Massachusetts taxes all contributions to 401(k) plans by self-employed individuals.

• Author: Koppel, Michael D.

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, [section]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 self-employed 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...