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When it comes to setting up a tax-favored retirement plan — such as a 401(k) plan, a pension or profit sharing plan, or a simplified employee pension (SEP) plan — law firm partnerships must follow essentially the same federal income tax rules as other employers. A partnership retirement plan can potentially cover both partners of the practice and eligible firm employees.
However, partnership plans can be a bit confusing because partners are considered to be employees of the firm for some purposes, but they are considered to be self-employed individuals for others.
A Variety of Tax-Favored Retirement Options are Available
First, let’s run down the types of qualified plans that are the most popular options for law firm partnerships to establish. (These are in addition to the non-qualified plans your firm may have established solely for the benefit of partners.)
- A simplified employee pension (SEP) plan where contributions are based on a percentage of each participant’s net self-employment income from the partnership (for partners) or salary (for employees). For 2023, the maximum amount that can be contributed to a participant’s account is $66,000 (up from $61,000 in 2022).
- A traditional profit-sharing plan where contributions are based on a percentage of each participant’s net self-employment income (for partners) or salary (for employees). For 2023, the maximum amount that can be contributed to a participant’s account is $66,000 (up from $61,000 in 2022).
- A 401(k) plan, where before-tax elective deferral contributions come out of each participant’s net self-employment income (for a partner) or salary (for an employee). Employee elective deferral contributions are often called salary reduction contributions. A 401(k) plan can permit additional catch-up elective deferral contributions for participants who are age 50 and older.
For 2023, the maximum elective deferral contribution is $22,500, or $30,000 for those age 50 and older, assuming the plan allows catch-up contributions (up from $20,500 and $27,000 respectively in 2022). As the employer, the partnership can also make additional contributions, subject to tax law limits. Finally, a 401(k) plan can also offer participants the new option of making after-tax elective contributions to separate Roth 401(k) accounts. For 2023, the maximum amount that can be contributed to a participant’s 401(k) account (including both the participant elective deferral contributions and partnership contributions) is $66,000, or $73,000 for those age 50 and older (up from $61,000 and $67,500 respectively in 2022).
- A SIMPLE IRA plan where before-tax elective deferral contributions come out of each participant’s net self-employment income (for a partner) or salary (for an employee). A SIMPLE IRA plan can also permit additional catch-up elective deferral contributions for participants who are age 50 and older. The partnership must also make relatively modest contributions on behalf of participants, subject to tax law limits. For 2023, the maximum elective deferral contribution is $15,500, or $19,000 for those age 50 and older, assuming the plan allows catch-up contributions.
- A traditional defined benefit pension plan where annual contributions are based on a number of factors and must be determined by actuarial computations. For calculating 2023 contributions, the maximum annual benefit that can be paid out is $330,000 (up from $305,000 in 2022).
Some Special Twists For Partners
- Next, here are some of the basic tax issues your firm has to keep in mind regarding partners and retirement plans: For tax-favored retirement plan purposes, partners are considered to be employees of the partnership. Therefore, they cannot set up their own plans independent of the partnership based on income from the partnership. Although a partner is technically considered an employee in this context, special considerations apply.
- Since a partner doesn’t actually receive a salary from the partnership, retirement plan contributions on behalf of each partner are based on his or her net self-employment (SE) income from the partnership. This is the amount used to calculate the partner’s SE tax bill, reduced by his or her deduction for 50% of SE tax attributable to income from the partnership. The partner’s deduction for 50% of SE tax is reported on page 1 of his or her Form 1040.
- Deductible retirement plan contributions made on behalf of a partner (including any elective deferral contributions made by the partner) are not deducted on the partnership’s Form 1065 tax return. Instead, they are reported to the partner on his or her Schedule K-1 from the partnership. The deductible contribution amounts are then written off on page 1 of the partner’s individual Form 1040 tax return. In contrast, retirement plan contributions made by the partnership on behalf of its employees are deducted on page 1 of the partnership’s tax return. Employee elective deferral contributions are included in the salary expense write-off on page 1 of the partnership’s tax return.
- In calculating the partner’s SE tax bill (on Schedule SE of Form 1040), the partner is not allowed to subtract retirement plan contributions.
If your law firm doesn’t currently have a qualified retirement plan in place, or wants to change its plan, now could be a good time to set one up. But you want to make sure you select the best retirement plan option for your firm’s particular circumstances. Your tax adviser can help if you have questions or want more information.
Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.
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