by Bob Rywick

Adding a 401(k) deferral arrangement to a profit-sharing plan may provide large tax deferrals for many sole proprietors.

An individual who makes most of his income as an employee, but has a small sole-proprietorship business on the side, may be able to use a profit sharing plan with a 401(k) arrangement to defer tax on most - and sometimes all - of his business income.

For purposes of this article, I’ll deal only with sole proprietors who have no employees. Thus, the article does not go into such issues as when employees must also be covered by a profit-sharing plan with a 401(k) elective deferral.

Deductible contributions to a profit-sharing plan. Annual additions to a profit-sharing plan in plan limitation years beginning in 2002 or 2003 can’t exceed the lesser of $40,000 or 100 percent of the participant’s compensation. However, the deductible contribution may not exceed the lesser of 25 percent of compensation or $40,000. For the sole proprietor, compensation equals the net profits from the business, less one-half of the self-employment tax attributable to the business, and less the amount of the profit-sharing contribution itself. In effect, this means that the profit-sharing contribution may not exceed 20 percent of the excess of the net profits from the business over one-half of the self-employment tax.

Example (1): Your client is a sole proprietor who has no compensation on which FICA taxes are paid. In 2003, he expects to earn $80,000 in net profits from his business. His self-employment tax on the $80,000 will be $11,304 (15.3 percent of $73,880 (92.35 percent of $80,000)). One-half of $11,304 is $5,652.

Your client’s maximum deductible profit-sharing contribution for 2003 will be $14,870 (20 percent of $74,348 ($80,000 less $5,652)). Thus, your client’s taxable income from his business for 2003 will be $59,478 ($80,000 less one-half of self-employment tax of $5,652 and less profit-sharing contribution of $14,870.

Observation: Note that in Example (1), the $14,870 profit-sharing contribution is 25 percent of the $59,478 taxable income of the business after deducting the profit-sharing contribution itself.

Example (2): The same facts apply as in Example (1), except that your client also earned wages as an employee on which the maximum FICA taxes were paid. Thus, his self-employment tax on his net business profits will only be $2,142 (2.9 percent of $73,880) since only the Medicare part of the self-employment tax has to be paid.

Your client’s maximum profit-sharing contribution for 2003 will be $15,786 (20 percent of $78,929 ($80,000 less $1,071 (one-half of $2,142))). The taxable income of the business will be $63,143 ($78,929 less $15,786).

How adding a 401(k) elective deferral arrangement to a profit-sharing plan increases the amount of deferred income. In addition to taking a deduction for a profit-sharing contribution, a sole proprietor may take a regular 401(k) elective deferral up to the lesser of the net profits from the business after making the profit-sharing contribution; or, $40,000 less the amount of the profit-sharing contribution; or, the maximum regular elective deferral amount ($12,000 in 2003).

In addition to the regular 401(k) elective deferral, an individual who will be 50 before the end of 2003 can take a catch-up 401(k) elective deferral of $2,000.

The amount taken as an elective deferral does not reduce the net profits from the business for purposes of determining the amount of the profit-sharing contribution.

Example (3): The same facts apply as in Example (1), except that your client’s profit-sharing plan includes a 401(k) arrangement, and he will not be 50 before the end of 2003. Your client can make a regular 401(k) elective deferral of $12,000. As a result the amount of his business income on which he will be taxed for 2003 will be $47,478 (taxable income of $59,478 per Example (1) less $12,000 elective deferral).

Example (4): The same facts apply as in Example (3), except that your client will be 50 before the end of 2003. He can make a total 401(k) elective deferral of $14,000 (regular elective deferral of $12,000 plus a catch-up elective deferral of $2,000). Your client’s taxable income from the business will be reduced to $45,478 ($47,478 per Example (3) less $2,000 catch-up elective deferral).

Catch-up contributions not taken into account in computing limits on annual additions. The sum of the profit-sharing plan contribution and the regular 401(k) elective deferral may not exceed $40,000. However, catch-up elective deferrals are not taken into account for purposes of the $40,000 limitation, i.e., the maximum limitation can equal $42,000 if the sole proprietor is eligible to make a catch-up contribution.

