timing of deferrals for self-employed and partners

Good morning to all,

I have been asked to research the following:  " Is it acceptable for salary deferrals to be funded well after the end of the plan year for self-employed individuals, i.e. sole proprietors. This is in the case of an ERISA plan, not a solo 401(k) plan. "

Your thoughts, opinions, and explanations of your practices are appreciated, as always.

For a Schedule C filer, yes. 

I agree with jpod. 

I think deferrals should be deposited as soon as reasonable after income is known for the year. Sometimes income isn't known until substantially later after year end. We have run into situations where deposits occur during the year, or shortly after year end, but later on the CPA determines the earned income is negative. This means those deferral deposits never should have occurred, and now there is excess money in the trust that has to be dealt with. 

Thank you, jpod and justanotheradmin.  I have worked in the past for one TPA firm where the owner was adamant that partners and sole proprietors absolutely must get their deferrals deposited prior to 12/31 (for a calendar year plan).  I have also worked for TPA firms where the owners more or less threw up their hands and said "I give up.  Let the partners and sole proprietors do whatever they please." And that wasn't being flippant - it was because they never seemed to know what their incomes actually were until the summer following 12/31.  So those TPA owners took the position that partners and sole proprietors could make their deferrals as late as the filing date for their own tax returns including any extensions.

Reading the latest out of Sal Tripodi's encyclopedia, he seems to be saying that as long as a deferral election is signed by 12/31, the actual funding can be as late as the determination of the income for the year.  

A Schedule C filer does not have to make a deferral election by 12/31.

13 minutes ago, jpod said:

A Schedule C filer does not have to make a deferral election by 12/31.

I think they do - make an election but not a deposit.

Respectively disagree.  We've been down this road before on BenefitsLink. 

The regs are quite specific 

A partner's earned income for a year is deemed to be currently available on the last day of the partnership taxable year. As a result, a partner in a partnership (or sole proprietor) may not make a salary reduction election after the last day of the partnership or sole proprietorship taxable year after the last day of that year.  [Treas. Reg. § 1.401(k)-1(a)(6)(iii)

EXACTLY - for partners in a partnership.

@Tom Poje thanks for jumping in here.  Do you agree that it's okay for the actual deposit of the deferrals for the partners and sole proprietors to occur deep into the summer following 12/31, as long as they have completed a salary deferral election form prior to 12/31?  (That's assuming that it takes that long to determine their earnings, of course)

yes, in fact the preamble to the regs anticipated the opposite, making deferrals before it is even known what the comp would be

One commentator asked for clarification of the interaction between these timing rules and the rule under the regulations that treats a self-employed individual's earned income as being currently available on the last day of the individual's taxable year and whether this last day rule precludes a partner from making elective contributions during the year through a reduction in the partner's draw. The restriction on the timing of contributions is not intended to prevent a partner from deferring amounts that are paid to the partner throughout the year on account of services performed by the partner during the year, and the final regulations have been modified to clarify this point. However, self-employed individuals who take advantage of this opportunity to defer amounts during the year must make sure that the amount contributed during the year will not exceed the limits (such as the limits of section 415) that will apply to the individual, based on the individual's actual earned income for the relevant period.

3 hours ago, jpod said:

Respectively disagree.  We've been down this road before on BenefitsLink. 

Link to a thread or two?

10 minutes ago, Mike Preston said:

Link to a thread or two?

I'm not good at finding old links.  I'm not saying everyone agrees with me.  My analysis is this:  The usually required election that must be made before the compensation becomes currently available is an agreement between the employee and the employer, or the partner and the partnership.  The reason the IRS regulation does not address a Schedule C filer is that even the IRS recognizes that it would be a complete fiction for the Schedule C filer to enter into an agreement with himself.  Those who are very conservative will advise the Schedule C filer to sign some sort of election form on or before December 31 and stick it in a file or the cookie jar, and that's fine, but I am absolutely confident that it is not necessary.  

2 hours ago, Tom Poje said:

The regs are quite specific 

A partner's earned income for a year is deemed to be currently available on the last day of the partnership taxable year. As a result, a partner in a partnership (or sole proprietor) may not make a salary reduction election after the last day of the partnership or sole proprietorship taxable year after the last day of that year.  [Treas. Reg. § 1.401(k)-1(a)(6)(iii)

 

 

jpod, your powers of persuasion are so strong you had me going for a minute, but I re-read the reg. It specifically addresses sole proprietors and puts them under the same rule! What am I missing?

