Deferrals Made on $0 Compensation Distribution Code

An owner of a sole proprietorship made deferrals from compensation. However, the owner also had losses and the net compensation for the year was $0. How would you distribute the excess? Would it be using code "8" (assuming the deferrals were pre-tax)?

Thanks,

It's a 415 violation, so code E.

From the instructions to the 1099-R:

Quote

The procedure for correcting excess annual additions under section 415 is explained in the latest EPCRS revenue procedure in section 6.06 of Rev. Proc. 2019-19, 2019-19 I.R.B. 1086, available at IRS.gov/irb/2019-19_IRB#REVPROC-2019-19.

Distributions to correct a section 415 failure are not eligible rollover distributions although they are subject to federal income tax withholding under section 3405. They are not subject to social security, Medicare, or Federal Unemployment Tax Act (FUTA) taxes. In addition, such distributions are not subject to the 10% early distribution tax under section 72(t). You may report the distribution of elective deferrals (other than designated Roth contributions) and employee contributions (and earnings attributable to such elective deferrals and employee contributions) on the same Form 1099-R. However, if you made other distributions during the year, report them on a separate Form 1099-R. Because the distribution of elective deferrals (other than designated Roth contributions) is fully taxable in the year distributed (no part of the distribution is a return of the investment in the contract), report the total amount of the distribution in boxes 1 and 2a. Leave box 5 blank, and enter Code E in box 7. For a return of employee contributions (or designated Roth contributions) plus earnings, enter the gross distribution in box 1, the earnings attributable to the employee contributions (or designated Roth contributions) being returned in box 2a, and the employee contributions (or designated Roth contributions) being returned in box 5. Enter Code E in box 7. For more information, see Rev. Proc. 92-93, 1992-2 C.B. 505.

On 6/17/2021 at 8:35 AM, C. B. Zeller said:

Distributions to correct a section 415 failure are not eligible rollover distributions although they are subject to federal income tax withholding under section 3405. They are not subject to social security, Medicare, or Federal Unemployment Tax Act (FUTA) taxes.

C.B. Zeller, I guess it's reasonable that a sole proprietor might have made elective deferrals (as opposed to nonelective) during the year, before he or she realized there would be a loss, but the result of this good faith error is to dodge the SE tax?

I agree it's a 415 issue rather than excess deferrals. Since the sole proprietor had $0 net earnings, there is no compensation eligible to defer.

On 6/18/2021 at 9:34 PM, Luke Bailey said:

C.B. Zeller, I guess it's reasonable that a sole proprietor might have made elective deferrals (as opposed to nonelective) during the year, before he or she realized there would be a loss, but the result of this good faith error is to dodge the SE tax?

Deferrals aren't normally exempt from FICA/FUTA taxes so any amount that would be taxable should still have been taxable during the year in which they were mistakenly withheld.

I will admit I am not thoroughly versed in the complexities of self-employment tax issues beyond the pension arena, so there may be some subtlety I am missing here.

On 6/18/2021 at 9:34 PM, Luke Bailey said:

C.B. Zeller, I guess it's reasonable that a sole proprietor might have made elective deferrals (as opposed to nonelective) during the year, before he or she realized there would be a loss, but the result of this good faith error is to dodge the SE tax?

2 hours ago, C. B. Zeller said:

Deferrals aren't normally exempt from FICA/FUTA taxes so any amount that would be taxable should still have been taxable during the year in which they were mistakenly withheld.

...and any amounts that would NOT be taxable would still NOT be taxable had deferrals been deposited by mistake, so I don't see any SE tax being dodged.  In other words, if the self-employed person had not made any deferrals, and had a loss, there would be no SE tax.  Making or not making deferrals doesn't change that.

22 minutes ago, Bird said:

In other words, if the self-employed person had not made any deferrals, and had a loss, there would be no SE tax.  Making or not making deferrals doesn't change that.

Good point regarding the loss, Bird. But C.B. Zeller, and Bird, I guess here is the (unlikely, but possible) hypothetical. Sole proprietor makes deferrals during year of $19,500. Ends up that, after taking the deduction for the deferrals into account, the sole proprietor had net SE income of -$9,750. If the money comes back in the next year as a 415(c) violation, it seems like the result is a -$9,750 loss in year 1, no SE tax, and then $9,750 in income in year 2, again no SE tax. If the individual had made an election in year 1 that said "lesser of SE income or $19,500," and they had waited until all the plan calculations were done to actually contribute the amount, presumably $4,675 would have gone into the plan and there would have been $4,675 in SE income?

Maybe with amounts this small, no one cares.

8 minutes ago, Luke Bailey said:

Good point regarding the loss, Bird. But C.B. Zeller, and Bird, I guess here is the (unlikely, but possible) hypothetical. Sole proprietor makes deferrals during year of $19,500. Ends up that, after taking the deduction for the deferrals into account, the sole proprietor had net SE income of -$9,750. If the money comes back in the next year as a 415(c) violation, it seems like the result is a -$9,750 loss in year 1, no SE tax, and then $9,750 in income in year 2, again no SE tax. If the individual had made an election in year 1 that said "lesser of SE income or $19,500," and they had waited until all the plan calculations were done to actually contribute the amount, presumably $4,675 would have gone into the plan and there would have been $4,675 in SE income?

Maybe with amounts this small, no one cares.

It should still come out right, since deferrals for self-employed individuals are deducted on their Form 1040 Schedule 1, not on their Schedule C or K-1, but the income from Schedule C or K-1 (before the deferral) is used to determine the self-employment tax.

7 hours ago, C. B. Zeller said:

It should still come out right, since deferrals for self-employed individuals are deducted on their Form 1040 Schedule 1, not on their Schedule C or K-1, but the income from Schedule C or K-1 (before the deferral) is used to determine the self-employment tax.

That make sense. Thanks, C.B. Zeller.