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Compensation Part II: Self-Employed Income and Combined W2
Ilene H. Ferenczy, Managing Partner
Ferenczy Benefits Law Center
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Ilene H. Ferenczy, Managing PartnerFerenczy Benefits Law Center
Ilene Ferenczy is the managing partner of Ferenczy Benefits Law Center
LLP in Atlanta, Georgia. Ilene particularly focuses her practice on qualified
retirement plans, benefits issues in mergers and acquisitions, and advising
third-party administrators of employee benefit programs on technical and
practice issues. Ilene became an attorney after more than ten years as a
third-party administrator, and she brings a unique and practical approach to
her advice to clients. She is a member of the State Bars of Georgia and
California, and holds designations as a Certified Pension Consultant from
the American Society of Pension Professionals and Actuaries (“ASPPA”)
and Accredited Pension Administrator from the National Institute of Pension
Administrators. She is a nationally known speaker on benefits issues and
has authored more than 85 articles and five books. She is a member of
ASPPA’s Leadership Council, a former co-chair of ASPPA’s Government
Affairs Committee, the 2007 recipient of ASPPA’s Educator of the Year
Award, and is also a Fellow in the American College of Employee Benefits
Counsel, the highest honor awarded to ERISA lawyers.
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What We Covered in Part I
• Types of Compensation
• Statutory Compensation
• Used for §415 limits, HCE determination, top-heavy,
deductions, 100% of comp limit on catch-up contributions,
5% gateway
• Compensation for Nondiscrimination Testing
• Defined by IRC §414(s) – safe harbor or tested
• Other Uses of Compensation
• IRC §401(a)(17) limits on compensation
• Applies to allocations and benefit accrual,
nondiscrimination testing, deduction limits
2
3
Compensation for
Self-Employed (Earned Income)
3
Compensation for Owners Who
Do Not Receive Form W-2
• Includes:
• sole proprietors,
• partners, and
• owners of entities taxed as partnerships
• Foundation:
• Net Earnings from Self-Employment (NESE) from a
trade or business in which the owner’s services are a
material income producing factor
4
Compensation for Plan
Purposes Is Earned Income
• NESE, with adjustments
• Must be attributable to personal services
• Investment income passed through is not Earned
Income
• Passive partners (e.g., limited partners) in a
partnership have no Earned Income
• S-corporation shareholder dividends are returns on
investment and not Earned Income (paid on a W-2 for
personal services) – so, there is no NESE or Earned
Income from a K-1 for an S-Corporation
5
Let’s Talk Business Entities …
• C-Corporations are separate legal entities from
their owners
• File separate tax returns
• Liable for income tax on net income
from business operations
• Shareholders who work for the corporation receive
Forms W-2 for their wages
• Sole proprietorships and partners are “pass-
through entities” – no taxes paid at their level; all
taxable income/deductions pass to the owners
and are shown on their Forms 1040
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Let’s Talk Business Entities …
• Sole Proprietorship
• One owner or married couple
• Sole proprietor does not receive
Form W-2
• Business income and expenses
are reported on Schedule C to Form 1040
• Bottom line of Schedule C goes on Form 1040, line 12
• The Line 12 amount, with some adjustment,
represents what the sole proprietor earned for his/her
work at the company
7
Let’s Talk Business Entities …
• Regular Partnership
• Multiple owners
• Partners do not receive Form W-2
• Business net income will flow through
to the partners
• Partnership income and expenses are reported on Form 1065
• Each partner’s share of that income and expenses is reported on
Schedule K-1 to the Form 1065
• The net income shown on K-1, with some adjustment, will
represent what the partner earned for his/her work at the company
• Note: even though the partner is self-employed for
compensation purposes, his “employer” for plan
sponsorship is the partnership
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Let’s Talk Business Entities …
• Limited Partnership
• Multiple owners
• Some of those partners are
“limited partners”
• A limited partner has limited levels of liability because
s/he cannot actively participate in the business
• A limited partner is a “silent partner”
• Any income the limited partnership gets from the partnership is
considered to be a return on investment (not earned income)
• General partners in a limited partnership are just like
partners in a regular partnership and their income is
considered to be what they earned for their work at the
company
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Let’s Talk Business Entities …
• LLCs and LLPs
• Creatures of state law
• Owners elect whether the entity will be taxed as a
corporation or a partnership/sole proprietorship
• Default: partnership/sole proprietorship
• Election is on Form 8832 (for C-corporation) or Form 2553
(for S-corporation)
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Let’s Talk Business Entities …
• S-Corporations (a mix of entities)
• Shareholders are both employees
(to the extent that they are paid for their
services as employees) and owners (called
“shareholder-employees”)
• If receive compensation for services rendered, an owner
receives a Form W-2
• If receive distribution from S-Corporation, an owner receives a
Schedule K-1
• Commonly, S-corporation shareholders do this to avoid having
to pay FICA taxes on this part of their income
• Note: their compensation portion must be “reasonable”
• Distributions must be pro-rata to ownership
• Only amounts shown on Form W-2 are compensation for plan
purposes
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First Step of Self-Employment
Income: Net Earnings from
Self-Employment
• Where found?
