My previous article examined the Internal Revenue Code (IRC) Section 404(a)(7) combined deduction limit. In addition to Section 404(a)(7), self-employed individuals also are subject to the limits of IRC Section 404(a)(8). (Editor's Note: The previous article, "404(a)(7) Deduction Limit Deep Dive," appears here.)
Section 404(a)(8) limits the combined deduction for each owner to his or her earned income. Earned income is reduced for contributions that are deductible under Section 404 per IRC Section 401(c)(2)(A), and the limitations of Section 404(a)(7) are based (at least in part) on benefit compensation. The result can be a messy circular calculation when earned income, after being adjusted for contributions, is less than the IRC Section 401(a)(17) compensation limit.
What happens when an owner’s plan contributions exceed the earned income limit? One possible solution for contributions deposited after year end is to claim them as deductions in the following year, assuming they fall within the following year’s deductible limits. Recall that Section 404(a)(6) grants flexibility in deduction timing for contributions deposited after year-end but before the tax filing deadline that have not yet been claimed as a deduction for the prior year. The allocation year does not necessarily need to be same as the deduction year. Contributions deposited during the current year exceeding the earned income limit, however, do not have the same flexibility and would be considered a limit violation.
The problem arises when the owner’s earned income for the year is lower than the defined benefit contribution. Note that there is a greater danger of this happening when the owner’s formula is not based on current year compensation, for example: when the plan uses a beginning of year valuation date and prior year pay, a flat dollar formula, or a formula based on average or highest years’ pay.
IRC Section 4972 generally imposes an excise tax when the business makes a nondeductible contribution. Section 4972(c)(4) specifies that for purposes of Section 4972, contributions made to satisfy the minimum required contribution are treated as allowable as a deduction under Section 404. Note this does not mean the contribution in excess of earned income is deductible; it simply means the minimum required contribution is not subject to the 10% excise tax. If only the minimum required contribution is made, there is no excise tax due and thus no need to file a Form 5330. If the contribution is greater than the minimum required contribution, the excise tax would only be due on the portion that exceeds the minimum. Note that Schedule A of the Form 5330 does not contain a line item for the Section 4972(c)(4) exemption as it does for the Section 4972(c)(6) and (c)(7) exceptions. Presumably, the portion representing the minimum required contribution would be included with the line item representing the amount allowable as a deduction under Section 404 when completing the Schedule A.
The question arises as to whether contributions exceeding the earned income limit can be carried forward to be deducted in future years. The debate centers around whether contributions in excess of earned income can be considered deductible under IRC Section 162. Section 162 limits deductions to ordinary and necessary business expenses. Under Section 404(a)(8)(C), plan contributions not exceeding earned income are considered to satisfy the conditions of Section 162. The question is whether contributions that exceeded the earned income limit could satisfy the conditions of Section 162 in a subsequent year. Some argue that the excess contributions would never be deductible, while others argue that the carryover provisions of Section 404(a) are broad enough to accommodate full carryover, or at the very least, carryover of the minimum required contribution.
Ultimately, it is up to the CPA to determine what portion is eligible for carryover since the CPA determines deductibility under Section 162. Note that if more than the minimum required contribution were contributed and the CPA took the harsher stance that none of the contribution exceeding the earned income limit could be carried forward and deducted, no excise tax would be due if utilizing a Section 4972(c)(7) election, but the plan would continue to carry the non-deductible contribution each year until the plan terminated (and would need to file Form 5330s every year if using the Form 5330 to document the Section 4972(c)(7) election). Perhaps this could be used as an argument against the no carryover stance, but also note that an IRS employee took the no carryover allowed stance at the Enrolled Actuaries Conference in 1999 (see 1999 “Gray Book” question 13. Note that the “Gray Book” is not law, it simply gives insight into how an individual IRS representative views a situation).
Situations involving earned income limit violations can be very messy, but can often be avoided by advising the plan sponsor to wait until after year-end and after net self-employment income has been calculated to make contributions. For DB plans, using end-of-year valuation dates and formulas that incorporate current year benefit compensation can also be helpful.
Tiffany Myers, FSA, EA, MSEA, is Manager, Actuarial Services, FuturePlan.
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