Can a partner participate in the company's 401(k) plan?

ABC LLC is a multi-member LLC taxed as a partnership.  One member, John, was incorrectly classified as a W2 employee for many years, and is a participant in the company's 401(k) plan.  Beginning 1/1/2021, John is receiving guaranteed payments on K-1 instead of W-2.  Is John able to continue to participate in ABC's 401(k)?  There has been no match or profit-sharing in the past though there may be in the future.  If so, how does this happen?  Does John need to set up his own corporation or LLC to receive the guaranteed payments, and to be the participant in ABC's 401(k)?  If he is eligible, will he then contribute once a year to the 401(k)?

It's all based on the document. Does the plan exclude partners? Why would you think he wouldn't be eligible?

Bill - Thanks for the reply. The plan document does currently only include employees.  They would be willing to amend it.  Does that solve the problem?  How does it work in practice then since previously he had his contributions deducted from his check by the payroll company?    

20 minutes ago, Sean Macklin said:

The plan document does currently only include employees.

Does it actually exclude partners though? The document that we use (FT William) defines "Employee" to mean "any individual who is employed by the Employer, including a Self-Employed Individual."

Guaranteed payments are not compensation for plan purposes. For a partner, compensation is net earned income. Net earned income is typically not known until the partnership's tax return is finalized, so that is when the income is considered to be available to the partner and they can make their contribution. The partner can make their deferral contributions out of their guaranteed payments if they wish, however it is going to cause problems if it turns out later that their compensation (net earned income) is not enough to support the deferrals that were made.

Since the plan was not using net earned income for this participant in the past, they should go back and calculate his true compensation for past years. They may need to re-run their ADP tests.

I agree with C.B. - but FWIW I'd be a little cautious on the "Guaranteed payments" question. Sometimes this terminology is used on a blanket basis, but certain "guaranteed payments" are included when computing net earnings from self-employment, and some (see IRC 1402(a)(10)) are excluded. And as C.B. notes, you can get into trouble if the "net earnings from self employment" turns out to be less than the guaranteed payments. 

BenefitsLink mavens, please help me fill-in a gap in my experience.

In collecting information to sort which workers are or were a 5%-owner or a 1%-owner (whether to find highly-compensated employees, key employees, those who must get a minimum distribution while still working, or something else), does a third-party administrator:

rely exclusively on the employer/customer’s information on a questionnaire or spreadsheet?

check information for logical consistency with the employer/organization’s tax return?

ask the employer/organization’s accountant to specify the ownership percentages?

do something else?

16 minutes ago, Peter Gulia said:

In collecting information to sort which workers are or were a 5%-owner or a 1%-owner (whether to find highly-compensated employees, key employees, those who must get a minimum distribution while still working, or something else), does a third-party administrator:

rely exclusively on the employer/customer’s information on a questionnaire or spreadsheet?

check information for logical consistency with the employer/organization’s tax return?

ask the employer/organization’s accountant to specify the ownership percentages?

do something else?

We ask in various ways until we are satisfied that we have the right answer, or at least have a paper trail that we can blame someone else for not providing accurate info (only half-joking).  Often it goes to your last item - ask the accountant.  Experience and getting a feel for things goes a long way.

As far as the original question, I believe it is highly unlikely that the partner is not included; as noted by C. B. Zeller, "employee" probably includes "partner."  On a somewhat related note, I've had accountants state that sole props or partners can't get contributions because the plan definition of comp is "W-2."  Sigh.  W-2 comp does include self-employment income; you don't literally (only) read numbers off of a W-2.

Bird, thank you for your helpful information.

About ownership percentages, people get it wrong if they don’t carefully distinguish a partner’s or member’s capital interests, profits interests, and loss interests.

And a count of a self-employed partner’s or member’s deemed compensation often is wrong if someone fails to account for the relation between guaranteed-payment rights and other elements.

Thank you all for the very, very helpful info.  This particular partner is a 1% owner.  His guaranteed payments will be a fixed monthly amount representing a fair and reasonable salary for his actual job responsibilities with the company.  I don't know the technical definition of earned income for these purposes, and I'm guessing it's not a short answer type question, but if it is possible to make general statements about how you would generally distinguish earned income from other guaranteed payments, or can link to something that provides some color on this, I'd appreciate it.  Again, thank you all.

Generally, I take what the accountant calculates on the K-1 as net Self Employment Earnings and start there.  As mentioned above, I believe some guaranteed payments are included in that figure, some are not.

22 hours ago, C. B. Zeller said:

Guaranteed payments are not compensation for plan purposes. For a partner, compensation is net earned income. Net earned income is typically not known until the partnership's tax return is finalized, so that is when the income is considered to be available to the partner and they can make their contribution. The partner can make their deferral contributions out of their guaranteed payments if they wish, however it is going to cause problems if it turns out later that their compensation (net earned income) is not enough to support the deferrals that were made.

I don't think I agree with this. If a partner is getting guaranteed payments, they are his/her share of the partnership's self-employment income, and therefore would be handled under the typical terms of a plan that has the proper wording (which is commonplace) to deal with partner participation in the plan, e.g. the definition of comp including self-employment income. I guess there is the theoretical issue of where a partnership has a net loss for the year, so the guaranteed payments are financed by debt or from capital, but that is probably handled somewhere in Subchapter K and my guess is the partner is still taxable on it, but maybe not.

Luke - maybe a matter of semantics, but I read C.B.'s statement as meaning that "guaranteed payments" - in and of themselves, are not the measuring compensation. Rather I understood him (her? Can't tell gender from initials)  to be saying that you use net earned income - which is correct. The guaranteed payments are generally (but not always) used when arriving at earned income. So I suspect we are all agreeing, albeit stating it a little differently.

