Chapter 6 — Employer/Employee

Qualified plans must be established by “an employer.” For unincorporated businesses, the term is specifically defined:

• A sole proprietor (an individual owning the entire interest in an unincorporated business) is considered to be his or her own employer.
• A partnership is considered to be the employer of each partner.

This has an important practical consequence: since a qualified plan must be a plan of an employer, an individual partner cannot establish a Keogh plan for himself alone — only the partnership as a whole may do so. A partner without a controlling interest must secure agreement from a voting majority of the other partners before the partnership can establish a Keogh plan.

A self-employed person, for Keogh purposes, is generally anyone who has earned income from personal services actually rendered and who is subject to self-employment tax under Social Security (with limited exceptions). The key is that the individual’s personal efforts must be involved in generating the income.

Mere financial backing of a business is not sufficient — the individual must actively work in it. As a result:

• Most limited partners are not considered self-employed for retirement plan purposes. Distributions of profit to them are investment income, not earned income.
• S corporation shareholders are not considered self-employed. Pass-through income from an S corporation does not constitute net earnings from self-employment.
• A retired partner who performs no services and holds no interest in the partnership is not self-employed merely because he or she receives partnership retirement benefits.

A retiree may earn self-employment income from consulting fees, provided actual services are performed. However, courts have ruled that an exclusive consulting arrangement with a former employer may violate the self-employed definition — retirees should be available to serve more than one client.

Royalties and licensing payments to an inventor or author for property they created through their own efforts are treated as self-employment income. However:

• The sale of a patent or copyright is treated as the sale of a capital asset — not self-employment income.
• Royalties paid for one’s name or reputation (not for property created through personal effort) are not self-employment income.

Self-employed individuals fall into two categories for Keogh purposes: those who are owner-employees and those who are not. An owner-employee is a self-employed person who:

• owns the entire interest in an unincorporated trade or business (a sole proprietor), or
• in a partnership, is a partner who owns more than 10% of the capital interest or profit interest of the partnership.

The partnership agreement ordinarily governs a partner’s capital and profit interest percentages.

An employee, for Keogh purposes, is someone who owns no part of the business and works for a self-employed person. Employees do not have the right to establish a Keogh plan themselves, but may be covered as participants by a Keogh plan established by their employer.

Keogh plan contributions on behalf of self-employed individuals — including owner-employees — are based on earned income: gross income derived from a sole proprietorship or partnership, less allowable business deductions. Contribution limits for Keogh plans are the same as those for corporate plans (see ch62).

If an owner-employee operates more than one business but only one has a Keogh plan, contributions to that plan may only be based on earned income from the business that maintains the plan — not from the owner’s other businesses.

When computing the deductible Keogh contribution for an owner-employee, the following items must be subtracted from net earnings before applying the contribution rate:

• a deduction for one-half of the self-employment tax paid (the employer-equivalent portion), and
• a deduction for the Keogh contribution itself on behalf of the self-employed person.

This second deduction creates a circular calculation: the contribution depends on net income, but net income is reduced by the contribution. The IRS resolves this by expressing the contribution as a reduced percentage of pre-contribution income:

The maximum plan contribution rate of 25% of post-contribution income translates to an effective rate of 20% of pre-contribution (gross) income. This is the same ~20% effective rate discussed for SEP-IRAs and applies for the same mathematical reason.