theworkplace.biz
MA may tax unincorporated owners and partners on 401(k)
George L. Chimento
March 6, 2008 [updated March 9]
1. Draft Directive 08-XX
Massachusetts Tax professionals received Draft Directive 08-XX by E-Mail from the
Massachusetts Department of Revenue ("DOR") on Friday, February 22. The DOR
seeks comments at the following address: RulesandRegs@dor.state.ma.us. For
those who like fine print, the full text of Draft Directive 08-XX is appended to this
alert.
2. What this means for owners and partners
Starting in 2008, DOR says it will want current taxes from the self-employed and
partners ("Unincorporated Owners") on their 401(k) deferrals and matches. For a
50 year old who saves $20,000, that's $1,060 to the Commonwealth at the 5.3%
rate.
Provided that the Unincorporated Owners keep records, they can then deduct
their Massachusetts "basis" ($20,000 in the above example) from taxable income
many years later, when they eventually get paid from the plan. Of course, if
Unincorporated Owners retire to a different state and do not owe Massachusetts
taxes on plan payments, they are out of luck. Massachusetts will not pay a refund.
Those Unincorporated Owners who retire in Massachusetts also face a daunting
task. Many qualified plan administrators are not geared up to track Massachusetts
basis. In addition, consider the extra difficulty in tracking Massachusetts basis if
Unincorporated Owners roll 401(k)s into IRAs, and take taxable distributions from
them. How many of us keep records for decades? As a practical matter,
Massachusetts will probably collect the tax twice from many of these unfortunates.
3. Is the Draft Directive correct ?
Frankly, the Draft Directive is a correct interpretation of a very unfair
Massachusetts statute, M.G.L. c. 62 § 2(d)(1)(D) (the "Unfair Law"), which the DOR
has not enforced for years in the case of 401(k) savings. (See Directives 00-5 and
01-7, and TIR 02-18, all of which would be "superseded" by this new draft.)
For those not familiar with the Unfair Law (my term, not theirs):
-- it singles out owners and partners of unincorporated businesses and
partnerships, and LLC members who are taxed as owners or partners;
-- it applies to employer contributions to all types of qualified plans, not just 401(k)
plans;
-- it does not penalize the workers who get contributions, only the Unincorporated
Owners;
-- it does not penalize shareholder-employees who own incorporated businesses,
only Unincorporated Owners;
-- the basis recovery allowed by M.G.L. c. 62 § 2(a)(2)(F) can only be used to
reduce Massachusetts taxable income paid from qualified plans, 403(b) plans and
IRAs. If payments are less than the amount contributed (i.e. if the plan lost
money), the basis cannot be applied against other Massachusetts taxable income.
4. Why is this happening now?
DOR representatives say that the Draft Directive simply corrects a long-standing
misinterpretation of the Unfair Law. They say the Unfair Law was meant to tax
Unincorporated Owners on contributions to all types of qualified plans, and there
is no exception for 401(k)s. As a technical matter, that's probably correct. The
Unfair Law "disallows contributions made on behalf of... (Unincorporated
Owners)." A voluntary 401(k) deferral of earnings is characterized in the Internal
Revenue Code as an employer profit sharing contribution. DOR reasons that the
Unfair Law does not distinguish one type of employer profit sharing contribution
from another. It taxes them all, so let's collect the money. Correct or not, this
reverses a policy at DOR that has been in effect since the year 2000 and which
simply treated Unincorporated Owners the same as the people who worked for
them, and the same as those who own incorporated businesses.
5. Is this good policy for Massachusetts?
Of course not. Why should an Unincorporated Owner be singled out for taxation
on retirement savings? If implemented, the new Directive will add to the State's
reputation as "Taxachusetts", and a place which is unfriendly to business.
The previous DOR policy prudently distinguished 401(k)s from other qualified plans
governed by the Unfair Law. It gave Unincorporated Owners an incentive to
sponsor 401(k)s, so that they, and their employees, would save for retirement. If
the DOR adopts this Directive, Unincorporated Owners may reconsider whether it's
worthwhile for them to sponsor 401(k) plans at all. Why should an Unincorporated
Owner have the expense and bother of a plan for others when he or she is the
only one not to get a tax break?
6. Comments
The deadline for comments to DOR has now passed. Howeevr, if you see strongly
about this issue, send an e-mail to the following address: RulesandRegs@dor.
state.ma.us. In my own comment I asked that DOR reject the Directive, or at least
delay its implementation so that a case can be made to the Governor and
Legislature that the Unfair Law should be repealed. If inclined to stay with past
policy, the DOR could easily distinguish 401(k) elective deferrals and matches from
other employer contributions, and give a break to Unincorporated Owners trying to
save for retirement.