15 hours ago, Luke Bailey said:

I don't think I agree with this. If a partner is getting guaranteed payments, they are his/her share of the partnership's self-employment income, and therefore would be handled under the typical terms of a plan that has the proper wording (which is commonplace) to deal with partner participation in the plan, e.g. the definition of comp including self-employment income. I guess there is the theoretical issue of where a partnership has a net loss for the year, so the guaranteed payments are financed by debt or from capital, but that is probably handled somewhere in Subchapter K and my guess is the partner is still taxable on it, but maybe not.

Section 707(c) of the Code and the Treasury Regulations treat these guaranteed payments as self-employment income to the partner and allow the partnership to take a Section 162 deduction for ordinary and necessary business expenses. Whether or not the payments are financed by debt of paid from partnership capital does not change their characterization. They are still first priority payments guaranteed to the partner for services rendered. 

7 hours ago, FORMER ESQ. said:

Section 707(c) of the Code and the Treasury Regulations treat these guaranteed payments as self-employment income to the partner and allow the partnership to take a Section 162 deduction for ordinary and necessary business expenses. Whether or not the payments are financed by debt of paid from partnership capital does not change their characterization. They are still first priority payments guaranteed to the partner for services rendered. 

Thanks, FORMER ESQ.

10 hours ago, Belgarath said:

Luke - maybe a matter of semantics, but I read C.B.'s statement as meaning that "guaranteed payments" - in and of themselves, are not the measuring compensation. Rather I understood him (her? Can't tell gender from initials)  to be saying that you use net earned income - which is correct. The guaranteed payments are generally (but not always) used when arriving at earned income. So I suspect we are all agreeing, albeit stating it a little differently.

Belgarath, I see what's going on, I think. You are actually addressing partner "draws," not guaranteed payments. "Draws" are advances by the partnership to its partners of what they think will be income by the end of the year. They are not guaranteed, and usually partners that get guaranteed payments don't get draws. If you are a partner who gets a draw and after the end of the year it turns out that your draws exceed your share of income, then yes, the excess if a distribution of capital, not self-employment income, and the capital amount would be nontaxable and not Section 415 comp.

No, that's not what I'm saying. I'm not talking about a "draw." I'm saying that "guaranteed payments" are not the definition of compensation - I am saying they would normally be included in arriving at net earnings from self-employment. However, it is possible for NESE to be less than the guaranteed payments. So if deferrals were being made based solely on guaranteed payments, and it turns out that NESE is less than the guaranteed payments, then you have a problem. 

Again, I suspect we are all agreeing on the final result, and it is just semantics in arriving at the final result.

8 hours ago, Belgarath said:

No, that's not what I'm saying. I'm not talking about a "draw." I'm saying that "guaranteed payments" are not the definition of compensation - I am saying they would normally be included in arriving at net earnings from self-employment. However, it is possible for NESE to be less than the guaranteed payments. So if deferrals were being made based solely on guaranteed payments, and it turns out that NESE is less than the guaranteed payments, then you have a problem. 

Again, I suspect we are all agreeing on the final result, and it is just semantics in arriving at the final result.

You may be right, Belgarath, but so I can understand can you provide an example? FORMER ESQ. provided the cite to guidance that the GP's are NESE. So what is going to reduce that?

See my first post.

If the partner were being treated as a W-2 employee, it is almost certain that their compensation was being calculated wrong. Even if their net earnings from self employment happened to be exactly equal to their guaranteed payments, that amount still needs to be adjusted for 1/2 self-employment tax and employer contributions made on behalf of the partner in order to obtain compensation for plan purposes.

Agree.

Related question:  Do he need to set up his own company, whether S corp or LLC?  (This is in financial services, so C corp Personal Service Corporation is not an option).  He would not go to the trouble of setting up a separate personal company unless necessary to participate in the 401(k).  Or can he just participate as an individual?  Based on everything I've read, it seems like he could just participate individually, but I did talk to a TPA who (although sounded very uncertain) seemed to think they needed to form their own entity.  If he did set up his own LLC, would the partnership then act as adopting employer for the personal company? 

24 minutes ago, Sean Macklin said:

Related question:  Do he need to set up his own company, whether S corp or LLC?  (This is in financial services, so C corp Personal Service Corporation is not an option).  He would not go to the trouble of setting up a separate personal company unless necessary to participate in the 401(k).  Or can he just participate as an individual?  Based on everything I've read, it seems like he could just participate individually, but I did talk to a TPA who (although sounded very uncertain) seemed to think they needed to form their own entity.  If he did set up his own LLC, would the partnership then act as adopting employer for the personal company? 

No need, unless there is something in the plan document that says self-employed individuals are excluded. And if that is the case, it's probably easier to amend the plan document than to set up a new entity.

14 hours ago, Belgarath said:

See my first post.

Belgarath, 1402(a)(10) deals with trailing nonqualified retirement benefits to inactive partners. Sure, that does not count for 415(c). I was talking active partners who receive guaranteed payments for services they perform during the year.

So you want to know how NESE can be less than guaranteed payments? 'Cause earned income also takes into account the partner's distributable share of partnership income that ISN'T attributable to guaranteed payments. This could be a loss. Also adjustments mentioned by C.B. above.

Is this common? Not in my experience. But it happens.

4 hours ago, Belgarath said:

Is this common? Not in my experience.

Belgarath, we are now in agreement.