As we are all aware, the issue of compensation for self-employed (SE) persons at times results in circular calculations. In general, compensation for such persons is their net income from self-employment, less the deduction for one half of the self-employment tax, less the deductions for employer contributions made to qualified plans on behalf of the SE person.
To the extent that the contributions for the SE person depend on compensation, the calculation becomes circular. This can be distinguished from compensation for employees, which is “simply” that received in the form of a paycheck from the employer and reported on Form W-2.
From a deduction perspective, the law limits the deduction on behalf of a SE person to such person’s earned income (determined before plan contributions) from the trade or business establishing the plan. This limitation can preclude a deduction for the funding required for a defined benefit plan to the extent such minimum funding exceeds such earned income.
Another issue SE persons face is the need to make estimated tax payments. While employees have income and payroll taxes withheld from their paychecks, SE persons must normally make quarterly tax payments to cover income taxes as well as self-employment taxes, the latter being the SE person’s version of FICA and Medicare taxes. Additionally, SE persons are responsible for 100% of FICA and Medicare taxes whereas in the employee-employer relationship the employer picks up half of the cost.
The above issues make it tempting to simply treat sole proprietors or partners as employees. That is, notwithstanding their status as SE individuals, life seems simpler giving such folks a paycheck and withholding taxes from such paychecks and having the employer pick up half of the FICA and Medicare cost. Apparently some accountants think this is okay, and many of us have been faced with the situation where we’ve been informed that a client has SE income as well as W-2 income.
Is this okay?
The IRS position is that it is not okay, and the courts have agreed. In a series of revenue rulings (69-184, 81-300, 81-301) the Service has held that an individual cannot be both an employee and a partner for employment tax purposes. Additionally, in such rulings, the Service held that to the extent a partner renders services “outside the scope of the partnership,” such services are those of an independent contractor and not an employee. This latter point is the Service’s response to Code Section 707(a)(1), which provides: “If a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner.”
Nevertheless, on occasion we are faced with the situation where we know the entity is taxed as a sole proprietorship or partnership, yet the participant receives a W-2 in addition to a K-1. What to do? As with any situation where faced with uncertainty, you should do something “reasonable.”
For example, you receive a census for a partnership and the two 50% partners have W-2 wages listed, let’s say $150,000 each. In addition, the K-1s shows SE income for the partners of $100,000 each. The partnership sponsors a cash balance plan that provides that the partners each get a pay credit of 50% of compensation and the partnership’s intention is to fund the pay credits. What’s the pay credit?
As previously indicated, and ignoring the W-2 income for a moment, the partner’s compensation is reduced for plan contributions made on the partner’s behalf. So if the partnership had reported the entire $250,000 as SE income (and assuming no outside W-2 income) the SE tax would be ($250,000 * .9235 * .029) + (118,500 * .124) = $6,695 + $14,694 = 21,389 and the deduction for 1/2 of the SE tax would be $10,695. Compensation before the pension would be $239,305 and his pay credit would be $239,305 / 150% = 159,537 * .5 = $79,768. (i.e., compensation would be $250,000 [10,695 – 79,768 = 159,537] and the pay credit would be $159,537 * 50% = 79,768.)
With the mixed bag, how would I handle it? First, it would seem to me that, irrespective of how the compensation is shown, the deduction is still limited by SE income. The pay credit would be $75,000 from the W-2 income plus some number from the SE income, the latter recognizing the full amount of the pension deduction (which again, we’ve deemed to be equal to the pay credit). The SE tax on the $100,000 of SE income would be $100,000 * .9235 * .029 = $2,678 and the deduction for 1/2 of the SE tax would therefore be $1,339. What’s the pay credit, though?
First, I would say compensation for the SE piece is ($100,000 – $75,000 – $1,339)/150% = $15,774. The pay credit would then be $75,000 + 15,774/2 = $82,887. That is, compensation is $150,000 + 15,774 = $165,774, and 50% of $165,774 is $82,887.
What if there isn’t enough SE income? For example, what if in the previous example the W-2 was $150,000 but SE income was only $10,000 (and the deduction for half of the SE tax was $134)? It would seem to me that the deduction would be limited to $9,866. But the pay credit would still be $75,000. What to do in such a situation?
Ask the accountant, since he or she is the one who created the issue in the first place. In the end there will be a minimum required amount that likely will exceed the SE income. In such a case the funding shouldn’t occur until the following year, at which time the accountant could correct the reporting going forward and hopefully have ample SE income for the deduction.
For what it’s worth, others have argued that the partner should be treated as two individuals – a regular employee to the extent of the W-2 compensation and a self-employed person to the extent of the SE income. With such treatment the portion of the deduction allocable to the employee portion would be deducted on the partnership return, creating a loss that possibly could be used against other income. Personally, I see no support for this treatment.
