As tax practitioners know, to err is human, but to forgive requires a new set of regs. Gayle Gaston v. Commissioner, T.C. Memo. 2021-107 (Sept. 2, 2021) (Judge Marvel), teaches us the lesson that if you want to get the §404(a) deduction for contributions to a profit-sharing plan, you need to be sure to properly link the plan to the taxpayer’s trade or business. In this case, the taxpayer received substantial deferred compensation payments from Mary Kay Cosmetics after her separation from that company and made substantial contributions to a retirement plan her tax advisor drafted for her. Unfortunately, her one-participant profit sharing plan did not identify any trade or business as the source of the plan contributions. That was error. Both the IRS and the Tax Court were unforgiving. Details below the fold.
Law: Employer Deductions For Contributions To Profit Sharing Plans
I freely confess I am no expert on retirement plans, so this is a very high level overview. And if alert readers spot errors in what I say, I hope you not only forgive me but, more importantly, correct my mistake. That said, here’s the law I think you need to know to learn today’s lesson.
Section 404(a)(1) allows an employer a deduction for contributions to “a stock bonus, pension, profit-sharing, or annuity plan” in the year that “an amount attributable to the contribution is includible in the gross income of employees participating in the plan,” so long as the expense is otherwise deductible under §162 or §212 and meets the other requirements of §404. The basic idea is that the employer contributions to the plan must be part of what would constitute reasonable compensation for services such that it would be deductible under §162 as an ordinary and necessary expense for carrying on the trade or business.
You see the required link to compensation more clearly in Treas. Reg. 1.404(a)-1(b):
“Contributions may therefore be deducted under section 404(a) only to the extent that they are ordinary and necessary expenses during the taxable year in carrying on the trade or business or for the production of income and are compensation for personal services actually rendered. In no case is a deduction allowable under section 404(a) for the amount of any contribution for the benefit of an employee in excess of the amount which, together with other deductions allowed for compensation for such employee's services, constitutes a reasonable allowance for compensation for the services actually rendered.” (emphasis supplied)
Employers and employees are two different legal actors. It is sometimes confusing for my students when they learn that a single individual can be both. While not as convoluted as being one’s own grandpa, the concept of a taxpayer being their own employee takes a bit of getting used to. We practitioners are so used to the concept of self-employment that we sometimes do not stop to think how weird it really is: a single person is, simultaneously, two legal actors.
Section 404(a)(8) allows self-employed folks—folks who are both the employer and the employee—to get the deduction allowed by 404(a)(1) for retirement plans they create for themselves. But here’s the wrinkle: the statute substitutes the concept of “earned income” for that of “reasonable compensation.” That is, instead of linking the deduction to contributions that are “compensation for personal services actually rendered” (i.e. wages) self-employed individuals must link their contributions to their earned income. While the taxpayer-qua-employer is allowed a deduction for contributions made to a plan for the benefit of the taxpayer-qua-employee, §404(a)(8)(C) explains that:
“the contributions to such plan on behalf of an individual who is an employee within the meaning of section 401(c)(1) shall be considered to satisfy the conditions of section 162 or 212 to the extent that such contributions do not exceed the earned income of such individual (determined without regard to the deductions allowed by this section) derived from the trade or business with respect to which such plan is established...”
The term “earned income” is defined in §404(c)(2)(A) as having the same meaning as it does in §401(c)(2). That section says earned income starts out having the same meaning as the term “net earnings from self-employment” as defined in section 1402(a) for purposes of the self-employment tax. Section 401(c)(2) then puts a bunch of qualifiers on the term, which are not relevant for today’s lesson. Similarly, trotting over to §1402(a) we find that net earnings from self-employment start out as “gross income derived by an individual from any trade or business carried on by such individual...” and then §1402(a) also throws out a bunch more qualifiers.
Bottom line: the term “earned income” for §404 purposes is the twin of the term for §401 purposes, but just a sibling, or maybe even a kissin’ cousin, to the term “net earnings” as used in §1402. We're not sure about that relationship. Fortunately, the uncertainty is not relevant to today’s lesson.