• Sole proprietor:
• NESE shown on Schedule C to Form 1040, line 31 (“Self-
employment earnings (loss)”)
• If individual uses Schedule C-EZ to Form 1040, NESE is on
line 3 (“Net profit”)
• This number is transferred onto Form 1040, line 12.
• Note, however, that line 12 may include income from other
ventures, i.e., there may be more than one Schedule C
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First Step of Self-Employment
Income: Net Earnings from
Self-Employment
• Where found?
• Partner:
• NESE is shown on the partner’s
Schedule K-1 to Form 1065, line 14.
• This is reported on Schedule E to Form 1040, line 32
(assuming that individual is a partner in only one partnership;
if not, take appropriate items 28[(j)-(h)-(i)] for relevant
partnership)
• This is then transferred onto Form 1040, line 17.
• Note, however, that line 12 may include income from other
ventures, i.e. there may be more than one Schedule K-1 or E
13
First Step of Self-Employment
Income: Net Earnings from
Self-Employment
• Where found?
• S-corporation shareholder-employee:
• Shareholder-employee receives Form W-2 for compensation
related to personal services for the company
• K-1 income from an S-corporation is not earned income
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Formula for Turning NESE
Into Earned Income
• Net Earnings from Self-Employment
• Less: ½ self-employment tax under IRC §164(f)
• Less: employer contribution for self-employed
individual
• Equals: Earned Income
15
Adjustment for Self-
Employment Tax
• Self-employed individuals pay both employer and
employee portions of FICA taxes under IRC §1401
• 12.4% of NESE up to $127,200 for 2017, plus 2.9% of NESE
• Shown on Schedule SE line 5 of short schedule, line 12 of long
schedule
• These individuals get to deduct ½ of that tax from their
self-employment income (in the same way that an
employee does not pay taxes on the employer’s
contribution to FICA) (IRC §164(f))
• Therefore, Earned Income is reduced by the deductible
½ of the self-employment tax (shown on Schedule SE,
line 6 of short schedule, line 13 of long schedule)
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Earned Income Example
• Sam owns his own business and his work
materially contributes to this business
• His 2017 Schedule C income is $150,000
and the SE tax on that income is $16,434
• Sam has a 401(k) plan. He deferred
$13,000 and made a $28,000 profit
sharing contribution for himself
• Sam’s Earned Income is:
$150,000 – ($16,434/2) - $28,000 = $113,783
(The $13,000 deferral does not reduce his Earned Income, in the
same way that the deferrals by his employees do not reduce their
§415 compensation.)
17
Looked at Another Way
• Sam’s share of the company profits is $150,000• From this, Sam will pay:
• $16,434 in self-employment tax
• $13,000 salary deferral to the 401(k) plan
• $28,000 “employer contribution” to
the 401(k) plan
• Net is $92,566
• Sam’s Earned Income is:• $150,000 – ½ self employment tax ($8,217) – employer
contribution ($28,000) = $113,783
• If take Sam’s “net income” and add back deferral
and ½ self-employment income (paid by
“employer”):• $92,566 + $13,000 + $8,217 = $113,783
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Deductions for Plan
Contributions
• Contributions for the rank-and-file employees are
subtracted before you get to the Net Earnings from
Self-Employment on the Schedules C or K-1
• Contributions for the self-employed owner will be
shown on the Form 1040. Therefore, Earned
Income is determined by subtracting out types of
contributions for the owner that are not includible in
plan compensation (i.e., employer contributions other
than salary deferrals)
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Okay, But What if We Don’t
Know What Earned Income Is?
