Taxpayer Denied Contribution Deduction to Sole Proprietorship Profit-Sharing Plan for Income Paid Under Deferred Compensation Plan of Prior Employer

In a recent Tax Court case, a taxpayer was denied a contribution deduction for income paid into a sole proprietorship profit-sharing plan when the Court determined that such income had not been derived from the trade or business with respect to which the plan was established.[1] Rather, the income was paid to the taxpayer under a deferred compensation plan from a previous career. The Court also dealt with the issue of whether the taxpayer’s acting and jewelry sales activities rose to the level of a trade or business, a topic we have written about on multiple occasions[2], ultimately concluding such activities did not. However, the focus of this article is on the denial of the deduction of income contributed to taxpayer’s sole proprietorship profit-sharing plan she established.

Facts

Gayle Gaston (“Gaston”) had a long career with Mary Kay, Inc. (“MK”) working there from 1967 to 2010. She served as a national sales director there. In 1991, Gaston joins MK’s deferred compensation plan known as the Family Security Program (“FSP”). The FSP provided for a mandatory retirement age of 65 and a monthly distribution upon retirement equal to a percentage of the retiree’s three highest commission years during the last five years before retirement. Gaston reached age 65 in 2010 and retired from MK. For the years at issues, 2013 and 2014, she received compensation from FSP in the amounts of $518,779 and $513,284 respectively.

In 2008, two years prior to her retirement from MK, Gaston established the Gayle Gaston Sole Proprietor Profit Sharing Plan (“Plan”). The Plan was prepared by Dennis Mehringer and the plan sponsor was listed as Gaston herself. The Plan did not identify a specific business or activity to which it related, and Mr. Mehringer testified that it was not related to any specific activity.

Upon receiving her distributions from FSP in 2013 and 2014, Gaston contributed $51,000 each year to the Plan and deducted these contributions on her income tax returns. Her return was audited and the deductions for the contributions to the plan were denied on the basis that the money was from MK and Gaston no longer worked for MK, and further, did not engage in any other trade or business activity. The IRS also contended that the income was not “earned income” within the meaning of §401(c)(2)(A), which is discussed below, and thus was not deductible as a contribution to a retirement plan.

Following her retirement from MK, Gaston engaged in several activities, including jewelry sales, a hair care products venture, and acting. None of these activities proved profitable. Gaston treated these activities as a trade or business and sought to deduct the expenses for them during the years at issues, 2013 and 2014.

While not the focus of this article, in addition to the denial of the contribution deductions, Gaston’s expenses related to her other activities were also denied on the grounds that they did not rise to the level or a trade or business, a key threshold for deductibility under current tax law as discussed in some of our prior articles.[3]

Analysis

In general, §404(a) provides for an employer deduction of contributions to a deferred compensation plan paid on behalf of an employee. When it comes to self-employed individuals, the deduction is still allowed as long as the contribution to the plan does not exceed the earned income of the individual from the trade or business for which the plan was established for the year of the contribution.[4] “Earned income” ultimately means the net earnings from self-employment.[5] §1402 defines net earnings from self-employment as the gross income from activities of the taxpayer, less allowable deductions, plus the taxpayer’s distributive share of partnership items from a partnership of which the taxpayer is a partner that carries on a trade or business, plus or minus a number of additional adjustments provided for in §1402.[6] But for purposes of §404, the net earnings from self-employment are determined only with respect to a trade or business carried on by the taxpayer in which the taxpayer’s personal services are a “material income-producing factor”.[7]

Gaston admitted that the payments that were contributed to the Plan were from the FSP, and thus were not generated by her current activities. Nevertheless, she contended that there was “earned income” within the meaning of §404 because they were subject to self-employment taxes under §1402. Gaston relied on Peterson v. Commissioner,  T.C. Memo. 2013-271 for the premise that her payments from the FSP were earned income under §404. However, Gaston acknowledged that the Peterson case did not address the primary question at issue in her case, that is, whether the FSP payments could be used to fund a qualified retirement plan and be deducted under §§401 and 404.

The IRS response was that she was not engaged in any trade or business during the years at issue, thus she was not entitled to make a contribution to the Plan in the first place. The IRS places special emphasis on the fact that the income was from MK and that Gaston had not provided any personal services to MK in the years at issue. Since Gaston did not provide any personal services, there were no net earnings from self-employment under §404 for which there could be a deduction.

In its analysis, the Court quickly pointed out that the issue of “earned income” was actually the second hurdle for Gaston to win, and in fact, the Court disposed of the issue prior to even getting to that second hurdle. As noted in §404(a)(8)(C), the contributions are only deductible to the extent that they do not exceed the “earned income derived from the trade or business with respect to which [the] plan is established.” It was conceded by Gaston that the income which was contributed to the Plan was in fact derived from MK, and the facts and testimony indicate that the Plan was not established for Gaston’s MK business. The Plan documents did not indicate any particular business for which the Plan was established, and Mr. Mehringer, who prepared the Plan, testified that there was no specific business for which the Plan was created. Based on these facts, the Court concluded that the contribution was not “earned income derived from the trade or business with respect to which [the] plan [was] established” and thus was not deductible under §§401 and 404.

As noted in the introduction, this article is focused on the deductibility of Gaston’s contributions to the Plan in 2013 and 2014. While not discussed in detail and not ultimately a deciding factor in the determination of the deductibility of such contributions, the Court also held that none of Gaston’s activities rose to the level of a trade or business and thus denied most of the other deductions she had claimed as business expenses on her return. While the Court ruled against Gaston on all issues in front of it, she did salvage a small win in the case since the IRS conceded §6662 understatement penalties prior to trial.

Conclusion

The case serves as a good reminder that compliance with the statutes is paramount to sustain a deduction under the Internal Revenue Code. The taxpayer here erred on several fronts, including having the Plan which was not for a specific trade or business as is required under §404, and further attempting to take a deduction for the contribution of income to the Plan which was not eligible under the earned income requirement of §404. While the taxpayer did have other activities she was involved in, the Court concluded none rose to the level of a trade or business, and further, she had no earned income from those activities. Even if she did have income from those activities, she would have lost on the contribution deduction anyway since her Plan was not designated for one of those activities. Had the Plan been designated for MK, she might have lost anyway due to the “personal services” being a “material income-producing factor” since her personal services had not been performed for MK since 2010. Nevertheless, with proper planning and paying attention to the specific details of the statutes under §§401 and 404, perhaps Gaston could have put herself in a better position with better arguments.

[1] Gaston v. Comm’r, TC Memo 2021-107.

[2] https://esapllc.com/the-importance-of-being-a-trade-or-business/; https://esapllc.com/side-hustle-business-or-hobby/

[3] https://esapllc.com/the-importance-of-being-a-trade-or-business/; https://esapllc.com/side-hustle-business-or-hobby/

[4] IRC § 404(a)(8)(C).

[5] IRC § 404(a)(8)(B), which cites to §401(c)(2), which in turn cites to §1402.

[6] There are number of adjustments that may factor into the ultimate determination of “net earnings from self-employment” which are not relevant to this particular case or article, see §1402 for more details.

[7] IRC § 401(c)(2)(A)(i).