Ms. Gaston enjoyed a lucrative independent contractor relationship with Mary Kay, Inc. for the 43 years between 1967 and 2010. Mary Kay relies for its success on a multi-level marketing scheme. Those who rise to pinnacle of the pyramid are called “National Sales Directors.” M.s Gaston hit that high point in 1974 and there she stayed. In the late 1980’s Mary Kay created a deferred compensation program for that elite group, called the “Family Security Program” (FSP). The FSP is a contractual obligation of Mary Kay and funded from the company’s general assets. It is explicitly designed to not qualify for tax treatment under §401. For a more detailed description, either click on the above link or see Judge Gerber’s excellent summary in Dunlap v. Commissioner, T.C. Summary Opinion 2020-10.
Mary Kay has a mandatory retirement age of 65. Ms. Gaston turned 65 in 2010 and was required to retire. She began receiving her FSP payments. They were substantial. In the years at issue, 2013 and 2014, she received around $520,000 and $513,000, respectively. From what I have read in other Mary Kay cases, these amounts suggest that Ms. Gaston was one of the very top National Sales Directors for many years.
In 2008, as Ms. Gaston approached her 2010 retirement, she engaged in some tax planning. She hired one Dennis Mehringer to help her. He drafted the Gayle Gaston Sole Proprietor Profit Sharing Plan for “Gayle Gaston, a California Sole Proprietorship (the ‘Plan Sponsor’).” Op. at 3. The Plan did not identify what trade or business Ms. Gaston’s Sole Proprietorship was engaged in and Mr. Mehringer told Judge Marvel at trial that the Plan had not been created with any particular line of business in mind.
After 2010, Ms. Gaston engaged in various activities: acting (reported on Schedule C each year), selling jewelry (through an S corp and reported on Schedule E), and starting, then abandoning, an effort to sell hair care products. It appears that the only income she reported on her Schedules C was from the large FSP payments from Mary Kay. Op. at 25 (“the revenues reported on her Schedules C as income from her trade or business actually represented payments from the Mary Kay FSP.”). And in 2013 and 2014, Ms. Gaston deducted $51,000 on each Schedule C for contributions to her Plan. She also reported losses from her jewelry activity, thus sheltering even more of her Mary Kay income. That may be what got her 2013 and 2014 returns picked up for audit.
On audit, the IRS decided all her post Mary-Kay activities were hobbies and not bona fide businesses. That, and the deductibility of various expenses related to the acting activity, is the bulk of the dispute that went to Tax Court. On that part of the case Judge Marvel mostly held for Ms. Gaston, finding her acting activity to be a bona fide business. Judge Marvel applied the Cohan rule generously to allow many of the claimed expenses. While that could make for a good lesson, it is Judge Marvel's disallowance of Ms. Gaston's $51,000 yearly contributions to the Plan that I thought gave us a better lesson for today. Let's take a look.
Lesson: Failure to Specify Business in Retirement Plan Proves Fatal
The IRS disallowed Ms. Gaston’s deductions for her Plan contributions because, it said, her she had no ongoing trade or business that produced earned income. Her activities were all hobbies. Ms. Gaston argued that her contributions should be deductible because the FSP payments were earned income for employment tax purposes, per Peterson v. Commissioner, T.C. Memo 2013-271, aff'd in part, 827 F.3d 968 (11th Cir. 2016).
In Peterson, the taxpayer was also another top National Sales Director, a contemporary of Ms. Gaston, who seems to have set up a similar tax strategy. Ms. Peterson had set up the Christine Peterson Defined Benefit Plan and Trust in 2006, three years before she retired in 2009. She made contributions to the Plan in 2006, 2007, and 2008 while still working for Mary Kay. She deducted those contributions. We don’t know, however, whether she continued to take those deductions after she retired because the big issue in Peterson was whether Ms. Peterson had to pay employment tax on her FSP payments.
On audit, the IRS both disallowed Ms. Peterson’s §404(a) deductions and dinged her for employment tax on the FSP payments. The Tax Court held for the IRS on the employment tax issue, finding the FSP payments were self-employment income within the meaning of §1402(a). That part of the Tax Court’s opinion was affirmed by the 11th Circuit.
