The
first, and major part of a presentation on potential problems faced by
employers who maintain SEP plans. This presentation is provided by IRS Mikio
Thomas, the Customer Education and Outreach Analyst for the Director of Employee
Plans. Mr. Thomas has, among other things, made many presentations before
employer groups and associations of tax professionals with the goal of
assisting employers in their effort to provide tax-favored retirement benefits
to their employees. You will find this presentation to be informative.
The
second part will consist of a question and answer session. The goal here will
be to cover the questions sent by e-mail.
Without
further ado, here is Mikio Thomas.
M.
Thomas: The listen-only mode by the operator -- I wish I could get some of that
so I could use it on my teenage kids. I was looking for a joke or a quote for a
Friday afternoon session, and I found the noted theologian, John Gresham Machen
said, “Afternoon classes – that evil invention.” And I’m sure he said that on a
Friday, but we’re going to make it a good one for you.
Many
of you have clients who are setting money aside in a SEP Retirement Plan. For
the next 60 minutes we will be talking about the pitfalls that employers
sometimes encounter when sponsoring a SEP. Let the IRS help you help your
clients keep their retirement plans running smoothly, and stay a step ahead of
the IRS.
Before
we dive into the details of each mistake, let’s take a few minutes to discuss
an overview of SEP plans. SEP is an acronym meaning Simplified Employee Pension
plan. Any size business, even self-employed individuals, can establish a SEP.
There are three basic steps in setting up a SEP. First, the employer must
execute a formal, written agreement. Second, the employer must give each
eligible employee certain information about the SEP. And last, a SEP-IRA must
be set up by or for each eligible employee.
Let’s
take a few minutes and get into more detail about each one. First, the written
agreement requirement. This can be satisfied by adopting an IRS model SEP using
Form 5305-SEP. You can simply download and print this form from the IRS Web
site. Your client does not need to file this form with the IRS. Using Form
5305-SEP will usually relieve the employer from filing annual retirement plan
information returns with the IRS and the Department of Labor.
Now,
there are some exceptions to using the Form 5305-SEP. An employer cannot use
this form if any of the following apply:
- It currently maintains any
other qualified retirement plan.
- It has any eligible employees
for whom it has not set up IRAs.
- It uses the services of leased
employees.
- It is a member of an affiliated
service group, controlled group of corporations or trades of businesses
under common control, unless the eligible employees of all the members of
these groups, trades or businesses participate in the SEP.
Another
type of written SEP document is a prototype SEP. Financial institutions and
other approved organizations can sponsor the prototype, and the IRS issues
opinion letters approving them. Prototype plans are then sold to individual
businesses, who adopt them.
One
other method for setting up a SEP, that is not as common, is for plan sponsors
to adopt an individually designed document and the IRS has not established any
approval process for these types of plans.
Second,
the employer must give each eligible employee certain information about the
SEP. So now, once you have the SEP document in its place, the employer must
give each eligible employee a copy of the Form 5305-SEP, its instructions and
the other information listed in the form instructions.
An
IRS model SEP is not considered adopted until the employer gives each eligible
employee this information. If the employer adopts a prototype SEP, it must give
each eligible employee similar information that can be found in the model Form
5305-SEP.
Lastly,
a SEP-IRA must be set up by or for each employee who was eligible to be in the
plan. SEP-IRAs can be set up with banks, insurance companies or other qualified
financial institutions and the employer sends its SEP contributions to where
the SEP-IRAs are maintained. The employer can set up a SEP for a year as late
as the due date, including extensions, of the business’s income tax return for
that year.
Under
a SEP, the employer makes contributions to traditional IRAs set up for eligible
employees, including self-employed individuals, subject to certain limits. A
SEP is funded solely by employer contributions, so no employee contributions
would be permitted. Each employee is always 100% vested in, or has ownership
of, all money in his or her SEP-IRA.
Generally,
any employee who performs services for the business must be included in the
SEP. However, there are some exceptions to this general rule. The employer may
exclude those employees who have not worked for the employer during three out
of the last five years; have not reached age 21; are employees who are covered
by union agreement and whose retirement benefits were bargained for in good
faith by the employer and the employee’s union; who are non-resident alien
employees who have no U.S. wages from the employer; and finally, employees who
received less than $550 in compensation, subject to cost-of-living adjustments
during the year. Generally, W-2 compensation satisfies the definition of
compensation.
