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CGCPA
CGCPA, CPA
Category: Tax
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Experience:  over 40 years experience in tax matters
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We file form 1065 (with 2 K-1s) for our small business; neither

Customer Question

We file form 1065 (with 2 K-1s) for our small business; neither of us takes a salary. In the past we have contributed to IRAs and deducted those contributions on the face of the 1040 just before the adjusted gross income subtotal. Now we are being advised that if we set up a 401k plan for the business and contribute to that instead of to the IRAs we will be able to deduct more - up to $16,500 each. Please explain how those mechanics should work; that is, how will the business adjust it's 1065 and/or K-1 filings to properly reflect our contributions to the 401k accounts? I understand that if we took a salary then the 401k deferral would be a subtract from W-2 wages and that is the way we would save on taxes. However, we don't get W-2s just K-1s. Thank you.
Submitted: 2 years ago.
Category: Tax
Expert:  CGCPA replied 2 years ago.

Welcome to Just Answer. I am here to help you resolve your tax and finance concerns. Please feel free to ask anytime you need extra help.

 

A form 1065 is the tax return form for a partnership. However, it can also be used by an LLC. So, let's look at this from a slightly different perspective. If your business is a Partnership, it may very well be worth your while to form either an LLC or a corporation(followed by an S Corp election to avoid double taxation). Then you can be on payroll, generate W-2 forms and have the 401(k). The added benefit of an S Corp or LLC is that they provide legal protections a partnership does not. Since formation costs vary by state, you will need to determine which is less costly for you.

 

If the business is a partnership, you are correct and will not be able to do a 401(k) plan. That is why I am suggesting consideration be given to the other choices. However, remember that a 1065 is merely a filing. If the business is an LLC, please read the following. You can switch to filing for an LLC as an S Corp and have W-2s etc.

 

Limited Liability Company (LLC)

A Limited Liability Company (LLC) is a business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation.

Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit "single member" LLCs, those having only one owner.

A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state's requirements and the federal tax regulations for further information. There are special rules for foreign LLCs.

Classifications

The federal government does not recognize an LLC as a classification for federal tax purposes. An LLC business entity must file a corporation, partnership or sole proprietorship tax return.

An LLC that is not automatically classified as a corporation can file Form 8832 to elect their business entity classification. A business with at least 2 members can choose to be classified as an association taxable as a corporation or a partnership, and a business entity with a single member can choose to be classified as either an association taxable as a corporation or disregarded as an entity separate from its owner, a "disregarded entity." Form 8832 is also filed to change the LLC's classification.

Effective Date of Election

The election to be taxed as the new entity will be in effect on the date the LLC enters on line 8 of Form 8832. However, if the LLC does not enter a date, the election will be in effect as of the form's filing date. The election cannot take place more than 75 days prior to the date that the LLC files Form 8832 and the LLC cannot make the election effective for a date that is more than 12 months after it files Form 8832. However, if the election is the "initial classification election," and not a request to change the entity classification, there is relief available for a late election (more than 75 days before the filing of the Form 8832).

References/Related Topics

CGCPA, CPA
Category: Tax
Satisfied Customers: 3740
Experience: over 40 years experience in tax matters
CGCPA and 6 other Tax Specialists are ready to help you
Customer: replied 2 years ago.
We already converted to an LLC, effective 9/1/2010 but we still file form 1065. You are saying that the ONLY way to benefit from a contributions to a 401k is if you are on a salary/w-2? This does not make sense to me. I have seen information relating to how a business would calculate the allowable contribution it could make on behalf of a partner who only gets a k-1.
Customer: replied 2 years ago.
I pressed the wrong button and I have not accepted your answer.

Here is the comment I wrote but the system did not forward to you.

We are already an LLC - converted from general partnership to LLC effective 9/1/2010. You are saying that the ONLY WAY a person can benefit from contributing to a 401K is if they receive a salary/w-2? That does not make sense to me because I have seen information about how a business should calculate compensation for a person receiving only a K-1.

Please explain further
Expert:  CGCPA replied 2 years ago.

An employer can only offer a 401(k) to its employees. Since you as the owners cannot be employees using the 1065 filing, at this time you cannot offer a 401(k). However, as an LLC you can switch to the S Corp filing election using form 8832 (see above). Then filing as an S Corp, you can be employees and offer the 401(k). The reason for this is that the employee contribution to a 401(k) is a salary deferral. To have a salary deferral you must be receiving a salary. Here is some additional information from the IRS to assist you.