Example (5): Your client, who is 45 years old, has a business that has a profit-sharing plan with a 401(k) elective deferral. The net profits from the business in 2003 will be $140,000 after deducting one-half of the self-employment tax. Your client makes a deductible profit-sharing contribution of $28,000 (20 percent of $140,000) and a regular 401(k) elective deferral of $12,000. The sum of her profit-sharing contribution and the regular 401(k) elective deferral is $40,000, the maximum amount of her allowable addition to the plan for the year.

Example (6): The same facts apply as in Example (5), except that your client will be 50 by the end of 2003. She can make a catch-up 401(k) elective deferral of $2,000, even though this will cause her total additions to be $42,000.

Suppose the sole proprietor also contributes to a 401(k) plan as an employee. The maximum regular elective deferral for all 401(k), 403(b) and SEP plans that a taxpayer is eligible to contribute to in 2003 is $12,000.

Thus, for example, if your client is both a sole proprietor and an employee of another business, he can make a regular elective deferral to his business’ 401(k) plan only if his regular elective deferral to his employer’s 401(k) plan is less than $12,000. Similarly, the total catch-up elective deferral that can be made by an individual who is at least 50 by the end of 2003 is $2,000 regardless of the number of 401(k) plans in which she participates.

Example (7): Your client, who will not be 50 before the end of 2003, is an employee of a corporation that has a 401(k) plan that allows employees to make elective deferrals of up to 16 percent of their salary. Your client expects to earn a salary of $50,000 in 2003, and plans to make the maximum 401(k) elective deferral of $8,000 allowed with respect to his employer’s plan (16 percent of $50,000).

Your client is also a sole proprietor who expects to have net profits of $10,000 from his business as a tax return preparer in 2003 after deducting one-half of the self-employment tax.

If he sets up a profit-sharing plan with a 401(k) elective deferral feature for his business, he will be able to make the following profit-sharing contributions and 401(k) elective deferrals in 2003: He will be able to make a profit-sharing contribution of $2,000 (20 percent of $10,000). He will also be able to make a 401(k) elective deferral of $4,000 with respect to his business’ plan (maximum allowable elective deferral of $12,000 less $8,000 elective deferral to his employer’s plan).

Thus, his taxable income from his business will be $4,000 ($10,000 less profit-sharing contribution of $2,000, less 401(k) elective deferral of $4,000).

Example (8): The same facts apply as in Example (7), except that your client will be 50 by the end of 2003. If your client makes a catch-up elective deferral of $2,000 to his employer’s plan, he will not be able to make a catch-up elective deferral to his business’ 401(k) plan.

However, if his catch-up elective deferral to his employer’s 401(k) plan is less than $2,000, then the excess of $2,000 over the amount of the elective deferral to his employer’s plan can be made to his own plan as a catch-up elective deferral.

Suppose your client has a profit-sharing plan as a sole proprietor and his employer also has a profit-sharing plan. The amount of the allowable addition to a profit-sharing plan applies separately to different profit-sharing plans in which an individual participates. Thus, if an individual has a profit-sharing plan as a sole proprietor and his employer also has a profit-sharing plan, it’s possible for deductible contributions to the two profit-sharing plans to be more than $40,000.

Example (9): Your client, who is 55 years old, participates in her employer’s profit-sharing plan. In 2003, she expects her salary to be over $160,000, and for her employer to make a deductible contribution of $40,000 to the profit-sharing plan on her behalf. The plan also has a 401(k) elective deferral feature, but since the profit-sharing contribution will be $40,000, she cannot take a regular 401(k) deferral, but can make the $2,000 catch-up elective deferral, which she does.

Your client also operates a small business on the side as a sole proprietor. This business has profits (after deducting one-half of the self-employment tax) of $20,000 in 2003. She has a profit-sharing plan with a 401(k) elective deferral for this business.

She can make a $4,000 profit-sharing contribution (20 percent of $20,000) and a $12,000 401(k) elective deferral for this business. Since she has taken the $2,000 catch-up contribution for her employer’s 401(k) plan, she cannot take it with respect to her own plan.

Caution: Profit-sharing plans maintained by related persons, e.g., corporations in a controlled group, will be treated as one profit-sharing plan.

Register or login for access to this item and much more

All Accounting Today content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access