In Employee Plans News (December 20, 2011), the Internal Revenue Service (the “IRS”) provided guidance on whether contributions to a tax-qualified, defined contribution retirement plan may be based on S Corp distributions made to an individual who is both a shareholder and employee. Here is what the IRS said.
Contributions to the plan can be made only from compensation, which, in the case of a self-employed individual, is earned income. Distributions received as a shareholder of an S corporation do not constitute earned income for these purposes (see IRC sections 401(c)(2) and 1402(a)(2)).
If an individual is a common law employee of the S corp, as well as a shareholder:
• the individual can make salary deferral contributions to the 401(k) plan based on his or her Form W-2 compensation from the S corp; and the S corp can make matching or nonelective contributions to the plan based on that Form W-2 compensation.
An individual cannot make contributions to a self-employed tax qualified, defined contribution retirement plan from his or her S corp distributions. Although, as an S corp shareholder, the individual receives distributions similar to distributions that a partner receives from a partnership, those shareholder distributions are not earned income for these purposes (see IRC section 1402(a)(2)). Therefore, an individual cannot establish such a plan for himself or herself based solely on being an S corp shareholder.