 

Topic 424 - 401(k) Plans

A 401(k) plan is a type of tax-qualified deferred compensation plan in which an employee can elect to have the employer contribute a portion of his or her cash wages to the plan on a pretax basis. Generally, these deferred wages (commonly referred to as elective contributions) are not subject to income tax withholding at the time of deferral, and they are not reflected on your Form 1040 (PDF) since they were not included in the taxable wages on your Form W-2 (PDF). However, they are included as wages subject to social security, Medicare, and federal unemployment taxes.

The amount that an employee may elect to defer to a 401(k) plan is limited by the Internal Revenue Code. In addition, your elective contributions may be limited based on the terms of your 401(k) plan. Refer to Publication 525, Taxable and Nontaxable Income, for more information about elective contributions. Employers should refer to Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans), for information about setting up and maintaining retirement plans for employees, including 401(k) plans.

Distributions from a 401(k) plan may qualify for optional lump-sum distribution treatment or rollover treatment as long as they meet the respective requirements. For more information, refer to Topic 412, Lump-Sum Distributions, and Topic 413, Rollovers from Retirement Plans.

Many 401(k) plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs. Generally, hardship distributions from a 401(k) plan are limited to the amount of the employees' elective contributions only, and do not include any income earned on the deferred amounts. Hardship distributions are not treated as eligible rollover distributions.

Distributions received before age 59 1/2 are subject to an early distribution penalty of 10% additional tax unless an exception applies. For more information about the treatment of retirement plan distributions, refer to Publication 575, Pension and Annuity Income.

Expert:  CGCPA replied 2 years ago.

Here is some additional information from the IRS. Please note the consistent and repetitive use of the word employee. Partnership owners cannot be employees of that same partnership. Since the business is already an LLC, all you need to do is file a completed form 8832 and you can be employees of the LLC filing as an S Corp.

 

401(k) Resource Guide - Plan Sponsors - 401(k) Plan Overview

This 401(k) Resource Guide provides general information. You should contact your plan administrator for information specific to your plan.

A 401(k) plan is a qualified (i.e., meets the standards set forth in the Internal Revenue Code (IRC) for tax-favored status) profit-sharing, stock bonus, pre-ERISA money purchase pension, or a rural cooperative plan under which an employee can elect to have the employer contribute a portion of the employee's cash wages to the plan on a pre-tax basis. These deferred wages (elective deferrals) are not subject to federal income tax withholding at the time of deferral, and they are not reflected as taxable income on the employee's Form 1040, U.S. Individual Income Tax Return.

The employer reports elective deferrals on the participant's Form W-2, Wage and Tax Statement. Although these amounts are not treated as current income for federal income tax purposes, they are included as wages subject to social security (FICA), Medicare, and federal unemployment taxes (FUTA). Refer to Publication 525, Taxable and Nontaxable Income, for more information about elective deferrals. Refer to the Form W-2 Instructions, for more information on how amounts should be reported.

401(k) plans are permitted to allow employees to designate some or all of their elective deferrals as "Roth elective deferrals" that are generally subject to taxation under the rules applicable to Roth IRAs. The information contained in this guide does not pertain to Roth 401(k)s unless specifically stated.

Two of the tax advantages of sponsoring a 401(k) plan are:

  • Employer contributions are deductible on the employer's federal income tax return to the extent that the contributions do not exceed the limitations described in section 404 of the Internal Revenue Code. Refer to Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans), for more information about deduction limitations.
  • Elective deferrals and investment gains are not currently taxed and enjoy tax deferral until distribution.

There are several types of 401(k) plans available to employers - traditional 401(k) plans, safe harbor 401(k) plans and SIMPLE 401(k) plans. Different rules apply to each. For tax-favored status, a plan must be operated in accordance with the applicable rules. Therefore, it is important that the employer be familiar with the special rules that apply to its plan so the plan is administered in accordance with those rules. To qualify for the tax benefits available to qualified plans, a plan must both contain language that meets certain requirements (qualification rules) of the tax law and be operated in accordance with the plan's provisions. The following is a brief overview of important qualification rules. It is not intended to be all-inclusive.

Traditional 401(k) plans. A traditional 401(k) plan allows eligible employees (i.e., employees eligible to participate in the plan) to make pre-tax elective deferrals through payroll deductions. In addition, in a traditional 401(k) plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employees' elective deferrals, or both. These employer contributions can be subject to a vesting schedule which provides that an employee's right to employer contributions becomes nonforfeitable only after a period of time, or be immediately vested. Rules relating to traditional 401(k) plans require that contributions made under the plan meet specific nondiscrimination requirements. In order to ensure that the plan satisfies these requirements, the employer must perform annual tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.

Safe harbor 401(k) plans. A safe harbor 401(k) plan is similar to a traditional 401(k) plan, but, among other things, it must provide for employer contributions that are fully vested when made. These contributions may be employer matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals. The safe harbor 401(k) plan is not subject to the complex annual nondiscrimination tests that apply to traditional 401(k) plans.