Actually, the cite Tom gave addresses both partners and sole proprietors.

Quote

(iii) Timing of self-employed individual's cash or deferred election. For purposes of paragraph (a)(3)(iv) of this section, a partner's compensation is deemed currently available on the last day of the partnership taxable year and a sole proprietor's compensation is deemed currently available on the last day of the individual's taxable year. Accordingly, a self-employed individual may not make a cash or deferred election with respect to compensation for a partnership or sole proprietorship taxable year after the last day of that year. See §1.401(k)-2(a)(4)(ii) for the rules regarding when these contributions are treated as allocated.

I stand corrected on what the regulation says.  I still believe it is ridiculous. 

What would the election say? 

Dear jpod:  Please contribute out of my earned income for 2019 the lesser of $X or the maximum elective contribution permitted under the Code.  Sincerely yours, jpod.

The same thing it would say for a partner in a partnership who does not know exactly what he or she will make for the year, and therefore how much he or she can or wants to contribute, but is required by his/her managing partner to submit (by hand, email, text, or fax) an irrevocable election by midnight 12/31 of year N:

"I hereby elect irrevocably to contribute the greater of $X or Y% of my "earned income" [formulas may vary, but must be objectively determinable in only one way once earned income is known] as "earned income" is explained in the firm's 401(k) plan's Summary Plan Description (the "Plan's SPD") to the Plan for the N plan year."

The only difference with a sole proprietor is that he or she would have an easier time faking it.

@jpod, yes, silly as it seems, here's what Sal says, Volume 11, page 64:  "The requirement for the partner to make an election by the last day of the partnership year applies even if the final tax accounting for the partnership is not completed until a later date and the actual amount of the partner's earned income is not determinable until such later date.  The deferral may be contributed after that date but the election to defer may not be made later than that date.  The election may state the deferral as a dollar amount or as a percentage of the partner's earned income.  It should also be acceptable to state that the deferral election as a formula (e.g. the greatest deferral amount that would be permitted under the ADP test)."

I have administered plans in the past where the partners filled out an election form and simply put MAX in the blank where the dollar amount or the percentage would go.  We just took it to be the statutory max as reduced by any considerations like failed ADP test, not enough income to support the contribution - in other words, the MAX possible under the circumstances....

He is talking only about partners in that excerpt, isn't he?  If he has a discussion about Schedule C filers please share. 

I did not see Schedule C specifically addressed in this passage but I will see if I can find something else on that in here...

11 minutes ago, Luke Bailey said:

The same thing it would say for a partner in a partnership who does not know exactly what he or she will make for the year, and therefore how much he or she can or wants to contribute, but is required by his/her managing partner to submit (by hand, email, text, or fax) an irrevocable election by midnight 12/31 of year N:

"I hereby elect irrevocably to contribute the greater of $X or Y% of my "earned income" [formulas may vary, but must be objectively determinable in only one way once earned income is known] as "earned income" is explained in the firm's 401(k) plan's Summary Plan Description (the "Plan's SPD") to the Plan for the N plan year."

The only difference with a sole proprietor is that he or she would have an easier time faking it.

That's not the only difference.  The critical difference is that in the case of a Schedule C filer there is only one party, whereas in the case of a p/s there are two parties:  one who is in control of the payment of the compensation and one who will receive it.  

1 minute ago, ldr said:

I did not see Schedule C specifically addressed in this passage but I will see if I can find something else on that in here...

I am not asking you to do any work but you cited Sal as rejecting my view but in fact what you shared didn't do that. 

@jpod Yeah I found it.  Next page, 65.  "Application of rule to sole proprietor.  Should a sole proprietor of an unincorporated business (or the sole owner of an LLC that is taxed as an unincorporated sole proprietorship) be subject to the same rules as discussed above for partners?  The regulations issued in 1991 did not address this issue, but Treas. Reg. 1.401(k)-1(a)(6) amends the regulations to apply the "currently available" rule described in 1.f above to sole proprietors.  As a result, a sole proprietor's deferral election also needs to be made before the close of his or her taxable year in order to apply to self-employment earnings for that year.  This makes sense and it should be reasonable to apply this rule to sole proprietors for years prior to the effective date of the proposed regulations.  Most sole proprietors will be on a calendar taxable year, so in most cases, the sole proprietor's earnings are treated under this rule as currently available on December 31, and a deferral election could apply to the sole proprietor's earnings for such a calendar year only if made by December 31 of that year."   etc.