If you care about Massachusetts, consider sending an E-mail. You do not need to
be technical.
_________________________________________________________________
The full text of DOR Directive 08-XX
WORKING DRAFT DIRECTIVE FOR PUBLIC AND PRACTITIONER COMMENTS 2/22/08
Income Tax
Draft Directive 08-XX
Massachusetts
Department of
Revenue
The Massachusetts Income Tax Treatment of Contributions on behalf of Partners
and Other Self-Employed Individuals under a 401(k) Plan
For taxable years beginning on or after January 1, 2008, this Directive clarifies and
prescribes the Massachusetts personal income tax treatment of contributions
made on behalf of partners and other self-employed individuals under a so-called
401(k) plan. As explained in this Directive, under G.L. c. 62 § 2(d)(1)(D), partners
and other self-employed individuals are denied any deduction for contributions to
their 401(k) plans, irrespective of whether the contributions are elective
contributions or matching contributions made on their behalf. This Directive
supersedes or modifies all other DOR public written statements to the extent that
they may be inconsistent with it.
Discussion
A. 401(k) Plans or CODAs, Generally
A qualified cash or deferred arrangement (CODA) is a type of IRC § 401(a) qualified
profit-sharing, stock bonus or money purchase plan that is commonly referred to
as a 401(k) plan. A CODA allows an employee to choose between receiving cash
currently or electing to have the cash placed in a qualified pension plan thereby
deferring current recognition of income. Treas. Reg. § 1.401(k)-1(a)(2)(i).
B. Partnership and Sole Proprietorship 401(k) Plans
A partnership or sole proprietorship may maintain a 401(k) plan on behalf of its
IRC § 401(c) employees (self-employed individuals or owner-employees), and
individual partners or owners are permitted to make cash or deferred elections.
Treas. Reg. § 1.401(k)-1(a)(6)(i). In the case of a partnership, a cash or deferred
arrangement includes any arrangement that directly or indirectly allows partners
to vary the contributions made on their behalf. Id. A partnership is treated as the
employer of each partner who is an employee. In the case of a sole proprietorship,
the owner is treated as the employer. IRC § 401(c)(4). Contributions on behalf of a
partner include contributions made by the partnership and contributions made by
the partner as a deemed employee; contributions on behalf of an owner of a sole
proprietorship include contributions made by the owner as both the deemed
employer and as a deemed employee. IRC § 401(c)(5).
C. Federal Income Tax Treatment of Elective Contributions and Matching
Contributions on behalf of Self-Employed Individuals
An individual partner or owner of a sole proprietorship may make elective
contributions to a 401(k) plan based on compensation for services he or she
provides to the partnership or sole proprietorship and the partnership or sole
proprietorship can make matching contributions with respect to these elective
contributions. Treas. Reg. § 1.401(k)-1(a)(6). These contributions are deductible by
the partnership or sole proprietorship under IRC § 404(a)(8) to the extent they
are within annual limits under various provisions of the Code. See, e.g., IRC §§ 402
(g)(1)(B) and (C) and § 414(v).
In the case of a partnership, the partner’s distributive share of the partnership’s
IRC § 404(a)(8) deduction flows through to the partner under IRC §§ 702(a)(8)
and 704. With respect to a defined contribution plan, the partner’s distributive
share of the deduction under such plan is that portion of the deduction
attributable to contributions made on the partner’s behalf. For a defined benefit
plan, the partner’s distributive share of the deduction is determined in the same
way as his or her distributive share of income. Treas. Reg. § 1.404(e)-1A(f)(1), (2).
The partner’s distributive share of the § 404 deduction for contributions on his or
her behalf is reported on Schedule K-1 of Form 1065, U.S. Partnership Return of
Income, in the box for other deductions (Box 13 for tax year 2007) using code Q
and reported on the partner’s Form 1040, U.S. Individual Income Tax Return, line
28.
In the case of a sole proprietorship, the owner’s § 404(a)(8) deduction is reported
on his or her Form 1040, U.S. Individual Income Tax Return, line 28, and not on
Schedule C of Form 1040.
As indicated, the mechanism under the Code for deferring a partner’s or owner’s
income on account of contributions to a 401(k) plan is a deduction under IRC § 404
(a)(8). There is no separate form of “exclusion” from a partner’s or owner’s income.
