Tag Archive for: sole proprietor

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Can My Client Still Set Up a 401(k) Plan for 2022?

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“I’m a wealth advisor working with sole proprietor who wants to set up a 401(k) plan for 2022. Is that still possible and could she make salary deferrals for 2022?”

Highlights of the Discussion

Because this question deals with specific tax information, business owners and other taxpayers should always seek the guidance of their tax professionals for advice on their specific situations. What follows is general information based on IRS guidance and does not represent tax or legal advice and is for informational purposes only.

With respect to setting up a plan for 2022, the short answer is, yes, provided your client has an extension to file her 2022 tax return. However, she could only make an employer contribution for herself—not employee salary deferrals for 2022. Here’s why.

Under the SECURE Act 1.0, for 2020 and later tax years, a business has until its tax filing deadline, plus extensions for a particular tax year to set up a plan. The plan establishment deadline is tied to the type of business entity and its associated tax filing deadline. Please see a prior Case of the Week, “Plan Establishment and Compensation,” for more detailed information.

For example, a sole proprietorship [or limited liability corporation (LLC) taxed as sole proprietorship] would have an extended plan establishment deadline of October 15, 2023, to set up a plan for 2022. That means your client could set up a 401(k) plan up until that date if she has a tax filing extension.

Regarding the ability to make retro-active employee salary deferrals, unfortunately, it is too late for your client to make salary deferrals for 2022. The change that allows sole proprietors or single member LLCs to make retroactive first-year elective deferrals under Section 317 of SECURE Act 2.0 takes effect for plan years beginning after December 29, 2022. Consequently, if she sets up a 401(k) plan now, she could only make salary deferrals on a prospective basis.

Conclusion
SECURE Acts 1.0 and 2.0 have made favorable changes to plan establishment and funding rules, including the ability to make retroactive first-year elective deferrals for certain unincorporated business owners beginning for the 2023 plan year. Before jumping into a plan, be aware there are lots of details that investors should discuss with their tax and legal advisors.

 

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Establishing a Solo 401(k) under the New Rules

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“My client is a sole proprietor and would like to set up a solo 401(k) plan for 2021. Are there any special considerations of which he needs to be aware?

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Connecticut is representative of a common inquiry related to establishing a Solo 401(k) plan.

Highlights of the Discussion
• Yes, there are special considerations with respect to establishing and contributing to a solo 401(k) plan. For that reason, your client should work with his CPA, tax advisor and/or legal counsel to address all the issues.

• Three of the key consideration would include the following items, the

 Deadline for establishing the solo 401(k) plan,
 Deadline for making a salary deferral election, and
 Owner’s compensation for contribution purposes.

• In order to be able to make employee salary deferrals to the solo 401(k) for 2021, a sole proprietor would have to establish the solo 401(k) and execute a salary deferral election by December 31, 2021. Here’s why.

• Although the Setting Every Community Up for Retirement Enhancement (SECURE) Act, delayed the deadline for establishing a qualified retirement plan for a particular tax year until the business’s tax return due date, plus extensions, in practice, the delay only applies for facilitating the ability to make employer contributions (e.g., a profit-sharing contribution) for the prior year—not employee salary deferrals. Let’s take a look at an example.

EXAMPLE
The 2021 maximum contribution for an unincorporated business owner to a solo 401(k) plan with enough earned income could be as high as $58,000 (or $64,500 if he or she turns age 50 or older before the end of the year). Anthony, a 54-year-old sole proprietor who earns $400,000, would like to set up a solo 401(k) plan for 2021. If Anthony establishes the solo 401(k) by December 31, 2021, and executes a salary deferral election by the same date, his maximum contribution for 2021 would be $64,500.

If, under the new plan establishment rules, Anthony waits until sometime in 2022 before his extended tax filing deadline for 2021 (i.e., October 15, 2022) to establish a solo 401(k) for 2021, he could not make employee salary deferrals for 2021. Consequently, his maximum contribution in this scenario would be limited to $58,000 for 2021.