@jpod   I never mind looking things up and doing a little work - people for the most part have been very nice on here about helping me with questions, even dumb questions.  When I throw something up I am grateful if anyone answers and I will share anything I can find that looks helpful...no worries!

1 hour ago, jpod said:

That's not the only difference.  The critical difference is that in the case of a Schedule C filer there is only one party, whereas in the case of a p/s there are two parties:  one who is in control of the payment of the compensation and one who will receive it.  

jpod, I think that if a tree falls in a forest, it makes a sound even if there's no one there to hear it.

And additional explanation from the Service:

"Another question that we often hear is how salary deferrals are made when a person is self-employed or involved in a partnership. The person doesn’t usually know for certain what their income will be until the end of the year, or later. The final 401(k) regulations address this issue. The regulations state that a partner’s or self-employed person’s income is deemed available to them on the last day of their taxable year. And since an employee must have a deferral election in place before compensation is available, a self-employed person may not make a cash or deferred election with respect to compensation for a partnership or sole proprietorship taxable year after the last day of that year. If a partnership provides for cash advance payments paid to the partner during the taxable year that is based on the value of the partner’s services prior to the date of payment (and which do not exceed a reasonable estimate of the partner’s earned income for the taxable year), the individual can defer a portion of these advances even though their final compensation has not yet been determined. Obviously, if the self-employed person wants to maximize their contribution, they can’t do so until their final compensation has been determined. That is o.k. as long as the election was in place as of the last day of the taxable year. Bottom line, self-employed participants may defer against 'advances' or 'draws.'

...

Lastly, employer contributions are not required to be made until the due date of
the employer’s tax return, plus extensions. So, in the case of a sole proprietor,
this is when the 1040 is due – October 15, if an extension was filed."

Thank you everyone for contributing to the discussion, notwithstanding the fact that I am clearly in the minority.  It is interesting that nobody addressed the elephant in the room which I keep mentioning:  What meaning does an election have when the same human is on both sides of the election?  I gave you my silly illustration, but it is an illustration of exactly why the rule stated in the regulation is so stupid.  I am willing to retire this discussion.       

what is guaranteed is that such election forms are never back dated. they might have been sitting in a desk drawer and no one else knew about them, but the election was certainly made ahead of time wink wink nudge nudge.

I will un-retire the discussion for a comment on the flipside of all of this.  Let's say an "election" is made by the Schedule C filer, and he's the only person on earth who knows about it, because there is no requirement that anyone else must know about it.  Then, he changes his mind and doesn't contribute anything.  Clearly an operational qualification violation, right?  If his plan is audited do you think the agent is going to inquire about any elections he might of made which he subsequently ignored?   More indication of the futility and irrelevance of a Schedule C filer needing to make an election.  

Not persuasive to me; we all know how easy it is to get away with stuff.  The front side is if there is an audit and the agent wants to see the election form validating a self-employed's contribution.  I know from experience with a partnership that they will ask, and imagine they would for a Schedule C as well.

51 minutes ago, Bird said:

Not persuasive to me; we all know how easy it is to get away with stuff.  The front side is if there is an audit and the agent wants to see the election form validating a self-employed's contribution.  I know from experience with a partnership that they will ask, and imagine they would for a Schedule C as well.

So you think a Note to Self dated on/before December 31 will satisfy an agent?   

If you are going to fraudulently back date a tax document. At least make it look formal, e.g. name/address/SSN of the participant, plan sponsor, election, signed and dated.

I would think a TPA plan should require the sole proprietor to furnish them with a copy of the initial election and any change in the election on or before 12/31.

You would think wrong.  I've never seen it done.

4 hours ago, Mike Preston said:

You would think wrong.  I've never seen it done.

I know that Vanguard's solo 401k instructions say very clearly:  DON'T SEND US THE ELECTION FORMS. 

9 hours ago, spiritrider said:

If you are going to fraudulently back date a tax document. At least make it look formal, e.g. name/address/SSN of the participant, plan sponsor, election, signed and dated.

 

Who said anything about back-dating a document?  My query is what is a sufficient election by a Schedule C filer?  If a note to self is sufficient, that proves how ridiculous the concept is. 

If that is the criteria, then it is indeed ridiculous.

Well it must be ridiculous then.

There is no requirement for a sole proprietor's one-participant 401k employee election to go anywhere, but from the participant to the one in same administrator into their own records for "possible" future request by the IRS.

I would be surprised if the participant in the majority of self-administered one-participant 401k plans from the mainstream brokerages has ever completed an election. The brokerages mass market the plans as essentially like an IRA, but only larger contribution limits and provide little if any pro-active guidance.