• Most computer programs will help you figure this
out
• However, if you know enough about the potential
variables, you can probably back into your
Earned Income (EI)
• Warning: the next part is not for the
mathematically faint of heart
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Example: Backing Into SE
Income• Assumptions:
• Margo is a sole proprietor physician with three employees
• Her company sponsors a 3% safe harbor 401(k) plan with a
tiered profit sharing allocation (one tier for her, one tier for
employees)
• Total payroll for the three employees is $150,000
• Margo would like to contribute the maximum to her plan
Preliminary cross-testing reflects that, if Margo contributes a
total of 5% of pay for her employees, she can get the
maximum contribution of $54,000 (Margo is under age 50)
• Margo’s NESE before any plan contribution is $300,000
• Because the employee 5% contribution is 5% of $150,000
($7,500), and that reduces NESE, the NESE is $300,000 –
$7,500) = $292,500
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Example – What Are Our
Known Adjustments to NESE?
• We assume that Margo’s Earned Income is more
than the Social Security wage base. Therefore, she
will pay self-employment taxes 12.4% of $127,200
(15,772), plus 2.9% of the excess EI over $128,200
• Margo will defer $18,000 (because this is not tested
for nondiscrimination due to the 3% safe harbor).
Therefore, her profit sharing contribution will be
$36,000
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Let’s Solve for EI (OMG, She’s
Doing Algebra!)
• EI = NESE – ½ self-employment tax – employee
costs – sole proprietor profit sharing contribution
• Let’s reflect our “knowns” from the last slide:
• EI = 292500 – ½(15772+[(EI-127200) x .029])- 36000
• Simplify:
• EI = 292500 –½(15772 + [.029EI – 3689]) – 36000
• EI = 292500 - ½(15772 -3689 + .029EI) – 36000
• EI = 292500 - ½(12083 + .029EI)- 36000
• EI = 292500 – 6042 -.0145EI – 36000
• EI = 250458 - .0145E1
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Let’s Solve for EI (OMG, She’s
Doing Algebra!)
• EI = 250458 - .0145E1 (where we left off)
• EI + .0145EI = 250458
• (1+.0145)EI = 250458
• EI = 250458/(1.0145) = $246,878
• Let’s check our numbers:
• EI = NESE - ½(.124 x (127200) + .029(EI – 127200)) –
SP Contribution
• 246878 = 292500 - ½(.124x(127,200) + .029 (246878-
127200)) –36000
• 246878 = 292500 – ½(15773 + .029(119678)) – 36000
• 246878= 292500 - ½(15773 + 3471) – 36000
• 246878 = 292500 -9622- 36000 = 246878 !!!!!
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25
Some Earned Income
Fine Points
25
Sole Proprietor with Multiple
Businesses
• Example of issue:
• Dr. Patrick works on an independent contractor basis
as an anesthesiologist for Hospital A on Mondays,
Wednesdays, and Fridays (he gets paid by the
operation), and for Surgery Center B on Tuesdays and
Thursdays. He has no ownership in either company
• Dr. Patrick receives a Form 1099 from
each entity at the end of the year
• How do you determine Dr. Patrick’s
earned income?
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Self Employed Individual With
Multiple Businesses
• Is the person an “owner-employee”?
• Owns the entire interest in an unincorporated trade or
business, or
• In the case of a partnership, owns more than 10% of
the capital or profits interest in the partnership
• Code section 401(d) limits the compensation
taken into account for owner-employees to the
income derived from the company that sponsors
the plan
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Sole Proprietor With Multiple
Businesses
• Who is the Employer for Plan purposes?
• If it is Dr. Patrick, a Sole Proprietorship, then all
earnings in Dr. Patrick’s business (which includes the
contract income from both facilities) would be included
• In all likelihood, Dr. Patrick would have one combined
Schedule C
• However, if there were two, but there is really only one
sole proprietorship, use the income from both (but be
sure the self-employment income is calculated
correctly)
28
Sole Proprietor With Multiple
Businesses
• Who is the Employer?
• What if Dr. Patrick has two businesses – Dr. Patrick,
M.D. Anesthesiology and Patrick Food Services (his
second income is as a caterer)?
• Be careful about who is sponsoring the plan
• If the sponsor of the plan is Patrick Food Services, then
the medical income will not count for plan purposes
• If the sponsor is both Patrick Food Services and
Dr. Patrick, M.D. Anesthesiology, then both incomes
are included
29
Sole Proprietor and Partner
• Dr. Patrick is a partner in the ABC
Anesthesiology Group, and that group provides
the anesthesiology services to Hospital A. He
gets a K-1 for this work
• Dr. Patrick also works as a sole proprietor two
days a week for the surgery center. This work is
reported on a Schedule C
• What is Dr. Patrick’s Earned
Income?
