Massachusetts Taxes All Contributions to 401(k) Plans by Self-Employed Individuals

Editor: Michael D. Koppel, CPA, PFS, CITP

On July 2, 2008, the Massachusetts Department of Revenue (DOR) issued Directive 08-3, The Massachusetts Income Tax Treatment of Contributions on Behalf of Partners and Other Self- Employed Individuals Under a 401(k) Plan. It concludes, based on MA Gen. Laws ch. 62, §2(d)(1)(D), that contributions made to a 401(k) plan by self-employed individuals are not deductible for Massachusetts income tax purposes effective for tax years beginning on or after January 1, 2008 (meaning that the directive is effective retroactively). The directive provides that taxpayers do not have to amend returns from prior years.

For purposes of this directive, the DOR defines a self-employed person as anyone who receives self-employment income as defined in Sec. 401(c) and related regulations. Therefore, the directive will apply to proprietors, partners in a partnership, and members of an LLC taxed as a partnership. In 1999, the DOR issued Directive 99-4, which clearly indicated that the shareholders in an S corporation could deduct contributions to a 401(k) for Massachusetts income tax purposes.

Directive 08-3 makes clear that not only is the contribution made by the selfemployed person not deductible, but any contributions made by the business for the benefit of the self-employed person are not deductible. This change can have a significant effect on a taxpayer’s Massachusetts 2008 taxes.

Tax advisers need to warn affected taxpayers that this additional Massachusetts tax is coming. Depending on the taxpayer’s situation, it may be beneficial to increase his or her fourth-quarter estimate and pay it in December to reduce the federal tax. Of course, if the taxpayer will be subject to the alternative minimum tax (AMT), accelerating the tax payment will not be beneficial because state income taxes are not deductible for AMT purposes (Sec. 164(a)).

The complications from this tax do not start with the additional tax. In order to prevent double taxation, when an affected taxpayer takes distributions from his or her 401(k) account in the future, a deduction will be allowed for the portion of the distribution that represents contributions that were taxed in the year they were made, provided that the taxpayer can substantiate the amount of the previously taxed contributions. Therefore, affected taxpayers will also have to keep track of the 401(k) contributions on which they have paid Massachusetts income tax. The burden of maintaining this information will fall directly on taxpayers and their tax preparers.

The requirement to pay Massachusetts income tax in the year of contribution to a 401(k) may also affect a business’s choice of entity. Because of the time value of money, a smaller business that will not be subject to the Massachusetts “sting tax” may elect to be an S corporation instead of a partnership or an LLC taxed as a partnership.

EditorNotes

Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.

The Tax Adviser would like to acknowledge the special contribution to the December Tax Clinic of Singer Lewak LLP; Mark G. Cook, tax partner in the Irvine, CA, office; and Steve Cupingood, the partner in charge of that firm’s tax practice.

For additional information about these items, contact Mr. Koppel at (781) 407-0300 or mkoppel@gggcpas.com.