The owner of an unincorporated business often works full time or performs substantial services for the business as its proprietor or one of its partners. However, under the law such a person is not technically an employee of the business, but is referred to instead as a self-employed person. For many years, partners and proprietors were not eligible to be covered under qualified plans adopted by their unincorporated businesses. Beginning in 1962, qualified plan coverage was allowed, but only under very restricted conditions. In particular, there was a relatively low limit on the amount that could be contributed to the plan (or on the benefit provided by the plan) for partners and proprietors. The special plans designed under these restrictions were known as Keogh or HR-10 plans. These restrictions were enough to induce many unincorporated businesses to incorporate, simply so that the partner or proprietor could become a legally recognized employee of the business and be eligible for full qualified plan coverage. However, for plan years beginning after 1983, most of these previous restrictions were eliminated and partners and proprietors were able to participate fully in qualified plans adopted by their unincorporated businesses. There are, however, a few differences in the treatment of unincorporated businesses, most of them related to basic differences in the form of business.
Earned Income
An unincorporated business is not treated for federal income tax purposes as a taxable entity but rather as a conduit for passing the business's taxable income or loss through to the partners or proprietor. By comparison, a corporation is a tax-paying entity, and income can be passed through to owners only in the form of salaries representing reasonable compensation for services rendered or as dividends. Because of this difference, plan benefits or contributions for partners and proprietors are based on a defined amount referred to as earned income, which is intended to be comparable to the compensation that employees receive.
Earned income is the partner's or proprietor's share of the net earnings of the business after taking all appropriate business deductions, and without including nontaxable income. However, earned income includes only earnings with respect to the trade or business in which the personal services of the partner or proprietor are a material income-producing factor. For example, the net profits of an investment type business could not be treated like compensation in order to provide a benefit under a qualified plan for a partner who provided no personal services to the business.
The fact that earned income is determined after all business deductions creates a computational complication. Business deductions include the plan contribution itself, as well as one-half the Social Security self-employment tax that is based on net income [Code Section 164(f)]. An illustration will show this without getting into the details of the algebra.
Dot Matrix is a self-employed computer consultant with no regular employees. She earned $100,000 of net income in 2000, not counting her Keogh plan contribution and the deduction for self-employment tax. Her deduction for self-employment tax is $6,063.48. The Keogh plan is a money-purchase plan calling for an annual contribution of 25 percent of earned income. How much can Dot contribute? The answer is $18,787.31. This amount is 25 percent of Dot's earned income. Her earned income is equal to
Initial net income
$100,000.00
Less
Self-employment tax deduction
$ 6,063.48
Keogh contribution
18,787.31
Earned income
$ 75,149.21
Insurance
Another group of special rules applies to a qualified plan providing insurance for a partner or proprietor. No deduction can be taken by the business for plan contributions that are allocatable to the purchase of incidental life, health, or accident insurance for the partner or proprietor. If cash-value life insurance is used, the deduction is denied for the portion of the premium allocatable to pure insurance protection, but the remainder of the premium is deductible as a plan contribution. The amounts not deducted are taxable income to the business owners, because all taxable income of a partnership or proprietorship flows through to the individual owners. Therefore, there are no PS 58 costs to include in the owner's income if insurance has been purchased because the full cost of the insurance has already been included in the owner's income. However, unlike regular employees, the owners do not obtain a cost basis for the cost of the insurance to apply to any distribution from the qualified plan.
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