Rev. Rul. 74-420

Advice has been requested whether an employee contribution made by an owner-employee on his own behalf, for a taxable year in which no contributions are made on behalf of any other employees, is an excess contribution within the meaning of section 401(e) of the Internal Revenue Code of 1954.

In 1965 a sole proprietorship established a qualified pension plan that provided benefits for the proprietor, an owner-employee within the meaning of section 401(c)(3) of the Code, and the proprietorship's two common-law employees. The plan permitted employee contributions to be made by all participants. On March 1, 1973, the two common-law employees' services were terminated and no contributions were made on their behalf for that year. New employees were hired to replace the terminated employees but they did not meet the plan's one-year length of service requirement before the end of the year and, therefore, were not included in the plan for that year.

An employer contribution of $2,500 was made on behalf of the owner-employee for 1973 and an additional employee contribution in the same amount was made by the owner-employee in his own behalf.

Section 401(e)(1)(A) of the Code provides that, in any taxable year in which contributions are made under the plan only on behalf of owner-employees, an excess contribution is the amount of any contribution made on behalf of any owner-employee which is not deductible under section 404 for the taxable year. See also section 1.401-13(b)(2)(i) of the Income Tax Regulations. On the other hand, if contributions are made on behalf of employees other than owner-employees, section 401(e)(1)(B) provides that an excess contribution is (i) the amount of any contribution made by the employer on behalf of the owner-employee which is not deductible under section 404, (ii) the amount of any contribution made by any owner-employee (as an employee) at a rate which exceeds the rate of contributions permitted to be made by employees other than owner-employees, or (iii) the amount of any contribution made by an owner-employee (as an employee) which exceeds the lesser of $2,500 or 10 percent of the owner-employee's earned income for the taxable year.

As provided in section 1.401-13(a)(2) of the regulations, employee contributions by owner-employees are not taken into account in determining the amount deductible under section 404(a) of the Code. Under section 401(e)(1)(A) any contribution on behalf of an owner-employee that is not deductible under section 404(a) is an excess contribution if it is made in any taxable year in which contributions are made only on behalf of an owner-employee. This is so even though contributions have been made on behalf of others in prior years and may be made on behalf of others in future years. Section 401(e)(1)(B) permits limited nondeductible employee contributions to be made on behalf of an owner-employee only for a taxable year in which an employer contribution is made on behalf of an employee who is not an owner-employee and then only if the employee contribution by the owner-employee is not made at a rate in excess of that which could have been made by employees who are not owner-employees.

Accordingly, the employee contribution by the owner-employee in this case was an excess contribution within the meaning of section 401(e) of the Code.