A. 401(k) Plans or CODAs, Generally
A qualified cash or deferred arrangement (CODA) is a type of IRC § 401(a) qualified profit-sharing, stock bonus or money purchase plan that is commonly referred to as a 401(k) plan. A CODA allows an employee to choose between receiving cash currently or electing to have the cash placed in a qualified pension plan thereby deferring current recognition of income. Treas. Reg. § 1.401(k)-1(a)(2)(i).
B. Partnership and Sole Proprietorship 401(k) Plans
A partnership or sole proprietorship may maintain a 401(k) plan on behalf of its IRC § 401(c) employees (self-employed individuals or owner-employees), and individual partners or owners are permitted to make cash or deferred elections. Treas. Reg. § 1.401(k)-1(a)(6)(i). In the case of a partnership, a cash or deferred arrangement includes any arrangement that directly or indirectly allows partners to vary the contributions made on their behalf. Id. A partnership is treated as the employer of each partner who is an employee. In the case of a sole proprietorship, the owner is treated as the employer. IRC § 401(c)(4). Contributions on behalf of a partner include contributions made by the partnership and contributions made by the partner as a deemed employee; contributions on behalf of an owner of a sole proprietorship include contributions made by the owner as both the deemed employer and as a deemed employee. IRC § 401(c)(5).
C. Federal Income Tax Treatment of Elective Contributions and Matching Contributions on behalf of Self-Employed Individuals
An individual partner or owner of a sole proprietorship may make elective contributions to a 401(k) plan based on compensation for services he or she provides to the partnership or sole proprietorship, and the partnership or sole proprietorship can make matching contributions with respect to these elective contributions. Treas. Reg. § 1.401(k)-1(a)(6). These contributions are deductible by the partnership or sole proprietorship under IRC § 404(a)(8) to the extent they are within annual limits under various provisions of the Code. See, e.g., IRC §§ 402(g)(1)(B) and (C) and § 414(v).
In the case of a partnership, the partner's distributive share of the partnership's IRC § 404(a)(8) deduction flows through to the partner under IRC §§ 702(a)(8) and 704. With respect to 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 the partner's behalf. For a defined benefit plan, the partner's distributive share of the deduction is determined in the same way as his or her distributive share of income. Treas. Reg. § 1.404(e)-1A(f)(1), (2). The partner's distributive share of the § 404 deduction for contributions on his or her behalf is reported on Schedule K-1 of Form 1065, U.S. Partnership Return of Income, in the box for other deductions (Box 13 for tax year 2007) using code Q and reported on the partner's Form 1040, U.S. Individual Income Tax Return, line 28 (for tax year 2007).
In the case of a sole proprietorship, the owner's § 404(a)(8) deduction is reported on his or her Form 1040, U.S. Individual Income Tax Return, line 28, and not on Schedule C of Form 1040.
As indicated, the mechanism under the Code for deferring a partner's or owner's income on account of contributions to a 401(k) plan is a deduction under IRC § 404(a)(8). There is no separate form of "exclusion" from a partner's or owner's income.
D. Massachusetts Income Tax Treatment
1. Disallowance of federal deduction for contributions. For Massachusetts income tax purposes the IRC § 404(a)(8) 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 subparagraph (D) of that section, the deduction for contributions on behalf of Code § 401(c)(1) employees (partners and owners of sole proprietorships) is specifically disallowed. G.L. c.62, § 2(d)(1)(D). There is no other Massachusetts provision that would provide a deduction or exclusion for such amounts for a partner or owner.
2. Treatment of distributions. In the case of a partnership, when the partner (or former partner) receives distributions under the plan, for Massachusetts income tax purposes the partner is permitted to deduct his or her 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. Likewise, in the case of a sole proprietorship, when the owner (or former owner) receives distributions under the plan, for Massachusetts tax purposes he or she is permitted to deduct the amount 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). Partners and other self-employed individuals must retain records to substantiate the deduction of previously taxed contributions.
E. Contributions for Prior Open Tax Years
The Department of Revenue will not assess partners or other self-employed individuals who excluded or deducted elective contributions to 401(k) plans within the limitations set out in IRC § 402(g)(1) for open tax years prior to 2008.
Partners and other self-employed individuals who included their elective contributions in their Massachusetts adjusted gross income may apply for abatements for open tax years prior to 2008 to the extent the elective contributions are within the limitations set out in IRC § 402(g)(1).
The exclusion or deduction of matching contributions to 401(k) plans of these individuals for prior open tax years is not allowed.
F. Distributions Related to Contributions Made in Years Prior to 2008
With respect to distributions related to 401(k) plan contributions made in years prior to 2008, partners and other self-employed individuals must retain records to show that contributions were not excluded or deducted, whether pursuant to an original return, amended return, abatement application, or otherwise, for Massachusetts personal income tax purposes in the years in which the contributions were made in order to substantiate any claimed deductions on account of previously taxed contributions.
G. Effective Date; Prior Public Written Statements Superseded or Modified
This Directive is effective for taxable years beginning on or after January 1, 2008, and supersedes or modifies all other DOR public written statements to the extent they may appear to be inconsistent with it. These include specifically Directives 00-5 and 01-7 and TIR 02-18.
/s/Navjeet K. Bal
Navjeet K. Bal
Commissioner of Revenue
July 2, 2008