3827 / What special qualification rules apply to Keogh plans?

A Keogh plan, which at one time was called an HR-10 plan, is a qualified plan that covers self-employed individuals such as partners in a partnership or sole proprietors. Since the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001, the qualified plan rules have not distinguished between plans sponsored by a corporation and plans sponsored by other types of entities so the terms “Keogh” and “HR-10” are not used frequently. The only difference is in determining the earned income of self-employed individuals and common law employees. As a general rule, a qualified trust must be established by an employer for the exclusive benefit of the employer’s employees or their beneficiaries.¹ Self-employed individuals (sole proprietors, partners in a partnership, or members in an LLC taxed as a partnership) are not common law employees ( Q 3928). For the purpose of allowing such individuals to participate in qualified plans and to enjoy the tax advantages available to other participants in such plans, the law confers employee status on these individuals. The IRC says that for purposes of IRC Section 401, the term “employee” includes for any taxable year an individual who has “earned income.”²

The term earned income means, in general, net earnings from self-employment in a trade or business in which personal services of the individual are a material income-producing factor.³ Thus, a partner who has contributed capital to the firm but renders no personal services for it has no “earned income” from the firm and cannot participate in a qualified plan of the partnership.⁴

In arriving at the net earnings that are used to determine a self-employed individual’s own contribution, business expenses, including contributions to the plan on behalf of regular employees, are deducted. The definition of earned income of a self-employed person (which is reported on Schedule K-1 for a partner) does not include a deduction for the contributions to the plan on behalf of the self-employed individual. The self-employed individual reports contributions on a Form 1040 individual income tax return.⁵ A partner’s earned income is the share of partnership net income, including any draw or “salary” the partner receives (other than separately stated items, such as rental income, capital gains and losses, most dividends, and most interest).⁶