D. Massachusetts Income Tax Treatment
1. Disallowance of federal deduction for contributions. For Massachusetts income
tax purposes the IRC § 404(a)(8) deduction is not allowed. In calculating adjusted
gross income, Massachusetts generally allows the deductions available under §
404 of the Code. G.L. c. 62, § 2(d)(1). However, under subparagraph (D) of that
section, the deduction for contributions on behalf of Code § 401(c)(1) employees
(partners and owners of sole proprietorships) is specifically disallowed. G.L. c.62, §
2(d)(1)(D). There is no other Massachusetts provision that would provide a
deduction or exclusion for such amounts for a partner or owner.
2. Treatment of distributions. In the case of a partnership, when the partner (or
former partner) receives distributions under the plan, for Massachusetts income
tax purposes the partner is permitted to deduct his or her distributive share of the
IRC § 404 deduction that was allowed federally but disallowed by G.L. c. 62, § 2(d)
(1)(D) in a prior year. Likewise, in the case of a sole proprietorship, when the
owner (or former owner) receives distributions under the plan, for Massachusetts
tax purposes he or she is permitted to deduct the amount of the IRC § 404
deduction that was allowed federally but disallowed by G.L. c. 62, § 2(d)(1)(D) in a
prior year. G.L. c. 62, § 2(a)(2)(F); TIR 78-1, section C (superseded with respect to
some other matters).
E. Effective Date; Prior Public Written Statements Superseded or Modified.
This Directive is effective for taxable years beginning on or after January 1, 2008,
and supersedes or modifies all other DOR public written statements to the extent
they may be inconsistent with it. These include specifically Directives 00-5 and 01-7
and TIR 02-18.
__________________________________________________________________
This article is provided as a courtesy and may not be relied upon as legal advice, or to
avoid taxes and penalties. Distribution to promote, market, or recommend any
arrangement or investment to avoid or evade taxes, including penalties, is expressly
forbidden. Any communication with the author as to its contents, does not, of itself,
create a lawyer-client relationship. Under the ethical rules applicable to lawyers in
some jurisdictions, this may be considered advertising.
[theworkplace.biz]
MA may tax unincorporated owners and partners on 401(k)
George L. Chimento
March 6, 2008 [updated March 9]
1. Draft Directive 08-XX
Massachusetts Tax professionals received Draft Directive 08-XX by E-Mail from the
Massachusetts Department of Revenue ("DOR") on Friday, February 22. The DOR
seeks comments at the following address: RulesandRegs@dor.state.ma.us. For
those who like fine print, the full text of Draft Directive 08-XX is appended to this
alert.
2. What this means for owners and partners
Starting in 2008, DOR says it will want current taxes from the self-employed and
partners ("Unincorporated Owners") on their 401(k) deferrals and matches. For a
50 year old who saves $20,000, that's $1,060 to the Commonwealth at the 5.3%
rate.
Provided that the Unincorporated Owners keep records, they can then deduct
their Massachusetts "basis" ($20,000 in the above example) from taxable income
many years later, when they eventually get paid from the plan. Of course, if
Unincorporated Owners retire to a different state and do not owe Massachusetts
taxes on plan payments, they are out of luck. Massachusetts will not pay a refund.
Those Unincorporated Owners who retire in Massachusetts also face a daunting
task. Many qualified plan administrators are not geared up to track Massachusetts
basis. In addition, consider the extra difficulty in tracking Massachusetts basis if
Unincorporated Owners roll 401(k)s into IRAs, and take taxable distributions from
them. How many of us keep records for decades? As a practical matter,
Massachusetts will probably collect the tax twice from many of these unfortunates.
3. Is the Draft Directive correct ?
Frankly, the Draft Directive is a correct interpretation of a very unfair
Massachusetts statute, M.G.L. c. 62 § 2(d)(1)(D) (the "Unfair Law"), which the DOR
has not enforced for years in the case of 401(k) savings. (See Directives 00-5 and
01-7, and TIR 02-18, all of which would be "superseded" by this new draft.)
For those not familiar with the Unfair Law (my term, not theirs):
-- it singles out owners and partners of unincorporated businesses and
partnerships, and LLC members who are taxed as owners or partners;
-- it applies to employer contributions to all types of qualified plans, not just 401(k)
plans;
-- it does not penalize the workers who get contributions, only the Unincorporated
Owners;
-- it does not penalize shareholder-employees who own incorporated businesses,
only Unincorporated Owners;
-- the basis recovery allowed by M.G.L. c. 62 § 2(a)(2)(F) can only be used to
reduce Massachusetts taxable income paid from qualified plans, 403(b) plans and
IRAs. If payments are less than the amount contributed (i.e. if the plan lost
money), the basis cannot be applied against other Massachusetts taxable income.
