A frequent and complex challenge for retirement plan advisors
can be properly defining compensation for plan eligibility and
contribution purposes, including income reported on a Schedule
K-1. Improper reporting of K-1 income may result in compliance
errors, contribution miscalculations, and/or plan disqualification.
What is K-1 Compensation? Owners of partnerships and
LLCs taxed as partnerships typically receive income reported
on a K-1, rather than wages reported on Form W-2. This means
that unlike employees, these owners do not receive traditional
salaries with FICA withholding; instead, they receive “earned
income,” which is derived from their distributive share of profits
and guaranteed payments for services. S-corporation shareholders
might also receive K-1 income, in addition to W-2 wages.
As advisors, it is important to understand that not all K-1 income
counts as plan compensation. For partners, plan compensation
is “earned income,” i.e., net earnings from self-employment,
which is generally the partner’s share of the trade
or business income and guaranteed payments for services to
the extent they are subject to self-employment taxes. Passive
income, investment returns, or distributions not tied to related
services are generally excluded.
Why it Matters for Retirement Plans: Contribution limits, nondiscrimination
testing, and plan allocations all depend on clear
and correct definitions of plan compensation. For example:
- Partnerships and LLCs: Contributions for partners are based
on earned income after deducting plan contributions and
one-half of self-employment taxes. - S-corporations: Only W-2 wages count as plan compensation;
K-1 distributions to shareholders do not. - Guaranteed Payments: Guaranteed payments for services
generally qualify as plan compensation.
Failing to distinguish between eligible K-1 income and other
partnership allocations can inflate or understate allowable
contributions, and result in issues for plan sponsors.
Key Takeaways for Plan Advisors: For business owners
with K-1 income, understanding plan compensation is not always
straightforward. As plan advisors, you can assist your
clients by identifying the type of entity they own, clarifying
the nature of their K-1 income, and ensuring plan documents
clearly define compensation. Be sure to coordinate with your
TPA and CPA partners to ensure plan compliance, crosscheck
calculations and make any necessary tax adjustments.
