Employee Benefits-IRS Provides Guidance On Computing Defined Contribution Plan Contributions For Self-Employed Individuals

Computing the amount of the contributions to be made to a qualified defined contribution plan on behalf of a self-employed individual has always been very confusing. Fortunately, in the October edition of employee plans news (2010-09, October 8, 2010), the Internal Revenue Service (the “IRS”) has provided some guidance on this topic.

In the news, the IRS posits the following hypothetical facts and question: I am self-employed and have a profit-sharing plan for my employees and myself. For 2009, I decided to make a plan contribution equal to 10% of each participant’s compensation. To determine the amount allocated to my own account, I multiplied my net profit on my Schedule C by 10%. Was this correct?

The IRS answers the hypothetical employer by saying that you are wrong, and you made two errors: (1) you used the net profit from your business to base your percentage on and (2) you did not reduce the plan’s contribution rate that you used for yourself. For a self-employed individual, “compensation” means “earned income.” You must use your earned income to calculate plan contributions for yourself. Your earned income is not the same as net profit from your business. You calculate your earned income by taking your net profit from Schedule C and subtracting: (a) ½ of your self-employment (SE) tax and (b) plan contributions for yourself. Your earned income and the amount of your plan contributions for yourself depend on each other. You must reduce the plan contribution rate to calculate the correct amount of plan contributions for yourself. IRS Publication 560 has a worksheet that may be used for this purpose.

The IRS offers the following example. Joe’s 2009 Schedule C net profit is $200,000 and he paid $18,600 in SE taxes. The plan contribution rate is 10% of each participant’s compensation. Joe would compute the amount of the 2009 plan contribution for himself as follows:
1. Net profit from Schedule C: $200,000 2. Less ½ of SE tax: (9,300)
3. Joe’s net profit less ½ SE tax is: $190,700 4. Joe’s reduced plan contribution rate (based on plan contribution rate of 10% of compensation): x 0.090909 (from rate table in Pub. 560)

5. Joe’s plan contribution for himself: $17,336.35
The limit on annual compensation (adjusted annually) for determining retirement plan contributions was $245,000 in 2009. Joe’s 2009 earned income (his compensation) was less than the 2009 annual limit and, therefore, he does not have to restrict contributions for himself.

The IRS added that plan contributions for a self-employed individual are deducted on Form 1040 (on the line for self-employed SEP, SIMPLE, and qualified plans) and not on the Schedule C. It said that if you made the deduction on Schedule C, or made and deducted more than your allowed plan contribution for yourself, you must amend your Form 1040 tax return and Schedule C. If your plan contribution for yourself was higher than allowed by the terms of your plan, you may have a plan qualification issue. However, you may fix this error by using the IRS’s Employee Plans Compliance Resolution System. -employed and have a profit-sharing plan for my employees and myself. For 2009,