Question 305: When calculating a sole proprietor or partner's earned income for retirement plan purposes, the reduction for "deductions for retirement plans allowed under Code 404" would INCLUDE the salary deferrals contributed for common law employees. Correct?
Answer: The employee deferrals reduce the owner's earned income. Let's take an example and show how that would work.
Sam is a sole proprietor. In 2011 his business earns $200,000 in gross revenue. Same has one employee, Kim. Kim's salary is $40,000, but Kim has chosen to defer $2,000 to Sam's 401(k) plan. Sam defers $8,000 and makes a matching contribution of 50% of the deferrals. Sam's other business expenses come to $40,000.
Sam's Schedule C will reflect the $200,000 of revenue and $81,000 of expenses. That includes Kim's $38,000 net salary, the $3,000 of contributions to Kim's account in the plan, and the $40,000 of other business expenses. The bottom line on Schedule C is $119,000.
This is Sam's net earnings from self-employment (NESE). Sam's earned income is equal to the NESE reduced by the 164(f) deduction (in most year's that's half the Self Employment (SE) Tax, but the computation is different in 2011 and 2012) and Sam's retirement plan contribution. The SE Tax is $14,294, but the 164(f) deduction for 2011 is $8,214. The retirement plan contribution for Sam is $12,000 ($8,000 deferral plus $4,000 match). Sam's earned income is $98,786. The upcoming 6th edition of my book, Who's the Employer, will discuss this in more detail.
What is Sam's compensation for purposes of the retirement plan? We add back the deferrals and get a total of $106,786. That's Sam's 415 compensation and is the basis for allocations and nondiscrimination testing in many plans (although some plans provide adjustments).
Sam's got some problems. Kim deferred 5% of compensation. Sam deferred nearly 7.5%. It looks like Sam will fail both the ADP and the ACP tests, but not by much. Fortunately, his entire contribution is deductible.
That's the way it works. The bottom line is that all contributions for the employees are deducted in computing NESE. Earned income deducts the owner's contributions and 164(f) deduction from the NESE. Compensation adds back the owner's deferrals.