4. Why is this happening now?
DOR representatives say that the Draft Directive simply corrects a long-standing
misinterpretation of the Unfair Law. They say the Unfair Law was meant to tax
Unincorporated Owners on contributions to all types of qualified plans, and there
is no exception for 401(k)s. As a technical matter, that's probably correct. The
Unfair Law "disallows contributions made on behalf of... (Unincorporated
Owners)." A voluntary 401(k) deferral of earnings is characterized in the Internal
Revenue Code as an employer profit sharing contribution. DOR reasons that the
Unfair Law does not distinguish one type of employer profit sharing contribution
from another. It taxes them all, so let's collect the money. Correct or not, this
reverses a policy at DOR that has been in effect since the year 2000 and which
simply treated Unincorporated Owners the same as the people who worked for
them, and the same as those who own incorporated businesses.
5. Is this good policy for Massachusetts?
Of course not. Why should an Unincorporated Owner be singled out for taxation
on retirement savings? If implemented, the new Directive will add to the State's
reputation as "Taxachusetts", and a place which is unfriendly to business.
The previous DOR policy prudently distinguished 401(k)s from other qualified plans
governed by the Unfair Law. It gave Unincorporated Owners an incentive to
sponsor 401(k)s, so that they, and their employees, would save for retirement. If
the DOR adopts this Directive, Unincorporated Owners may reconsider whether it's
worthwhile for them to sponsor 401(k) plans at all. Why should an Unincorporated
Owner have the expense and bother of a plan for others when he or she is the
only one not to get a tax break?
6. Comments
The deadline for comments to DOR has now passed. Howeevr, if you see strongly
about this issue, send an e-mail to the following address: RulesandRegs@dor.
state.ma.us. In my own comment I asked that DOR reject the Directive, or at least
delay its implementation so that a case can be made to the Governor and
Legislature that the Unfair Law should be repealed. If inclined to stay with past
policy, the DOR could easily distinguish 401(k) elective deferrals and matches from
other employer contributions, and give a break to Unincorporated Owners trying to
save for retirement.
If you care about Massachusetts, consider sending an E-mail. You do not need to
be technical.
_________________________________________________________________
The full text of DOR Directive 08-XX
WORKING DRAFT DIRECTIVE FOR PUBLIC AND PRACTITIONER COMMENTS 2/22/08
Income Tax
Draft Directive 08-XX
Massachusetts
Department of
Revenue
The Massachusetts Income Tax Treatment of Contributions on behalf of Partners
and Other Self-Employed Individuals under a 401(k) Plan
For taxable years beginning on or after January 1, 2008, this Directive clarifies and
prescribes the Massachusetts personal income tax treatment of contributions
made on behalf of partners and other self-employed individuals under a so-called
401(k) plan. As explained in this Directive, under G.L. c. 62 § 2(d)(1)(D), partners
and other self-employed individuals are denied any deduction for contributions to
their 401(k) plans, irrespective of whether the contributions are elective
contributions or matching contributions made on their behalf. This Directive
supersedes or modifies all other DOR public written statements to the extent that
they may be inconsistent with it.
Discussion
A. 401(k) Plans or CODAs, Generally
A qualified cash or deferred arrangement (CODA) is a type of IRC § 401(a) qualified
profit-sharing, stock bonus or money purchase plan that is commonly referred to
as a 401(k) plan. A CODA allows an employee to choose between receiving cash
currently or electing to have the cash placed in a qualified pension plan thereby
deferring current recognition of income. Treas. Reg. § 1.401(k)-1(a)(2)(i).
B. Partnership and Sole Proprietorship 401(k) Plans
A partnership or sole proprietorship may maintain a 401(k) plan on behalf of its
IRC § 401(c) employees (self-employed individuals or owner-employees), and
individual partners or owners are permitted to make cash or deferred elections.
Treas. Reg. § 1.401(k)-1(a)(6)(i). In the case of a partnership, a cash or deferred
arrangement includes any arrangement that directly or indirectly allows partners
to vary the contributions made on their behalf. Id. A partnership is treated as the
employer of each partner who is an employee. In the case of a sole proprietorship,
the owner is treated as the employer. IRC § 401(c)(4). Contributions on behalf of a
partner include contributions made by the partnership and contributions made by
the partner as a deemed employee; contributions on behalf of an owner of a sole
proprietorship include contributions made by the owner as both the deemed
employer and as a deemed employee. IRC § 401(c)(5).
