March 2002

The Self-Employed 401(K) Plan

By Sheldon M. Geller, Esq., Geller & Wind, Ltd.

The 2001 Tax Act (Economic Growth and Tax Relief Reconciliation Act) has made extensive changes to the rules relating to qualified retirement plans, most of which take effect in 2002. The new provisions include increased contribution and benefit limits, 401(k) elective deferral limits, deductibility limits, and compensation limits.

Increased Deductible Contributions

Prior to the Act, self-employed individuals were able to receive larger deductible contributions from less complicated, lower-cost qualified plans such as profit-sharing and money purchase pension plans. Nevertheless, the Act enables self-employed individuals, as well as corporate owners, to receive larger deductible contributions under a profit-sharing/401(k) plan.

The Act permits plan sponsors to deduct employee 401(k) elective deferrals in addition to the employer contribution, effective for tax years beginning after December 31, 2001 (see the Exhibit). The Act also increases the profit-sharing/401(k) plan deduction limit for employer contributions from 15% of compensation to 25% of compensation, effective for tax years beginning after December 31, 2001. Accordingly, elective 401(k) deferral contributions are not taken into account for purposes of determining the employer contribution deduction limits, allowing self-employed individuals and corporate owners to make greater deductible 401(k) and employer contributions.

Self-employed individuals and corporate owners that have annual self-employment and W-2 income of less than $160,000 may receive greater deductible contributions under a profit-sharing/401(k) plan. Traditional profit-sharing and money purchase pension plans enable self-employed individuals or corporate owners to deduct 20% and 25% of compensation, respectively; profit-sharing/401(k) plans enable an additional 401(k) elective deferral of $11,000.

Because the maximum annual addition, and thus deductible employer contribution, is $40,000 in 2002, individuals earning $160,000 or more may receive a $40,000 deductible contribution under either a profit-sharing plan, a money purchase pension plan, or a profit-sharing/401(k) plan.

When income is less than $160,000, however, profit-sharing/401(k) plans provide dramatically greater deductible contributions, enabling self-employed individuals and corporate owners to deduct amounts greater than 25% of their compensation. For example, an individual who earns $100,000 may deduct $25,000 under either a profit-sharing plan or a money purchase plan, or they may deduct $36,000 under a profit-sharing/401(k) plan [the $25,000 employer contribution and the $11,000 401(k) contribution], for 36% of compensation. Individuals age 50 or over may deduct an additional $1,000 catch-up contribution.

Catch-up contributions. Catch-up contributions may be made by individuals age 50 and over in the amount of $1,000 in 2002, $2,000 in 2003, $3,000 in 2004, $4,000 in 2005, and $5,000 in 2006. These amounts are additional contributions above the normal limits that apply to 401(k) plans and are not subject to the special non-discrimination tests.

Other Changes

Contribution limits. The Act gradually increases the 401(k) contribution limit from $10,500 to $15,000, beginning with a $500 increase to $11,000 in 2002. The limit then increases $1,000 for each of the next four years, to $15,000 in 2006. Furthermore, the Act increases the defined contribution annual addition limit from $35,000 in 2001 to the lesser of $40,000 or 100% of compensation in 2002. The Act increases the compensation limit from $170,000 to $200,000 in 2002, effective for qualified plan purposes. Owner-employees may receive more favorable allocations due to this increased compensation limit in determining plan benefits.

Participant loans. The Act permits 401(k) plans to make participant loans to owner-employees, including S corporation shareholders, partners, limited liability company members, and sole proprietors, effective in 2002. These self-employed individuals may now receive the same loan privileges as employees of C corporations.

Discretionary contributions. Self-employed individuals and corporate owners may make 401(k) elective deferral contributions and employer contributions at their discretion. That is, there is no annual statutory requirement to make a minimum contribution to a profit-sharing/401(k) plan.

Plan administration. Profit-sharing/401(k) plans that cover only owners and their spouses do not need to meet the discrimination tests. These plans do not need to file IRS Form 5500 (an annual report) unless the plan covers one or more common-law employees or plan assets exceed $100,000.

Rollover contributions. The Act eliminates rollover restrictions and thus enables owners to comingle funds from different types of plans and consolidate retirement assets. For example, self-employed individuals and corporate owners may roll over their 403(b) distributions and IRA accounts to a profit-sharing/401(k) plan.

Favorable Allocations

To the extent that self-employed individuals or corporate owners have employees that are eligible to participate in profit-sharing/401(k) plans, profit-sharing provisions may be designed to favorably allocate contributions for the business owner. That is, a cross-tested or new comparability allocation formula may provide significantly greater profit-sharing contribution allocations for business owners, improving employer funding for common law employees.