30
Sole Proprietor and Partner
• Again, it is critically important to identify who is
the sponsor of the plan.
• If the plan is a partnership plan, the sole proprietorship
income is not relevant
• If the plan is a sole proprietorship plan, the partnership
income is not relevant
• If the plan covers both entities (e.g., it’s a controlled
group or a multiple employer plan), get total earned
income
31
Combined Earned Income
• What if Dr. Patrick is a partner in two businesses,
and one has a net gain and the other has a net
loss?
• Not entirely clear
• The IRS has said informally that the net
loss is converted to a zero, and the
Earned Income for plan purposes is the
positive income from the profitable
partnership
32
Can the Plan Contribution
Exceed Earned Income?
• Dr. Patrick is 95 years old. He has an average
earned income from prior years of $270,000. His
earned income this year is $75,000.
His actuary tells him that his
required contribution for his
defined benefit plan is
$100,000
• What is the result?
33
Can the Plan Contribution
Exceed Earned Income?
• Result:
• Dr. Patrick must contribute $100,000, or he will be
charged an excise tax for underfunding his pension
plan under IRC section 4971
• Dr. Patrick can deduct only up to his Earned Income
($75,000)
• Even though Dr. Patrick had $25,000 of nondeductible
contribution to his plan, it is not subject to the excise
tax under IRC section 4972
34
§414(s) and Earned Income
• Earned Income is the exclusive basis for
414(s) compensation of a self-employed
individual; there is no alternative definition
• If the plan uses an alternative definition of
compensation for nondiscrimination testing for
“common law” employees, the plan must
adjust Earned Income compensation
• Multiply Earned Income by NHCE compensation
ratio
35
Example: Earned Income
§414(s) Adjustment
Total Comp Bonus Plan Comp Ratio
Hermione $ 85,000 $10,000 $ 75,000 88.24%
Fred $ 75,000 $10,000 $ 65,000 86.67%
George $ 50,000 $ 5,000 $ 45,000 90.00%
Ginny $ 40,000 $ 5,000 $ 35,000 87.50%
• Plan excludes bonuses for §414(s) purposes
• NHCE ratio = 88.10%
• Harry is a sole proprietor who owns the business. His
Earned Income (§415 comp) is $155,000. Harry’s
§414(s) compensation is $136,555 (88.10% of $155,000)
36
Effect of §414(s) Adjustment:
Automatic Pass of Comp Ratio
Test• The §414(s) adjustment to Earned Income means that
every plan in which the only HCEs are partners or a sole
proprietor with compensation below the §401(a)(17) limit
will always pass the compensation ratio test
• Example:
• Safe harbor 401(k) plan
• Defines comp for 3% QNEC as base compensation, excluding
bonus, overtime, shift differential, and fringe benefits
• NHCE compensation ratio is 52%
• Therefore, sole proprietor’s compensation is 52% of his Earned
Income. This means his compensation ratio is also 52%
Definition is nondiscriminatory and plan can allocate 3% QNEC
accordingly
37
38
Controlled Groups and
Multiple Employer Plans
38
Aggregate
• If the Employee receives pay from more than
one member of a controlled group, group under
common control, or affiliated service group, the
plan must aggregate all pay from all group
members for purposes of §415 compensation
and likely for §414(s) nondiscriminatory
compensation
39
Controlled Group Example
• Alice works for both Tweedledee and Tweedledum, two
members of a controlled group
• Tweedledee sponsors a plan for its employees only,
and the plan passes §410(b). The plan covers Alice
• When the plan computes Alice’s §415 compensation, it
must include the Tweedledum pay, just as it must
include the hours of service Alice performs for
Tweedledum
40
Alternative Definition
• If a controlled group plan excludes compensation
from a group member, that is an alternative
definition of compensation that the plan must test
to determine if it is nondiscriminatory
• Is it a “reasonable” definition? Possibly not
• Does it pass compensation ratio test? Total
compensation (including all group members) is in
the denominator
41
Multiple Employer Plan
• Aggregate compensation from all sponsors todemonstrate compliance with §415
• Each sponsor counts only its own compensation for purposes of:• Testing nondiscrimination (including testing
an alternative definition of compensation
to determine if it is nondiscriminatory)
• Analyzing HCE status
• Applying the top-heavy rules
• Applying the §401(a)(17) limit
• Determining the deduction limit, unless the
plan was adopted before 1989 (This last
point also applies to affiliated service group
plans.)