C. Federal Income Tax Treatment of Elective Contributions and Matching
Contributions on behalf of Self-Employed Individuals
An individual partner or owner of a sole proprietorship may make elective
contributions to a 401(k) plan based on compensation for services he or she
provides to the partnership or sole proprietorship and the partnership or sole
proprietorship can make matching contributions with respect to these elective
contributions. Treas. Reg. § 1.401(k)-1(a)(6). These contributions are deductible by
the partnership or sole proprietorship under IRC § 404(a)(8) to the extent they
are within annual limits under various provisions of the Code. See, e.g., IRC §§ 402
(g)(1)(B) and (C) and § 414(v).
In the case of a partnership, the partner’s distributive share of the partnership’s
IRC § 404(a)(8) deduction flows through to the partner under IRC §§ 702(a)(8)
and 704. With respect to a defined contribution plan, the partner’s distributive
share of the deduction under such plan is that portion of the deduction
attributable to contributions made on the partner’s behalf. For a defined benefit
plan, the partner’s distributive share of the deduction is determined in the same
way as his or her distributive share of income. Treas. Reg. § 1.404(e)-1A(f)(1), (2).
The partner’s distributive share of the § 404 deduction for contributions on his or
her behalf is reported on Schedule K-1 of Form 1065, U.S. Partnership Return of
Income, in the box for other deductions (Box 13 for tax year 2007) using code Q
and reported on the partner’s Form 1040, U.S. Individual Income Tax Return, line
28.
In the case of a sole proprietorship, the owner’s § 404(a)(8) deduction is reported
on his or her Form 1040, U.S. Individual Income Tax Return, line 28, and not on
Schedule C of Form 1040.
As indicated, the mechanism under the Code for deferring a partner’s or owner’s
income on account of contributions to a 401(k) plan is a deduction under IRC § 404
(a)(8). There is no separate form of “exclusion” from a partner’s or owner’s income.
D. Massachusetts Income Tax Treatment
1. Disallowance of federal deduction for contributions. For Massachusetts income
tax purposes the IRC § 404(a)(8) deduction is not allowed. In calculating adjusted
gross income, Massachusetts generally allows the deductions available under §
404 of the Code. G.L. c. 62, § 2(d)(1). However, under subparagraph (D) of that
section, the deduction for contributions on behalf of Code § 401(c)(1) employees
(partners and owners of sole proprietorships) is specifically disallowed. G.L. c.62, §
2(d)(1)(D). There is no other Massachusetts provision that would provide a
deduction or exclusion for such amounts for a partner or owner.
2. Treatment of distributions. In the case of a partnership, when the partner (or
former partner) receives distributions under the plan, for Massachusetts income
tax purposes the partner is permitted to deduct his or her distributive share of the
IRC § 404 deduction that was allowed federally but disallowed by G.L. c. 62, § 2(d)
(1)(D) in a prior year. Likewise, in the case of a sole proprietorship, when the
owner (or former owner) receives distributions under the plan, for Massachusetts
tax purposes he or she is permitted to deduct the amount of the IRC § 404
deduction that was allowed federally but disallowed by G.L. c. 62, § 2(d)(1)(D) in a
prior year. G.L. c. 62, § 2(a)(2)(F); TIR 78-1, section C (superseded with respect to
some other matters).
E. Effective Date; Prior Public Written Statements Superseded or Modified.
This Directive is effective for taxable years beginning on or after January 1, 2008,
and supersedes or modifies all other DOR public written statements to the extent
they may be inconsistent with it. These include specifically Directives 00-5 and 01-7
and TIR 02-18.
__________________________________________________________________
This article is provided as a courtesy and may not be relied upon as legal advice, or to
avoid taxes and penalties. Distribution to promote, market, or recommend any
arrangement or investment to avoid or evade taxes, including penalties, is expressly
forbidden. Any communication with the author as to its contents, does not, of itself,
create a lawyer-client relationship. Under the ethical rules applicable to lawyers in
some jurisdictions, this may be considered advertising.
[theworkplace.biz]
Simply request to DOR: "Please do not tax Massachusetts owners and partners of unincorporated businesses on their 401(k) retirement savings. Draft Advisory 08-XX is not fair. The same rules should apply to all of us, and you should not discourage business owners from sponsoring 401(k) plans." |
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