A fundamental requirement for 401(k) plans is that participant salary reduction elections be made before the compensation is currently available. To properly implement a deferral election, most 401(k) plans require employees to make elections, including elections to change an existing deferral election, 7-10 days before the payroll date. Partnership 401(k) plans (and LLCs taxed as partnerships) present a different challenge because the partners do not receive regular paychecks like employees. Because of the special nature of partnerships, plan sponsors and practitioners often misunderstand and misapply the rules regarding the timing of the partners’ deferral elections. In this technical update, we will discuss the timing of a partner’s deferral election. 

What is the timing for a participant to make a deferral election? 

A participant must make an election to defer his/her compensation to a 401(k) plan before the compensation is available. Treas. Reg. §1.401(k)-1(a)(3).  

Example. Ellen, a shareholder-employee, after the close of the plan year, determines that she could have deferred more to the 401(k) plan. Accordingly, she writes a check to the trustee for an additional $4,000 and asks the trustee to treat is as an elective deferral. The contribution is not an elective deferral because the election was made after the compensation was already available to the participant.

Do different rules regarding the timing of deferral elections apply with respect to partners? 

Effectively, no. For purposes of making a 401(k) deferral election, a partner’s compensation (earned income) is currently available on the last day of the partnership taxable year. A sole proprietor’s compensation is currently available on the last day of the sole proprietor’s taxable year. A self-employed individual may not make a 401(k) deferral election after the last day of the partnership’s or proprietor’s taxable year. Treas. Reg. §1.401(k)-1(a)(6)(iii). This time frame relates to the timing of the owner’s “salary reduction” election, not necessarily the timing of the employer’s actual contribution of elective contributions to the plan.   

Example. X LLC has elected to be taxed as a partnership and its tax year is a calendar year. X also maintains a calendar year 401(k) plan. The partnership’s accountant determines the partners’ distributive share of earned income for 2013 on March 5, 2014. Several of the partners wait until the accountant makes a final determination of their distributive share of partnership earned income (March 5^th) to make their deferral election for 2013. The election is too late because the earned income is considered available on December 31, 2013. 

May a partner make a deferral election with respect to his/her partnership draws? 

A partner, during the plan year, may defer from partner draws or from guaranteed payments. In addition, partner draws against income during the taxable year do not cause an election at the end of the partnership taxable year to have been made after the income is currently available. See LR 200247052. Under the final regulations, if a partnership provides draws (“cash advance payments”) during the year based on the value of the partner’s services prior to the date of payment, which do not exceed a reasonable estimate of the partner’s earned income for the taxable year, the partner may defer from the draw even though the deferral occurs before the determination of the partner’s earned income. Treas. Reg. §1.401(k)-1(a)(6)(iv). However, the partnership cannot withhold from a draw unless the participant has delivered a deferral election. 

Comment: Since a partnership will not determine each partner’s earned income until after the end of the partnership’s taxable year, a partner who defers during the year: (i) may “overshoot” a plan imposed limit on deferrals based on compensation (earned income) or a deferral election made as a percentage; (ii) may have to “true-up” the deferrals at year end to correspond to his/her election; and (iii) may not have sufficient earned income to sustain the deferral. For these reasons, a partner may wish to defer in fixed dollar increments, during the year, and to defer “conservatively” if it is not possible to reasonably forecast earned income until late in the year.  

If a partner makes a deferral election with respect to partnership draws and the accountant later determines that the partner had no earned income for the year, how should the plan correct the error?  

If a partner makes elective deferrals with respect to partnership draws and it is later determined that he/she had no earned income for the year, the participant (and plan) has exceeded the 415 limit and the plan should correct in accordance with EPCRS (Rev. Proc. 2013-12). Generally, the plan would distribute the deferrals (and earnings) and place any matching contributions in a suspense account to reduce future employer contributions. 

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