The 401(k) deferral contribution feature provides leverage to business owners to the extent that there is no corresponding cost to the employer for the allocation of the 401(k) deferral amount. The new comparability and age-weighted profit-sharing plan allocation formulae combine a profit-sharing plan’s flexibility with a pension plan’s ability to allocate benefits in favor of higher-paid employees or older employees. This flexibility creates new plan choices for plan sponsors.

New comparability plans are generally used by doctors, accounting firms, law firms, and closely held businesses that want to provide owners and management with better benefit packages than those available under traditional defined contribution plan arrangements.

Technology Driving SAS 70 Reports

By Sheldon M. Geller, Esq., Geller & Wind, Ltd.

The dynamic change in the 401(k) plan service model, including a paradigm utilizing technology, has increased the demand for SAS 70 reports (Reports on the Processing of Transactions by Service Organizations). The integration of daily valuation systems, automated voice-response system access, as well as internet-based processing, has been the technological force driving auditors to request SAS 70 reports.

Plan auditors will increasingly request plan sponsors to obtain SAS 70 from their plan recordkeepers. Auditors need an understanding of the underlying internal controls of a plan’s operation and must review plan transactions under a daily valuation system. The SAS 70 report is intended to provide the plan auditor with an opinion to the effect that the internal controls implemented and utilized by the recordkeeper are suitably designed to provide reasonable assurance that control objectives will be achieved and compliance will be met in actual plan operation.

Controls related to the processing of plan transactions under a daily valuation system for defined-contribution benefit plans greatly assist the plan auditor in a field examination. Plan sponsors and plan recordkeepers must create and develop a reporting system that provides all of the necessary information for plan auditors.

SAS 70 reports represent a substantial benefit for plan sponsors and plan auditors. Best practices for plan sponsors to improve audit quality would include the retention of plan recordkeepers that have SAS 70 reports. Plan sponsors that implement best practices significantly improve audit quality and client service, and reduce related enforcement and litigation risks.

A Telling Stock Option Court Decision

By Lawrence M. Lipoff, CEBS, CPA, Weinick Sanders Leventhal & Co., LLP

Given the current prevalence of stock options as a component of employee compensation, a definitive court decision is extremely important for the proper administration of such plans. Filed December 10, 2001, Tanner v. Comm’r (117 T.C. No. 20) ruled that deferral of income recognition under IRC section 83(c)(3) cannot be extended past the Securities Exchange Act of 1934, section 16(b)’s six-month period on the basis of a lockup agreement independently negotiated between a corporation and employee. Furthermore, the section SEA section 16(b) period commences when the employee is granted a nonqualified stock option rather than when he exercises the option and receives corporate stock.

Generally, the net fair market value of assets transferred for the performance of services is taxable under IRC section 83(a) when the service provider’s rights are transferable or not subject to substantial risk of forfeiture. Treasury Regulations section 1.83-7(a) expands upon IRC section 83(c)(3) to prevent taxation under section 83(a) when the service provider could be under suit per SEA section 16(b) for selling stock for a profit. In fact, IRC section 83(c)(3) reaches this result by defining the service provider’s rights as “(A) subject to a substantial risk of forfeiture, and (B) not transferable.” In understanding that the SEA section 16(b) six-month period commences at the time an option is granted, the Tax Court held that if an option grant does not cause income recognition, then income is recognized when the option is exercised, rather than when the restriction no longer applies.

The SEA section 16(b) “short-swing profit rule” requires a corporate insider who sells any equity security within six months of issuance to disgorge any profit to the issuing corporation. SEC amendments adopted in 1991 “recognized that holding options is functionally equivalent to holding the underlying equity securities for section 16(b) purposes.”

Paul Tanner argued that his exercise of the stock option was exempt under IRC section 83(c)(3) since it would have generated a lawsuit under SEA section 16(b), and he argued that the stock received after his exercise of the stock option was nontransferable and subject to a substantial risk of forfeiture because of a two-year lockup agreement. The IRS responded that the section 16(b) period began upon the grant of the stock option and that the statutory six-month period cannot be extended voluntarily by individuals or corporations (e.g., through a lockup agreement). After an exhaustive, integrated analysis of the IRC and SEC rules and related regulations, the Tax Court found for the IRS.

As for the future applicability of Tanner, it is important to note that, in 1996, an SEC regulation was promulgated that exempted a discretionary transaction from SEA section 16(b). That is to say, in a compensatory transaction where the option grant meets the definition of a discretionary transaction (which is beyond the scope of this article) and where the stock received upon option exercise is not transferable or subject to substantial risk of forfeiture, income recognition will be properly deferred until the restriction (e.g., from a lockup agreement) ceases to apply. Since Tanner’s transaction occurred in 1994 (prior to this rule change), the Tax Court properly declined to address this issue in its opinion.


Sheldon M. Geller, Esq.
Geller & Wind, Ltd.

Mitchell J. Smilowtiz
GBS Retirement Services Inc.

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