Why the PA?  The election constitutes direction to the "employer" to contribute money to the plan rather than pay it to the employee.  For a Schedule C filer, it is the same person.  Sure, the Schedule C filer may also be the PA, but he is not wearing his PA hat when he is the recipient of the supposed election. 

On 4/5/2019 at 2:59 PM, jpod said:

So you think a Note to Self dated on/before December 31 will satisfy an agent?   

Yes.  I'm not saying they (IRS) will definitely disallow deductions based on lack of an election, but having one erases all doubt, I think.  We get all of our self-employeds, whether partnerships or sole props, to sign an election.  (Well, we try...we provide forms and even typically fill them out for the owner but whether we get a copy or not is another thing.)

As far as Vanguard not wanting election forms, I'm not surprised at all.  They are neither the PA nor the TPA and don't want to be seen as fulfilling either role by even accepting such documents.  But that doesn't mean they're not required.

2 hours ago, Bird said:

We get all of our self-employeds, whether partnerships or sole props, to sign an election.

Care to share the form of election you provide for a Schedule C filer?  

1 hour ago, jpod said:

Care to share the form of election you provide for a Schedule C filer?  

I hope the image comes through below.  We usually write in "402(g) limit plus catchups" or something similar for owners.  

Thanks.  If a pre-end-of-year election by a Schedule C filer is necessary (I don't believe it is), this is no different than what I would expect and I am sure I wouldn't write it any differently.  By this election the "employee" is authorizing the "employer" to deduct from his compensation the amount stated.  In the context of a Schedule C filer, the employee and employer are the same individual.  Accordingly, this is nothing more than a "note to self."  I am not being critical, just stating a fact.  

I'm honestly baffled by the extent of this thread. I fully understand the opinion that the IRS stance is stupid or ridiculous, but when has that generally been the determining factor? It seems like it is more about "winning" a discussion point than it is about what the IRS regulations say about it. Tom already quoted it - (1.401(k)-1(a)(6)(iii)) -  I don't see how one can read the plain language here and come away with anything other than that the deferral election should be signed by 12/31. They specifically mention both a partnership or a sole proprietorship.

(iii) Timing of self-employed individual's cash or deferred election. For purposes of paragraph (a)(3)(iv) of this section, a partner's compensation is deemed currently available on the last day of the partnership taxable year and a sole proprietor's compensation is deemed currently available on the last day of the individual's taxable year. Accordingly, a self-employed individual may not make a cash or deferred election with respect to compensation for a partnership or sole proprietorship taxable year after the last day of that year. See §1.401(k)-2(a)(4)(ii) for the rules regarding when these contributions are treated as allocated.

If you want to argue that the IRS doesn't enforce this requirement, or that there is little or no "risk" or that you have had lots of plans ignore this requirement and it hasn't been mentioned on audit, then that's a different story. But to my weary brain, the "correct" answer, backed by the regulations, is that ya gotta have it signed on or before 12/31.

I think jpod is hung up on the meaningless of an agreement between a sole proprietor and him/herself. With a partner in a partnership, or a shareholder (even 100%) of a corporation, you have a legal person that the individual partner or shareholder employee can enter into an agreement with. You can't really have that between a sole proprietor and his/her sole proprietorship. Such an "election" is more like a New Year's resolution.

Having said that, it's clearly the IRS's rule, and they're calling the shots on this. Probably better to think of it as a type of IRS filing or election that simply has a deadline. Sole proprietors do have to comply with deadlines, e.g. making contribution for year by tax return filing deadline.

In any event, thank you ALL for your input and Bird for providing a form.  For our shop, it means we will stop telling our partners and sole props that they have to get their deferrals in by 12/31, and we will tell them that they have to have an election form on file.  And before this whole long thread happened we weren't really sure what to do.

Very informative thread. My client elected S Corp status for 2023, previously an LLC, taxed as C corp, and the TPA told the client she could contribute her deferral plus cstch up by the due date of the LLC tax return.

Obviously, the TPA was not correct.

For 2022, the client adopted S Corp status.  I may be incorrect here, but would not  the deferral plus catch up have had to have been made by 12/31/22, as the shareholder of an S Corp is not a sole prop.

The fact that the accountant did not code box 12 with a code D tells all.

You reference two years here, 2022 and 2023, but as far as 2022 goes, that ship has sailed. There is no opportunity to defer in a corporate setting other than through a paycheck. 

That's what I thought; I think the accountant needs a little educating!

TX