The Tax Court, however, held for Ms. Peterson on the §404(a) deduction issue, finding that she had properly set up her Plan so that contributions made to her Plan during her last three years with Mary Kay were deductible. Id. at page 9 (“Mrs. Peterson is entitled to deduct, pursuant to section 404(a), the retirement contributions relating to 2006, 2007, and 2008.”). Notice, however, that holding did not address any issue of whether contributions made to the plan from FSP payments could also generate a §404(a) deduction.
In today’s case, Ms. Gaston nonetheless invoked Peterson to argue that if the FSP payments were “net earnings” for §1402 purposes (as Peterson held), then they must also be “earned income” for §404 purposes. They are twins!
Judge Marvel refused to wade into the uncertainties of the relationship between §1402 and §404. That was because Ms. Gaston’s retirement Plan instrument was defective. Judge Marvel pointed out that §404(a)(8)(C) says only contributions that are from earned income “derived from the trade or business with respect to which such plan is established...” In this case, Ms. Gaston’s retirement Plan instrument did not specify any trade or business to which it was attached. And Ms. Gaston’s tax advisor even testified that he drafted the Plan without linking it to any specific trade or business. Wrote Judge Marvel: “whether petitioner’s FSP income is ‘earned income’ within the meaning of sections 401 and 404 is a question we need not reach because petitioner has not proven that the plan was established with respect to her former Mary Kay activity.” Op. at 28.
Comment 1: Fixing the Problem
I think we can all agree that Ms. Gaston’s deductions would be allowable if her retirement Plan had specified her business as acting and she had earned income from her acting activity. It is not clear whether she did in 2013 and 2014. Op. at 25. (her acting “generated no taxable income”). Since those tax years, however, Ms. Gaston's acting career has flourished, at least as evidenced by her IMDb page. Mr. Mehringer's career, however, has not—at least if he is the same Daniel A. Mehringer who has been the subject of multiple lawsuits.
Comment 2: A Bigger Question Unanswered?
Judge Marvel admirably focused on what was needed to decide the case before her and so did not answer the question raised by both the IRS and Ms. Gaston: are the FSP payments “earned income” for §404(a) purposes. I am not so constrained and so offer some thoughts on why they are not.
Section 1401 imposes an excise tax. It's substance. Sections 401-404, however, are basically timing provision. They do not by themselves impose a tax. They just explain when some taxpayers may defer reporting certain items of income and when other taxpayers can take deductions for certain items of expense. Contributions by an employer to a retirement plan implicates both timing questions.
It is that difference between imposition of tax and timing that I think results in a seemingly heads-IRS-wins-tails-taxpayer-loses result for the question of whether FSP payments can generate a §404(a) deduction. I don’t think they can.
First, I note that an expense is deductible under §162 only if it is “necessary.” Sure, that’s a low bar. It still means, however, that the expense must be helpful in some way to generate the income being received and reported that year. See Welch v. Helvering, 290 U.S. 111 (1933).
Second, I note that one requirement for deduction under §404(a) is that the contributions be properly deductible under §162, including that they be necessary. Treas. Reg. 1.404(a)-1(b), says:
“Contributions may therefore be deducted under section 404(a) only to the extent that they are ordinary and necessary expenses during the taxable year in carrying on the trade or business or for the production of income and are compensation for personal services actually rendered. In no case is a deduction allowable under section 404(a) for the amount of any contribution for the benefit of an employee in excess of the amount which, together with other deductions allowed for compensation for such employee's services, constitutes a reasonable allowance for compensation for the services actually rendered.” (emphasis supplied).
The Peterson courts (Tax Court and 11th Circuit) said FSP payments are subject to employment tax because they represent compensation for past services. Thus, they continue to be self-employment income. See e.g. T.C. Memo 2013-231 at 9 (“The Mary Kay distributions were "tied to" the quantity and quality of Mrs. Peterson's prior labor.”). However, while the FSP payments are indeed compensation for personal services actually rendered, they are not paid for services rendered “during the taxable year in carrying on the trade or business.” Accordingly, I cannot see how contributions to a retirement plan from FSP funds are in any way “necessary” for production of the FSP payments. They simply cannot connect to the activity that produced the income...unless you have a time machine.
Feel free to use the comments to explain what error you see in my analysis.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each week (usually Mondays) to TaxProf Blog for another Lesson From The Tax Court.