ISSUE 1: Are a partner's elective contributions to an IRC § 401(k) plan, including any partnership matching contributions that are treated as elective contributions, excludable from the partner's Massachusetts gross income?
DIRECTIVE 1: A partner's elective contributions are excluded from the Massachusetts gross income of the partner when the contributions are made, provided they are excluded from his federal gross income.
ISSUE 2: Is the partner's distributive share of the partnership deduction for contributions to the plan made on the partner's behalf deductible for Massachusetts tax purposes?
DIRECTIVE 2: No. The partner's distributive share of the partnership deduction for contributions made to the plan on the partner's behalf is specifically disallowed by G. L. c. 62, § 2(d)(1)(D).
A. 401(k) Plan - Qualified Cash or Deferred Arrangement (CODA)
A cash or deferred arrangement (CODA) is a popular plan feature of IRC § 401(a) qualified profit-sharing, stock bonus or money purchase plans. A CODA allows an employee to choose between receiving cash or electing to have the cash placed in a qualified pension plan. Treas. Reg. § 1.401(k) - 1(a)(2)(i). A CODA can be either qualified or nonqualified. A qualified CODA is commonly referred to as a "401(k)" plan, a reference to the Code provision that describes and controls its federal tax treatment. In general, to be qualified, a CODA must satisfy the standard discrimination requirements, distribution limitation rules (such as the prohibition of distributions before age 59 ½) and the nonforfeitability requirements. Treas. Reg. §§ 1.401(k)-1(b),(c),(d) and (e).
B. 401(k) Contributions - Exclusion from Gross Income
Massachusetts gross income equals federal gross income with certain modifications not relevant to this inquiry. G.L. c. 62, § 2(a). Employer contributions to a qualified plan are excluded from an employee's federal gross income. Treas. Reg. § 1.402(a)-1(a). Employee contributions, however, are included in the employee's federal gross income. Treas. Reg. § 1.402(a)-1(d)(1). But when an employee chooses to make elective contributions to a 401(k) plan or CODA rather than receive cash, such contributions are considered, by regulation, to be made on behalf of the employee by the employer and are not treated as employee contributions. Treas. Reg. § 1.402(a)-1(d)(2)(i). Instead, such elective contributions are given, by regulation, the same pre-tax benefit as employers' contributions to a qualified plan. Treas. Reg. § 1.402(a)-1(a). Therefore, elective contributions to a 401(k) plan are excluded from federal and Massachusetts gross income. IRC § 402(e)(3); Treas. Reg. § 1.401(k)-1(a)(4)(iii).
C. Partnership 401(k)s
A partnership is permitted to maintain a 401(k) plan, which includes any arrangement that directly or indirectly allows partners to vary the contributions made on their behalf to the plan. Treas. Reg. § 1.401(k)-1(a)(6). The partnership is treated as the employer of each partner who is an employee. IRC § 401(c)(4).
1. Exclusion of Partner's Elective Contributions from the Partner's Gross Income
A partner may make contributions to a 401(k) plan and elect to have them considered to be made by the partnership on his behalf. The elective contributions are excluded from his federal gross income when the contributions are made if the requirements of IRC § 401(k) and Treas. Reg. § 1.401(k)-1(a)(6) are met. Treas. Reg. § 1.401(k)-1(a)(6). The elective contributions are excluded from his Massachusetts gross income to the extent they are excluded for federal tax purposes. G.L. c. 62, § 2(a).
2. Tax Treatment of Partnership Matching Contributions
a. Excluded from the Partner's Federal and Massachusetts Gross Income
If the partnership makes matching contributions to a partner's elective contributions, the matching contributions are treated as elective contributions made on behalf of the partner, deductible under IRC § 404(a) and excluded from the partner's gross income when the contributions are made to the extent they are within the applicable limit under IRC § 402(g). Treas. Reg. § 1.401(k)-1(a)(6)(i), (iii). For tax years beginning on or after January 1, 1998, partnership matching contributions are treated as elective contributions only if the partnership elected to have them so treated for purposes of the nondiscrimination test for 401(k) plans. IRC §§ 402(g)(9) and 401(k)(3)(D)(ii). Though the federal rule for what constitutes a partnership's elective contribution changed in 1998, the result for Massachusetts tax purposes remains the same: if the partnership's contribution is excluded from the federal gross income of the partner when the contribution is made, it will be excluded from Massachusetts gross income. G.L. c. 62, § 2(a).
b. Federal Deductibility of Partnership Contributions; Massachusetts Deduction Disallowed
For federal tax purposes, the partnership's contributions on the partner's behalf are deductible to the extent allowable under IRC § 404 and the partner's distributive share of the deduction flows through to the partner under IRC §§ 702(a)(8) and 704. In the case of a defined contribution plan, the partner's distributive share of the deduction under such plan is that portion of the deduction attributable to contributions made on his behalf. In the case of a defined benefit plan, the partner's distributive share of contributions is determined in the same way as his distributive share of taxable income. Treas. Reg. §1.404(e)-1A(f)(1).
For Massachusetts tax purposes this deduction is not allowed. In calculating adjusted gross income, Massachusetts generally allows the deductions available under § 404 of the Code. G.L. c. 62, §2(d)(1). However, under paragraph (D) of that section, the § 404 deduction for contributions on behalf of Code § 401(c)(1) employees (sole proprietors and partners) is specifically disallowed. G.L. c. 62, § 2(d)(1)(D).
When the partner receives distributions under the plan, for Massachusetts tax purposes he is permitted to deduct his distributive share of the IRC § 404 deduction that was allowed federally but disallowed by G.L. c. 62, § 2(d)(1)(D) in a prior year. G.L. c. 62, § 2(a)(2)(F); TIR 78-1, section C (superseded with respect to some other matters).
/s/ Bernard F. Crowley, Jr.
Bernard F. Crowley, Jr.
Acting Commissioner of Revenue
October 25, 2001
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