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Answers are provided by S. Derrin Watson, JD, APM
LLC Member's Compensation for 401(k) Purposes
(Posted January 23, 2001)
Question 74: I am taking over a 401(k) plan sponsored by an LLC, which is taxed as a partnership. The members of the LLC would like to participate in the plan. Is this possible? Does it matter how much of the LLC they own? If so, how do they make contributions, since they don't have salary to defer? Can it come out of their draws?
Answer: Yes, it is certainly possible.
- Members of LLCs that are taxed as partnerships are treated for tax purposes as though they were partners in a partnership.
- IRC 401(c)(1) says that "employee" includes "self-employed individual," and that a self-employed individual is someone with earned income.
- IRC 401(c)(2) says that earned income is net earnings from self-employment (i.e., self-employment tax income) from a business in which the taxpayer's services are a material income-producing factor, with a number of adjustments. So, a member who is involved in the business has earned income. A member who is not involved in the business does not have earned income, whether or not he or she pays self-employment tax.
- Put those together and you find that, in general, a member of an LLC whose services are a material income-producing factor is deemed to be an employee and hence can participate in the plan.
- IRC 415(c)(3) (which is applicable to the rest of pension law through section 414(s)), says that the compensation of a self-employed individual is his or her earned income under section 401(c), with adjustments. Accordingly, payments received from the LLC are, in effect, plan compensation. So, yes, the contribution can come out of the individual's draw, and indeed that it is the only place it can come from. (In other words, the member shouldn't write a personal check.)
These issues are discussed in more detail in Chapter 1 of the second edition of my book, Who's the Employer?.
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