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When a corporation makes an election to be taxed as an S-corporation, the owners’ individual retirement plan contributions must be based on eligible Plan Compensation. For this article, a retirement plan includes 401(k) plans, profit-sharing plans, pension plans, and SEP-IRAs, Simple-IRAs, and SAR-SEPs.
Plan Compensation is used for retirement plan contribution calculations, deduction of contributions, and application of certain IRS and plan-level limitations.
Owners of an S-corporation can basically receive 2 types of earnings from the corporation:
Plan Compensation: The compensation (usually referred to as W-2 wages) is plan compensation for the company retirement plan, while K-1 pass-through earnings from an S-corporation will be ignored or disregarded.
There are a variety of considerations when setting an appropriate level of wages for an owner, including reasonableness, payroll taxes, and retirement plan contributions. However, K-1 earnings from an S-corporation would not be treated as plan compensation.
Keep in mind that retirement plans have a dollar limit (or cap) set by the IRS on the level of compensation used for retirement plan purposes. For 2017, the maximum compensation limit under IRC§401(a)(17) is $270,000. If wages are in excess of this limit, anything over the IRS limit will be disregarded. The IRS can change or modify the annual compensation limit so be sure to know the current limit when working with retirement plan contributions.
I encourage business owners to talk to their CPA and their retirement plan consultant about this topic to determine what level of wages is appropriate and how that will affect retirement plan contributions for the S-corporation owner.
~ Joy Hodgson, CPC, QKA