Application of Last Day of Employment Rule for Self-Employed Partner in Profit Sharing Plan

Welcome any thoughts or experience on this.  Still waiting to see exactly what the specific plan document provisions say here but situation involves a partner in a partnership who leaves the partnership mid-year.  Partner continues to be entitled to a portion of revenues collected during the second half of the year, is assisting generally with collecting receivables and other transition issues, reflected as a partner in the partnership for the year, etc. but is not performing new services / generating new fees for the second half of the year.  Can the partner be considered "employed" on the last day of the plan year for purposes of profit sharing?

I am of the opinion that if still a partner in the partnership and still receiving earned income from the partnership, then still employed.

I agree.

Thanks very much. 

Apologies, I should clarify my facts a bit.  The individual here (a lawyer) left law firm partnership 1 mid-year and became a partner in a new law firm partnership for the second half of the year.  I think both partnerships would view him as only being a "partner" in one firm at a time--indeed I think there are probably state bar concerns and partnership agreement concerns if he tried to claim he was still technically a partner in law firm 1 as of December 31st. 

That said, it seems he arguably is receiving "earned income" from law firm (1) through December 31st.  And he was (albeit on a "volunteer" basis) trying to collect on fees outstanding from the first half of the year on behalf of law firm 1 but was not getting paid to do that directly or doing so pursuant to any formal employment relationship--just doing it in order to get the benefit of hopefully collecting more accounts receivable of law firm 1 that existed when he left mid-year.  

Maybe its just me and my lack of understanding of partnership tax but it does not seem right that he should be considered "employed" on the last day when I think a former common law employee in a similar situation (e.g., if a commissioned employee with trailing commissions left employment but continued to follow up with old clients to collect on outstanding amounts or assist with other transition items on behalf of the former employer but without any formal employment relationship) would not be considered employed on the last day. 

I'll take the contrary position—when the individual stops performing personal services for the business, they stop being an employee for plan purposes. The fact that they remain a partner is not relevant, as they may continue to be a "silent partner" and receive a share of partnership income resulting solely from investment in the partnership without performing personal services.

I think you could make a pretty good case either way, if necessary.  I lean towards saying s/he is employed.  Is it that significant? Contributions would come out of the partners' pocket.

If the plan’s year and the employer’s tax year are the same, some practitioners read this rule as some support for treating a worker as a deemed employee for the whole of the year.

“For purposes of section 401, a self-employed individual who receives earned income from an employer during a taxable year of such employer beginning after December 31, 1962, shall be considered an employee of such employer for such taxable year. Moreover, such an individual will be considered an employee for a taxable year if he would otherwise be treated as an employee but for the fact that the employer did not have net profits for that taxable year. Accordingly, the employer may cover such an individual under a qualified plan during years of the plan beginning with or within a taxable year of the employer beginning after December 31, 1962.”

26 C.F.R. § 1.401-10(b)(1) (emphasis added) https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/subject-group-ECFR6f8c3724b50e44d/section-1.401-10#p-1.401-10(b)(1).

The definition of "earned income" is important here. Not all income that the partner receives from the partnership is earned income.

1.401-10(c) Definition of earned income—(1) General rule. For purposes of section 401 and the regulations thereunder, “earned income” means, in general, net earnings from self-employment (as defined in section 1402(a)) to the extent such net earnings constitute compensation for personal services actually rendered within the meaning of section 911(b).

Emphasis added.

If the individual is not performing personal services then whatever income they might be receiving can not be earned income within the meaning of sec. 401.

Further, a practitioner might read the law firm’s partnership agreement and consider an interpretation of the retirement plan that’s logically consistent with the partnership agreement and the firm’s tax accounting.

If it is determined the partner is eligible for the profit sharing, make sure everyone knows as soon as possible.  It gets messy when the partnership has to fund a contribution for an ex-partner and no way to collect it from him.

Assisting with collections and transition is part of a partner's expected duties, so he is performing services for the partnership and will have earned income.

Thanks very much to all.  This is a great discussion.

Bird, for what it is worth, the partner agrees with you and its certainly significant to him from a contribution perspective because the contributions he can make under the terms of the law firm 2 plan are minimal.   

