A frequent and complex challenge for retirement plan advisors can be properly defining compensation for plan eligibility and contribution purposes, including income reported on a Schedule K‑1. Improper reporting of K-1 income may result in compliance errors, contribution miscalculations, and/or plan disqualification.

What is K-1 Compensation?

Owners of partnerships and LLCs taxed as partnerships typically receive income reported on a K‑1, rather than wages reported on Form W-2. This means that unlike employees, these owners do not receive traditional salaries with FICA withholding; instead, they receive “earned income,” which is derived from their distributive share of profits and guaranteed payments for services. S-corporation shareholders might also receive K-1 income, in addition to W-2 wages.

As advisors, it is important to understand that not all K-1 income counts as plan compensation. For partners, plan compensation is “earned income,” i.e., net earnings from self-employment, which is generally the partner’s share of the trade or business income and guaranteed payments for services to the extent they are subject to self-employment taxes. Passive income, investment returns, or distributions not tied to related services are generally excluded.

Why it Matters for Retirement Plans

Contribution limits, nondiscrimination testing, and plan allocations all depend on clear and correct definitions of plan compensation. For example:

• Partnerships and LLCs: Contributions for partners are based on earned income after deducting plan contributions and one-half of self-employment taxes.
• S-corporations: Only W-2 wages count as plan compensation; K-1 distributions to shareholders do not.
• Guaranteed Payments: Guaranteed payments for services generally qualify as plan compensation.

Failing to distinguish between eligible K-1 income and other partnership allocations can inflate or understate allowable contributions, and result in issues for plan sponsors.

Key Takeaways for Plan Advisors

For business owners with K-1 income, understanding plan compensation is not always straightforward. As plan advisors, you can assist your clients by identifying the type of entity they own, clarifying the nature of their K-1 income, and ensuring plan documents clearly define compensation. Be sure to coordinate with your TPA and your trusted TBC advisor to ensure plan compliance, cross-check calculations and make any necessary tax adjustments.