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43
A Few More
Compensation Notes …
43
Reasonable Definition of
Compensation
• Used in:
• §410(b) average benefit percentage test (does
not have to pass compensation ratio test but HCE
disparity cannot be “significantly higher”)
• Safe harbor match plan can limit compensation an
employee can defer to a reasonable definition of
compensation (no compensation ratio test)
• While also used to define “deferrable
compensation,” QACA regulations require
deferrable comp to be nondiscriminatory
44
Cross-Tested Gateways
• If the plan uses 5% gateway, then the plan must base the minimum contribution on gross 415 compensation
• If the plan uses the 1/3 gateway, then the plan can base the minimum contribution on the same definition used to compute the HCE allocation rates
• In either case, the plan can use compensation while a participant
45
Any Definition
• A plan can use any definitely determinable
definition of compensation, including an
unreasonable or clearly discriminatory definition,
to allocate employer contributions
• However, the plan must test for
nondiscrimination based on a nondiscriminatory
definition
46
Effect of Discriminatory
Definition: Example
• FastNLoose Enterprises Profit Sharing Plan defines
compensation as W-2 compensation less overtime pay
• The plan allocates contributions equal to 20% of plan
compensation
• If the definition passes the compensation ratio test, the
plan is a uniform allocation safe harbor plan which does
not need to be tested for nondiscrimination
• If the definition fails the compensation ratio test, the plan
is not a uniform allocation safe harbor plan and must
pass the general nondiscrimination test
47
Non-Uniform Allocation
Total Comp Bonus Plan Comp
Comp.
Ratio
(Plan to
Total)
Allocate
on Plan
Comp
Alloc.
Rate on
Total
Comp
Harry $190,000 $0 $190,000 100.00% $38,000 20.00%
Ron $150,000 $15,000 $135,000 90.00% $27,000 18.00%
Hermione $85,000 $10,000 $75,000 88.24% $15,000 17.65%
Fred $75,000 $10,000 $65,000 86.67% $13,000 17.33%
George $50,000 $5,000 $45,000 90.00% $9,000 18.00%
Ginny $40,000 $5,000 $35,000 87.50% $7,000 17.50%
• Every participant has a different allocation rate based on a
nondiscriminatory (total) definition of compensation
• So, plan fails uniform allocation safe harbor and must perform
general nondiscrimination test
• General test must be performed using a nondiscriminatory
definition of compensation
48
Permissible Definition
Summary
415 414(s) Other
Determine HCEs Yes No No
Coverage (average benefit % test) Yes Yes Reasonable
Allocate 3% safe harbor QNEC Yes Yes No
Deferrable compensation Yes Yes Reasonable
Catch-up limit Yes No No
Allocate matching contributions Yes Yes No
ACP test Yes Yes No
Allocate cross-tested PS contribution Yes Yes Yes
Allocate minimum gateway Yes If 1/3 gw No
General nondiscrimination test Yes Yes No
Imputing permitted disparity Yes Yes No
415 limits Yes No No
Deduction limits Yes No No
Top-heavy minimum contributions Yes No No
49
50
Practical Concerns
50
Determining Self-Employment
Income
• Two Choices:
• Ask the CPA to do it
• Get from the CPA:
• Form 1040, Schedules C (C-EZ) and SE (for sole prop)
• Form 1040, Schedule SE (or Schedule E) and Form
1065, Schedule K-1 (for partnership)
51
Complication #1: Getting the
Data
• How much time will you need to
spend explaining to the employer
what data you need?
• And, if you don’t do that, who will?
• How difficult will it be for the employer
to provide the data?
• How much time will you need to spend
checking the data for accuracy?
(Should you??)
52
Complication #2: Using the
Data
• Each new definition of compensation
exponentially increases the probability of
administration error
• Is it computed correctly?
• Does it conform with the document?
• Are you using the right definition for the right purpose?
• Does an alternative definition pass every year?
• How will you maintain the data on your system?
53
Working at Cross Purposes
• Does it make sense to use a “safe harbor”
allocation formula or adopt a safe harbor 401(k)
plan, presumably because you do not want to do
testing, only to use an alternative definition of
compensation which you must test annually?
54
Questions?
55
Contact Information
Ilene H. FerenczyFerenczy Benefits Law Center LLP
2200 Century Parkway, Suite 560
Atlanta, Georgia 30345
(678) 399-6602 (V)
(866) 515-5140 (toll free)
(404) 320-1105 (F)
Follow us on Twitter: @ferenczylaw
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