Would this somehow be significant to the IRS agent that wonders why the partner should get to do this when the receptionist that worked through Thanksgiving and quit didn't get any profit sharing contribution for 2021?  I do not know.  I get that the partner is funding the amounts and the partner's ability to contribute isn't resulting in some harm to others but there is still a deferral opportunity available to him (as the formerly highest compensated ""employee") that was not available to common law employees. I don't mean to suggest that has to be the result or that there is some huge risk but can see arguments either way as noted.

C.B., I agree the earned income distinction and definition is important here.  Sort of difficult for me to decide how to analyze though as the run-out income being received / collected does reflect income from fees that were derived from the prior rendering of personal legal services.  Although the partner is no longer providing personal legal services through that firm, his prior services were what generated the fees.  Plus, as I understand it, "earned income" for such purposes is determined as of the last day of the year so maybe that makes it more likely all gets categorized as earned income?  Especially when you layer in the rule Peter notes as sometimes being viewed as deeming a partner for part of a year as being an employee for the whole year--if you do that and determine earned income on 12/31, it would seem good arguments could be made for inclusion.

Looking at Sal, I don't see much guidance and I still don't have the basic plan document to review yet but am not expecting it to have anything helpful really.  (If this is a gray area under the rules, I guess a plan could always try and address specifically?  If so, I am sort of surprised not to have ever seen that but may just have limited perspective.)

Ultimately, it's seeming like there is probably enough here to conclude this is not clearly prohibited and so may depend on overall risk tolerance for the old firm.   

And whichever way your client, the law firm, decides, do what lawyers do for everyone else—insist on “get it in writing” (whether their writing to you, or your email to confirm what you were told) so the plan’s administrator bears responsibility.

On 4/2/2022 at 8:05 AM, Peter Gulia said:

And whichever way your client, the law firm, decides, do what lawyers do for everyone else—insist on “get it in writing” (whether their writing to you, or your email to confirm what you were told) so the plan’s administrator bears responsibility.

2000%!  They're a law firm, let them make the "legal" determination, or have them hire appropriate counsel to make it for them.  TPA's aren't attorney's, our services to Plan's are not legally binding except upon acceptance by the Sponsor/Administrator.

Sorry I'm coming so late to the party, so to speak, on this one. I agree with pretty much all of the comments above.

Individuals who are no longer practicing with a firm or authorized to do so may, generally, receive two types of payments, return of capital, which are generally not taxable, and amounts they are owed as their share in receivables when they leave, if the partnership has a provision for the latter. The latter can be formulaic based on aggregate receivables and/or represent an interest in specific matters, e.g. contingent fees. Amounts paid to the departing partner for their share of the receivables on the books as of the date they ceased to work for the firm , which may occur over a multi-year period, are generally fully taxable as self-employment income. Furthermore, they are, generally, payment for services performed.

Before the 2007 changes to the 415 regs, I thought that it was probably permissible, if the plan did not have a last day of the year rule for receiving an allocation, to make an allocation for the departing partner based on all of the self-employment income they received during the year of their departure. And even if the plan did have a last day of the plan year condition for receiving allocations, it's usually not completely clear that a departed partner is not "employed" on the last day of the year, when you look at the plan's wording of the self-employment provisions, which usually just say that partners are treated as employees and their self-employment income is treated as W-2 compensation. They are, after all, still receiving self-employment income all the way through the end of the year, and probably in future years as well. I even concluded that, as odd as this sounds, you arguably could make a contribution for a departed partner in the plan year after they had left, as long as they still had self-employment income from the partnership and the allocation was not inconsistent with the plan terms.

With the 2007 changes to the 415 regs, the partner's ceasing to be actively involved in the partnership's provision of services should probably be treated as a "severance from employment" under Treas. Reg. 1.415(a)-1(f)(5) for purposes of the Treas. Reg. 1.415(c)-2(e) rules regarding post-employment compensation. However, the regs are not completely clear on this point, since they do not specifically address the special issues of self-employed individuals and merely use the term "severance from employment" and then say that when that occurs is based on "facts and circumstances." To the best of my knowledge, the issue has not been specifically addressed in any guidance interpreting the regs.

Probably the best course of action is to specifically treat a departing partner as having had a "severance from employment" on the date they stopped working for the partnership, and apply the plan's rules for post-employment compensation. But the specifics of how you should address this should probably be written into the plan document, or if that is not practical, then adopted by the firm as the plan administrator as its interpretation of the plan's provisions on this point.

Luke,

Thanks very much for this post.  Very helpful.