Safe harbor 401(k) plans that do not provide any additional contributions in a year are exempted from the top-heavy rules of section 416 of the Internal Revenue Code.

Employers sponsoring safe harbor 401(k) plans must satisfy certain notice requirements. The notice requirements are satisfied if each eligible employee for the plan year is given written notice of the employee's rights and obligations under the plan and the notice satisfies the content and timing requirements.

In order to satisfy the content requirement, the notice must describe the safe harbor method in use, how eligible employees make elections, any other plans involved, etc. Income Tax Regulations section 1.401(k)-3(d)(2), contains information on satisfying the content requirement using electronic media and referencing the plan's Summary Plan Description.

The timing requirement requires that the employer must provide notice within a reasonable period before each plan year. This requirement is deemed to be satisfied if the notice is provided to each eligible employee at least 30 days and not more than 90 days before the beginning of each plan year. There are special rules for employees who become eligible after the 90th day. See Income Tax Regulations section 1.401(k)-3(d)(3).

Both the traditional and safe harbor plans are for employers of any size and can be combined with other retirement plans.

SIMPLE 401(k) plans. The SIMPLE 401(k) plan was created so that small businesses could have an effective, cost-efficient way to offer retirement benefits to their employees. A SIMPLE 401(k) plan is not subject to the annual nondiscrimination tests that apply to traditional 401(k) plans. As with a safe harbor 401(k) plan, the employer is required to make employer contributions that are fully vested. This type of 401(k) plan is available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding calendar year. Employees who are eligible to participate in a SIMPLE 401(k) plan may not receive any contributions or benefit accruals under any other plans of the employer.

For more information on traditional, safe harbor and SIMPLE 401(k) plans, see Publication 4222, 401(k) Plans for Small Businesses.

Restriction on conditions of participation. A 401(k) plan cannot require, as a condition of participation, that an employee complete more than 1 year of service.

Automatic enrollment in a 401(k) plan. A 401(k) plan can have an automatic enrollment feature. This feature permits the employer to automatically reduce the employee's wages by a fixed percentage or amount and contribute that amount to the 401(k) plan unless the employee has affirmatively chosen not to have his or her wages reduced or has chosen to have his or her wages reduced by a different percentage. These contributions qualify as elective deferrals. This has been an effective way for many employers to increase participation in their 401(k) plans. These contributions qualify as elective deferrals. For more information about 401(k) plans with an automatic enrollment feature, refer to Income Tax Regulations section 1.401(k)-1(A)(3)(ii).

Elective deferral limits. The law, under IRC section 402(g), limits the amount that a participant can defer on a pre-tax basis each year. A discussion of those limitations is available.

Elective deferrals that exceed the section 402(g) dollar limit for a year or are recharacterized as after-tax contributions as part of a correction of the Actual Deferral Percentage (nondiscrimination) test are included in the employee's gross income.

Matching contributions. If the plan document permits, the employer can make matching contributions for an employee who contributes elective deferrals to the 401(k) plan. For example, a 401(k) plan might provide that the employer will contribute 50 cents for each dollar that participating employees choose to defer under the plan. As mentioned earlier, employer matching contributions may be subject to annual tests to determine if nondiscrimination requirements are met.

Other employer contributions. If the plan document permits, the employer can make additional contributions (other than matching contributions) for participants, including participants who choose not to contribute elective deferrals to the 401(k) plan. If the 401(k) plan is top-heavy, the employer may be required to make minimum contributions on behalf of certain employees. In general, a plan is top-heavy if the account balances of key employees exceed 60% of the account balances of all employees. The rules relating to the determination of whether a plan is top-heavy are complex. Please refer to section 1.416-1 of the Income Tax Regulations for the rules describing how to determine whether a plan is top-heavy.

Employee compensation limit. In 2010 and 2011, no more than $245,000 of an employee's compensation can be taken into account when figuring contributions. This is indexed for inflation.

Vesting requirements. All employees must be fully (100%) vested in their elective deferrals. A plan may require completion of a specific number of years of service for vesting in other employer or matching contributions. For example, a plan may require that the employee complete 2 years of service for a 20% vested interest in employer contributions and additional years of service for increases in the vested percentage.

Distributions. General rules relating to distributions are available. For more information about the treatment of retirement plan distributions, refer to Publication 575, Pension and Annuity Income.

Customer: replied 2 years ago.
Thank you.
Expert:  CGCPA replied 2 years ago.
You are quite welcome. I try to help you find a way to get to your goal, if at all possible and legal, rather than simply say yes or no. This is a relatively simple fix.

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