• In all cases, a salary deferral election must be made prior to the receipt of compensation Treasury Regulation (Treas. Reg.) 1.401(k)-1(a)(3)]. Pursuant to Treas. Reg. 1.401(k)-1(a)(6)(iii), for self-employed individuals (i.e., sole proprietors and partners), compensation is considered paid on the last day of the business owner’s taxable year (e.g., December 31, 2021 for 2021). Therefore, a self-employed person has until the end of his or her taxable year to execute a salary deferral election for “the plan.” Conservatively, that means the plan would have to be in place by December 31, 2021, as well to allow for the sole proprietor to make the salary deferral election.

• The definition of compensation for contribution purposes for an unincorporated business owner is unique IRC 401(c)(2)(A)(I). It takes into consideration earned income or net profits from the business but must be adjusted for self-employment taxes. Please refer to the worksheet for calculating contributions to a solo 401(k) plan for a self-employed individual in IRS Publication 560, Retirement Plans for Small Businesses

 

Conclusion
For self-employed individuals and their tax advisors, there are several special considerations with respect to setting up and contributing to solo 401(k) plans, including, but not limited to, the deadline for establishing a 401(k) plan, the deadline for making a salary deferral election, and the owner’s compensation for contribution purposes.

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“Disregarded Entities,” 403(b)s and 457(b)s

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“How are subsidiaries and affiliates of an employer eligible to sponsor a 403(b) plan treated for plan participation purposes?”

Highlights of the Discussion

Generally, in order to offer an IRC §403(b) plan, the sponsor must be an “eligible employer” [e.g., a public school, church, or IRC §501(c)(3) organization as defined under Treasury Regulation (Treas. Reg) §1.403(b)-2(b)(8)(i)]. If the eligible 403(b) sponsor has a subsidiary or other affiliate; it, too, must be an eligible employer, in and of itself, in order to allow its employees to participate in the 403(b) plan [Treas. Reg. §1.403(b)-2(b)(8)(ii)].  There is an exception, however, for “disregarded entities” under Treas. Reg. §301.7701-3(b)(ii), including certain limited liability companies (LLCs) as explained in Chief Counsel Memorandum 201634021.[1] Memoranda are not formal guidance, but they do provide insight into how the IRS interprets and applies its rules and regulations.

In general, an LLC with a single owner may elect to be classified as either an association by filing Form 8832, Entity Classification Election or to be disregarded as an entity separate from its owner pursuant to Treas. Reg. §301.7701-3(b)(ii). If an entity is a disregarded entity, its activities are treated as those of a sole proprietorship, branch, or division of the owner under Treas. Reg. §301.7701-2(a). Consequently, a disregarded entity is treated as a branch or division of the 403(b) plan sponsor and not as a subsidiary or affiliate. Therefore, the employees of a disregarded entity are treated as employees of the entity sponsoring the 403(b), and must be allowed to make elective deferrals in order to satisfy the universal availability rule under Treas. Reg. § 1.403(b)-5(b).

The IRS applies similar reasoning to a governmental or tax-exempt, single-member LLC with a disregarded entity that sponsors a 457(b) plan. The disregarded entity is treated as a branch or division of the governmental or tax-exempt organization, so the employees of the disregarded entity are treated as employees of the governmental or tax-exempt organization and may, but are not required to, participate in the 457(b) plan.

Conclusion

In most cases, if a 403(b) sponsor has a subsidiary or other affiliate; it, too, must be an eligible employer, on its own, in order to allow its employees to participate in the 403(b) plan. There is an exception for certain disregarded entities. Employees of a disregarded entity are treated as employees of the entity sponsoring the 403(b), and must be allowed to make elective deferrals in order to satisfy the universal availability rule.

 

[1] Note:  General Counsel Memoranda are prepared by Chief Counsel attorneys and are intended primarily for IRS internal use. They are similar to standard attorney opinions and indicate the reasoning behind revenue rulings, private letter rulings, and technical advice memoranda.

 

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Tax Reporting of Retirement Plan Contributions for Unincorporated Businesses

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“Tax season has me wondering how sole proprietors deduct contributions they make to their qualified retirement plans?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Oklahoma is representative of a common inquiry related to deducting retirement plan contributions.

