limited such that, immediately after payment into the plan’s trust, Supportable Inc.’s cash-on-hand is no less than $5,000.

Could we defend an election like that as determinable and as decided before the year closed?

This is not advice to anyone.

Peter Gulia PC

Fiduciary Guidance Counsel

Philadelphia, Pennsylvania

215-732-1552

Peter@FiduciaryGuidanceCounsel.com

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I suppose there's always the opportunity to elect X% of pay not to exceed $Y.   Might not really get you what you want but illustrates some flexibility perhaps.

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3 hours ago, Belgarath said:

The "real life" big difference being that a W-2 employee typically has a pretty good idea of the compensation they will be receiving, and also has the ability to cease at any time. And most plans allow modifications at points during the year.

Just to be argumentative, to put the Schedule C proprietor on the same playing field as an employee, they can make contributions during the year. The only possible problem is exceeding the 100% of pay limit and that is solved by removing the 415 excess.

Ed Snyder

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Hi Bird - I don't disagree, except to the extent that deferring during the year, assuming they don't exceed the limit, means they are stuck with it. So suppose they defer the maximum during the year. Their ultimate Schedule C is sufficient so there's no violation of the limits. But their circumstances have changed by the time their taxes and income have been computed, and they don't WANT to have, for example, 85% of their Schedule C income deferred. The W-2 employee knows what percentage of their pay they are deferring every paycheck, and they can stop at any time. 

Anyway, your point is well taken. As I said, I'm unable to come up with a compliant solution that works all the time... 

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If there is a glimmer of hope, it may well spring from SECURE 2.0 section 317:

SEC. 317. RETROACTIVE FIRST YEAR ELECTIVE DEFERRALS FOR SOLE
PROPRIETORS.
(a) IN GENERAL.—Section 401(b)(2) is amended by adding at
the end the following: ‘‘In the case of an individual who own
the entire interest in an unincorporated trade or business, and
who is the only employee of such trade or business, any elective
deferrals (as defined in section 402(g)(3)) under a qualified cash
or deferred arrangement to which the preceding sentence applies,
which are made by such individual before the time for filing the
return of such individual for the taxable year (determined without
regard to any extensions) ending after or with the end of the
plan’s first plan year, shall be treated as having been made before
the end of such first plan year.’’.

The logic would be if an owner who sets up a retroactive one-person plan can wait until they file their tax return to decide and fund the amount of deferral, why can't any other owner wait until their net earnings from self-employment is known to decide and fund the amount of deferral?

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On 5/30/2024 at 5:33 AM, Belgarath said:

Complete the form as "maximum" - and therefore MUST defer the maximum

That is my understanding. Or any formula, really, that has only one solution once earned income has been calculated.

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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Until the law changes for years after a plan’s first year, consider that this point is one on which a third-party administrator might add value.

A recordkeeper might have no facility to record a deferral election expressed with anything beyond the deferral’s amount or percentage of compensation. And a recordkeeper might not explain that if a participant’s deferral is expressed in part with other terms or conditions, the plan’s administrator must keep that record without relying on the recordkeeper.

A good TPA might explain how a deferral election might be stated with conditions, if the plan’s governing documents allow it.

I’m aware that many self-employed individuals manage this point by falsely dating a deferral election as having been made in the preceding December. But why do that if a needed or desired flexibility in the elective-deferral amount can be specified with a proper election?

Peter Gulia PC

Fiduciary Guidance Counsel

Philadelphia, Pennsylvania

215-732-1552

Peter@FiduciaryGuidanceCounsel.com

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