IRS 401C3 Tax Regulations

IRS code section 401(c)3 defines the term owner-employee as it is used when discussing qualified pension, profit-sharing and stock bonus plans. It is not, as some erroneously believe, a type of nonprofit organization tax classification. Individuals who make this error are likely confusing the 401(c)3 with the 501(c)3, which is the IRS classification for a corporation or a limited liability company that uses its profits for charitable purposes within the educational, literary, scientific, religious or otherwise humanitarian realm. The 401(c)3 designation has nothing to do with non profit organizations.

The 401(c)3 is part of IRS code 401, which refers to retirement plans. Perhaps the most well-known retirement plan defined by this code is a 401(k), an employee-sponsored retirement account that defers taxes on income saved in the account until the money is withdrawn. A 401(a) is a similar type of retirement plan that is available to certain government employees and employees of nonprofit organizations. Section 401(c)3 defines owner-employees, one of the categories of worker who may use a 401(a).

Who Is an Owner-Employee?

IRS code section 401(c)3 defines an owner-employee as an individual who:

  • Owns the entire interest in an unincorporated business or trade, or
  • Is a partner who holds more than 10 percent of the capital interest or profits interest within her partnership.

In other words, a sole proprietor is an owner-employee. This could be an individual plumber who operates her own plumbing business as a sole proprietorship or a freelance copywriter who operates similarly. Similarly, if two lawyers operate a small firm as partners, both are considered owner-employees because they both own more than 10 percent of the capital interest or profit interest in the legal practice.

Because 401(a) plans are restricted to government and nonprofit organizations, owner-employees must be contracted by this type of employer in some capacity in order to participate in a 401(a) retirement plan. Section 401(c)2 states the criteria that an owner-operator must meet in order to be eligible for a 401(a), which includes a requirement that the owner-operator’s net earnings be calculated according to the amount that she earned through providing services to the taxpayers.

401(a) Regulations for Owner-Employees

IRS code section 401 grants owner-employees and self-employed individuals a significant amount of autonomy in determining how a plan is to be set up and how contributions are to be made. With a 401(a) plan, the party that establishes the plan decides how contributions are to be made. This party may opt to make all the contributions or to split the contributions with the employee, in which case the employer may choose to make the employee’s contributions either voluntary or mandatory.

A 401(a) plan may be structured in a variety of ways. It could be a qualified pension plan, but it could also be a profit-sharing or stock bonus plan. A profit-sharing plan is a plan that grants employees a share of the company’s profits based on the company’s earnings. A stock bonus plan is a similar type of profit-sharing plan, but employees receive stock, rather than cash compensation, based on the company’s earnings.

Tax Burdens on 401(a) Retirement Plans

When an individual withdraws funds from a 401(a) retirement account, he must pay federal income tax on those funds. Funds may be taken out without a tax penalty starting at age 59 1/2 or upon leaving the employer that sponsored the plan and transferring them to another qualified retirement plan. Any other withdrawals are considered unqualified withdrawals, and these withdrawals incur a 10 percent tax penalty. At this point, these withdrawals are considered taxable income.

When funds are deposited into a 401(a) account, they are not taxed as part of that year’s taxable income. Knowing this, an owner-employee can use 401(a) contributions to strategically reduce her taxable income for a given year. For 2020, the contribution limit for a 401(a) account is $57,000.

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