Highlights of the Discussion

Unincorporated business owners, such as sole proprietors, farmers and partnerships, are among the IRS’s list of “pass through” business entities. Why the name—because the profits of these firms directly pass through the businesses to their owners, and are taxed on the owners’ individual income tax returns.

Special rules apply for how such businesses report and deduct contributions to their retirement plans for themselves and their employees. The following table provides a general, informational summary of annual tax reporting requirements for unincorporated business owners who make retirement plan contributions. The table is based on the instructions to the filing forms noted. IRS Publication 560, Retirement Plans for Small Businesses provides additional information. Please consult a tax advisor for specific guidance.

Tax Reporting of Retirement Plan Contributions for Unincorporated Businesses
Type of Employer Contributions for Common Law Employees Contributions for the Business Owner
Sole proprietorship Line 19 of 2018 Schedule C, Profit or Loss From Business (attachment to IRS Form 1040)

 

Instructions to Schedule C

 

 Line 28 of 2018 Schedule 1, Additional Income and Adjustments to Income,(attachment to IRS Form 1040)

 

Instructions for Schedule 1

 
Farmers Line 23 of 2018 Schedule F, Profit or Loss From Farming, (attachment to IRS Form 1040)

 

Instructions to Schedule F

 

 Line 28 of 2018 Schedule 1, Additional Income and Adjustments to Income, (attachment to IRS Form 1040)

 

Instructions for Schedule 1

 
Partnership Line 18 of 2018 Form 1065, U.S. Return of Partnership Income

 

Instructions to Form 1065

 

 Box 13 of Schedule K-1 Partner’s Share of Income, Deductions, Credits, etc. (attachment to Form 1065)

 

Instructions for Schedule K-1

 

 

 

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Deferral election timing for the self employed

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“Several of my clients are self-employed and have 401(k) plans. What is the date by which a self-employed individual must make his or her salary deferral election?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Nevada is representative of a common inquiry related to 401(k) plan salary deferral elections.

Highlights of the Discussion

Special rules regarding salary deferral elections apply to self-employed individuals (e.g., sole proprietors or partners). They must make their cash or deferred elections no later than the last day of their tax year (e.g., by December 31, 2018, for a 2018 calendar tax year). The timing is connected to when the individual’s compensation is “deemed currently available” [see Treasury Regulation Section (Treas. Reg. §) 1.401(k)-1(a)(6)(iii)].

Often a self-employed individual’s actual compensation for the year is not determined until he or she completes his or her tax return, which, in most cases, is after the end of the partnership or individual’s taxable year. However, the IRS deems a partner’s compensation to be currently available on the last day of the partnership taxable year and a sole proprietor’s compensation to be currently available on the last day of the individual’s taxable year. Therefore, a self-employed individual must make a written election to defer compensation by the last day of the taxable year associated with the partnership or sole proprietorship.

EXAMPLE

A partner can make a cash or deferred election for a year’s compensation any time before (but not after) the last day of the year, even though the partner takes draws against his/her expected share of partnership income throughout the year.

There are also special rules that address when salary deferrals for self-employed individuals are treated as made to the plan (versus when they may actually be made). Treas. Reg. §1.401(k)-2(a)(4)(ii) states that an elective contribution made on behalf of a partner or sole proprietor is treated as allocated to the individual’s plan account as of the last day of the partnership or sole proprietorship’s taxable year.

With respect to the DOL’s deferral deposit deadline, deferrals for self-employed individuals must be deposited as soon as they can be reasonably segregated from the business’s general assets. The DOL’s safe harbor for plans with fewer than 100 employees also applies. Therefore, as long as the deferrals are transmitted within seven business days after the amounts are separated from the business’s assets, the contributions are deemed timely made.

From the IRS’ tax perspective, in no event can the deferrals be deposited after the deadline for filing the business’s tax return, plus extensions.

Conclusion

With respect to making a salary deferral election, a self-employed individual must do so no later than the last day of his or her tax year. The election should be documented in writing for proof in the event the plan later undergoes an audit. Therefore, those self-employed individuals following a calendar tax year must be sure to execute their written deferral elections by December 31, 2018!

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