Legal ruling 431

Qualified Plan Contributions - NonResident Partner

Advice has been requested as to the proper method of computing the allowable deduction to be claimed on a nonresident individual tax return (Form 540NR) for partnership contributions to a qualified retirement plan made on behalf of a nonresident partner in a personal service partnership which derives income from both within and without California.

For the reasons set forth below, the allowable deduction is limited to that portion of the allowable federal deduction attributable to earned income from California sources.

Internal Revenue Code §§ 415(a)-(c) and 404 provide limitations on the deductibility of contributions to retirement plans made on behalf of self-employed individuals.

For years beginning on or after January 1, 1987, the Revenue and Taxation Code has incorporated by reference the above-cited provisions of the Internal Revenue Code. ( See § 17501; see also § 17503, as repealed by Assembly Bill 53, Stats. 1987, Ch. 1138.)

Thus, in the case of a full-year resident of California taxed on income from whatever source derived (§ 17041 (a)), the amount of allowable federal and California deduction for retirement plan contributions made on behalf of self-employed partners should be the same.

However, it must be kept in mind that the deduction for contributions to a qualified retirement plan on behalf of a self-employed partner is an individual and not a partnership deduction, and is deducted outside the partnership context. This deduction is reflected on line 11, Schedule K-1, and is to be transferred to page 1 of the individual's personal income tax return.

Further, if a self-employed individual receives earned income with respect to which deductions would be allowed from two or more employers, the deduction limitations apply in the aggregate (Internal Revenue Code § 415).

A nonresident may only be taxed upon income derived from California sources (§ 17041(b)).

In the case of a nonresident, the proper apportionment and allocation of deductions with respect to sources of income within and without California is to be determined under rules and regulations prescribed by the Franchise Tax Board (§ 17301).

If a trade or business such as a professional partnership is carried on within and without California, its income derived from California sources must be determined in accordance with the provisions of the Uniform Division of Income for Tax Purposes Act as adopted in §§ 25120-25139 (Cal. Code Regs., tit. 18, Reg. §§ 17951-4(e) - (h)).

The deduction under consideration is intimately connected to the earned income upon which the deduction is based. Therefore, even though the deduction is computed at the individual level outside the partnership context, it is appropriate to apply concepts similar to those which apportion income and deductions within and without California in order to apportion the deduction properly, even though the Uniform Division of Income for Tax Purposes Act, supra, is not directly applicable.

Because of this relationship, taking into account the factors discussed above, it is our opinion that the deduction under consideration should be sourced in California to the same extent as the income upon which it is based. The appropriate method of accomplishing this goal is to apportion the federal deduction based upon the ratio of earned income sourced in California to total earned income.

The following example is illustrative:

A, a single nonresident individual, is a partner in a personal service partnership which does business within and without California and which reports on a calendar year. A's share of partnership income from this personal service partnership is $300,000. A also has $25,000 of self-employment income within the meaning of Internal Revenue Code § 401(c)(2) received from a general partnership in which A is a passive investor only.

For 1987, A's share of partnership income from all sources is $325,000. Under §§ 17951-17954, A's share of partnership income from the personal service partnership attributable to California sources is $100,000.

For federal income tax purposes, a partnership contribution is made on behalf of A to a defined contribution Keogh plan in the amount of $15,000, and is properly reflected by the partnership on A's K-1 ( see Internal Revenue Code § 702(a)(8).

A files a nonresident California income tax return (Form 540 NR).

A's California adjustment for the contribution to the Keogh plan made on his behalf is computed as follows:

1. Ratio of earned income sourced in California/total earned income used to support the contribution: $100,000/$300,000 = 33%.
2. Ratio in a. above applied to the allowable federal deduction: 33% of $15,000 = $5,000.
3. Federal deduction (deducted in computing federal adjusted gross income) less the amount in b. above: $15,000 - $5,000 = $10,000 California adjustment.

This amount should be treated as an addition to be shown and detailed on Schedule SI (California Source Income) and carried over to page 1 of Form 540 NR.

It is also noted that, under § 18408.5 (Assembly Bill 129, Stats. 1987, Ch. 918), a partnership doing business or deriving income from California sources may elect to file a single group return on behalf of its nonresident partners. The return may only include partners having no other income derived from California sources. The tax on each electing partner's distributive share is the highest marginal rate provided for individual income taxpayers, and no deductions shall be allowed except those necessary to determine each partner's distributive share.

Because the deduction discussed herein is computed independently of the computation of the individual partners' distributive shares, if a partnership elects the provisions of § 18408.5, no deduction may be claimed by the individual partners for contributions made on their behalf to qualified retirement plans.