LLC owner who deferred but had negative earnings from self employment

[Guest Robin S. Vatalaro]

FACTS:

I have a three owner LLC who sponsors a 401(k) plan. Net earnings from self employment for one of the partners is negative (the use of guaranteed payments to partners allows self employment earnings to be different between the shareholders, even though the profit/loss split is 1/3 1/3 1/3). This partner deferred. My understanding is that in this situation, he should not have deferred because he had no "compensation" from which to defer.

QUESTIONS:

I presume the deferrals and appropriate earnings should be distributed. Can this be done via self correction?

Because he had no "compensation" for the year - is it correct that he is not reflected on the ADP test at all?

A curiosity question - how are other people handling the fact that self employment earnings is not usually known prior to the March 15th testing deadline - e.g. how do you handle damage control for a client who wants refunds prior to 3/15 but can't get them because their CPA won't provide me w/ net earnings from self employment in time to run the test?

Thanks for any help!

[Guest S FISCHER]

It is my understanding that the deferrals would go back as if they failed the 402g limit. The owner would not participate in the ADP test if he has no or negative comp. If it were me, I would explain the situation to the owner and if he can't help provide you with an estimated annual earnings report than tell him not to defer.

[BeckyMiller]

I don't think it would be a failure of 402(g), I think it would be a failure of 415. Since you have zero income, 25 percent of zero is zero. Thus, the entire amount would be a 415 excess and treated as such under the plan's terms. Typically, we see a plan providing for the refund of the salary deferrals and forfeiture of the related match. Correction of a 415 violation is more flexible than the rules associated with an ADP or 402(g) violation. If the plan does so provide, it would not be an event that triggers EPCRS. (Note, I am leaving open the window that such circumstances would qualify as "reasonable error.")

As we see more and more businesses in the form of LLC's we are going to have to deal with this issue. I agree that it would be easier if the determination of net-self employment income could be done faster. But, I can't let you blame the CPA. Most of these are calendar year ventures and it is a crazy time of year for the tax preparation profession. The books and records are the responsibility of the business and they should make sure that they have a good understanding of the measurement of income throughout the year, so the CPAs responsibility is to audit or do tax work on what are otherwise good numbers. Most tax preparers would love it if the client would ask questions about new activities before they enter into them, rather than waiting until the end of the year and having their CPA correct their misunderstandings.

O.K. I will get off my soap box, now.

I have never thought about the implications to the ADP test, but I don't see any basis in the Code for excluding them from the calculation just because they have zero income. If the 415 test is done first and the refund made, you have an HCE (because of ownership) making a zero contribution. Can you give me a cite for the argument that you can exclude them?

[Guest MTransue]

I don't believe there is a site that specifically discusses excluding HCE from ADP that have $0 comp. We have always excluded them from our ADP/ACP and 410(B) tests because by including them, it "pads" your averages and ratios.

We don't treat them as benefitting, nor do we treat them as eligible for that plan year.

[Guest S FISCHER]

The conservative argument is that a participant cannot make deferrals if there is no comp to defer. The participant is not considered to be benefiting and therefore cannot be included in the ADP test. With that in mind the deferral would need to be refunded to the individual. I like your approach using 415 limits but would be wary of arguing that to a DOL auditor, especially since it is more flexible than ADP and 402(g).

[Alf]

Assuming the plan states that participants can defer "compensation," I don't think that the deferrals are allowed. They would violate the terms of every plan that I have seen. However, I would include the person in the ADP test because they were eligible to defer under the terms of the plan and therefore benefits for purposes of the ADP test.

[Guest Robin S. Vatalaro]

Thank you everyone for your help. My choice of wording re: "CPA won't get me the data" was veeeerrrrryyyy poor - I am a CPA and do books for a living. I know very well the issues! No sleep, bad client data, etc etc etc etc etc

One final question - when zero (deferrals) are divided by zero (compensation), the result is "NOT DEFINED." Hence how do I include this person on the ADP test? I think mathematically they have to be excluded, although I realize the law may not have provided for this issue.

Thanks again.

[BeckyMiller]

O.K. Robin - all is forgiven.

Personally, I would include them in the test and I would make them a zero. I know that it doesn't work mathematically, but in fact they deferred nothing once the 415 correction was made. I can't give you a cite for that, it is just what I think is the correct answer.

[Bill Berke]

I think you have to count the deferrals. I think the guaranteed payment is the comp you count. The problem, as you know, is that a self employed individual may not deduct more then his/her earned income. And aren't you really saying that the loss wiped out the guaranteed payment for income tax purposes? So, perhaps there is compensation for plan purposes, but then you get into the deduction quagmire. And I'm just guessing, partially using the logic of the "count the total deferral despite refund rule".

[rcline46]

The IRS has stated at the ASPA conference very clearly and concisely - NO PAY, NO PLAY. They are excluded from testing and are not entered into testing as zeros.

Acquire the IRS Q & A from the 2000 conference. Or if Mr Poje is really nice he might chime in here.

[Guest]

chime chime

The marvelous Mr. Cline stated the IRS position correctly. Of course, that was at the ASPA conference and is not necessarily binding, but there really isn't anything in the regs indicating how to handle.

And given lack of anything, I think you fall into the 'use reasonable approach', but what is reasonable?

If the HCE in question had comp in the past and never deferred, I would probably go out on a limb and treat them in the test with zero. (Especially if the year in question was a fluke and they will have comp once again - but you really won't know that until the end of the next year.)

If the HCE in question deferred 5% in the past, I would personally have a problem showing them with 0, especially if it helps my ADP test. granted, you could argue they are at their 415 limit, but I find that flimsy.

[Bill Berke]

I agree with rcline - no pay=no play. But in the fact situation we have here, at least one owner has a guaranteed payment. As I remember (vaguely) my income tax rules, the guarantee is treated more like a salary/paid compensation (as opposed to "earned income") for partnership return purposes. I don't think we can dismiss the guarantee out of hand - it does have special rules attached to it and it may be considered income to the owner(s), albeit with a net taxable of zero because of the off-setting K-1 loss described in the facts. I think this is the area that needs to be looked at. If there was no guarantee, then clearly no pay=no play.

[BeckyMiller]

ERISA person who is also a partnership person, here. The guaranteed payment is simply a special allocation of partnership income. IRC Section 707©. It is possible that allocations under the plan would be made based upon guaranteed payments, rather than net-self employment income. Though it may be tough to prove a non-discriminatory definition of compensation in such case. However, for 415 testing, ADP, deductions, etc. you would have to use the total net self-employment income from the partnership activity in aggregate. See 401©(2), 414(s) and 415©(3)(B).