The
SEP plan requires a SEP-IRA to hold the contributions made for each of the eligible
employees. The SEP plan document will indicate the amount the employer has
agreed to contribute. This amount can be discretionary, including zero. The SEP
document must include a definite, written allocation formula for determining
how the employer will allocate its contributions to employee SEP-IRAs. SEP
contributions must bear a uniform relationship to compensation, meaning each
employee’s contribution must represent the same percentage of compensation. The
amount of compensation taken into account under the plan is limited to $245,000
in 2012, and this, too, is subject to cost-of-living adjustments in later
years.
Another
limit is on the total contributions to each employee’s SEP-IRA. They cannot
exceed the lesser of $50,000 for the year 2012, or 25% of compensation. And,
again, the $50,000 is subject to the cost-of-living adjustment in later years.
The
employer sends the SEP contributions to the financial institution that will
manage the funds. Depending on the financial institution, SEP contributions can
be invested in individual stocks, mutual funds and other similar types of
investments. Each SEP participant must receive an annual statement showing the
amount contributed for the year.
I want to talk a little bit about taking money
out of a SEP-IRA. We receive a lot of questions on this. Because the SEP
investment vehicle is an IRA, the IRA rules apply. Therefore, employees can
withdraw SEP contributions and earnings at any time. Money withdrawn is taxable
in the year it is received. If an employee makes a withdrawal before he or she
is age 59-1/2, generally a 10% additional tax applies.
Employees
may roll over SEP contributions and earnings tax-free to other IRAs and
retirement plans. SEP contributions and earnings must eventually be
distributed. The law requires specific minimum amounts to be distributed by
April 1st of the year following the year the employee turns age 70-1/2, and by
December 31st of all later years.
An
employer generally has no filing requirements of the Form 5500 series return
for a SEP. The financial institution that holds the plan’s SEP-IRAs handles
most of any other paperwork.
If
an employer makes mistakes with respect to a SEP plan, he can use the IRS’s
Employee Plans Compliance Resolution System, or as it’s affectionately known,
EPCRS, to remedy the mistakes and avoid the consequences of plan
disqualification. A correction for the mistakes should be reasonable and
appropriate. The correction method should resemble one already provided for in
the code, and the employer should consider all applicable facts and
circumstances. The Revenue Procedure is 2008-50. Again, Revenue Procedure
2008-50 sets forth the EPCRS, which has three components.
The
first component is the Self-Correction Program, or the acronym SCP. It permits
a plan sponsor to correct certain plan failures without contacting the IRS and
without paying any fee. In order to be eligible for this program, the plan
sponsor or administrator must have established formal or informal practices and
procedure in place. They must be reasonably designed to promote and facilitate
overall compliance with the Code.
Let
me give you an example. The plan sponsor of a SEP may include in its plan
operating manual specific steps to determining when new employees are eligible
to enter the plan, so that the eligibility rules of the Code will always be
satisfied. Please remember that a plan document alone does not constitute
evidence of any established procedures.
SCP
is available for correcting operational problems only. That is, the failure to
follow the terms of the plan. SCP is not available for other types of problems,
such as failing to keep the plan document up-to-date to reflect all changes. We
will talk about this issue in more detail later in the presentation.
Under
SCP, the plan sponsor corrects mistakes using the general correction principles
described in Section 6 of the EPCRS Revenue Procedure. If a plan sponsor
corrects a mistake listed in, and in accordance with, the correction methods
included in Appendix A or Appendix B of the Revenue Procedure, it may be
certain that the correction is reasonable and appropriate for the mistake. The
plan sponsor may need to make changes to its administrative procedures to
ensure the mistakes don’t happen again.
Now
the Self-Correction Program may be used if, considering all the facts and
circumstances, the mistakes in the aggregate are insignificant operational
failures. You may be wondering to yourself, how do you decide if a mistake is
significant or insignificant? Look at the facts and circumstances. The Revenue
Procedure lists some to consider. This list is not all-inclusive, but some
examples include: the percentage of plan assets involved in the failure, the
number of years the failure occurred and whether the correction was made within
a reasonable time after discovery of the failure.
If
you determine the failure is insignificant, then document how you came to that
decision. When using Self-Correction, the plan sponsor should maintain adequate
records to demonstrate they have corrected the mistake in the event of an audit
of the plan, and that is very important. If there is an audit of the plan, the
agent will want to see the records that show how the mistake was corrected, and
I would suggest also that you show them a written procedure on how you
determined it was insignificant. That would be better off in case of an audit for
a revenue agent to see to how what conclusions you came to and why you came to
them.
Again,
there is no fee for Self-Correction. I like to use a car analogy with this.
Think of this program as similar to changing a tire on your car when you get a
flat. You don’t call the dealership, you don’t bother anybody else, you fix the
tire by yourself and then you move on.
The
next program is called the Voluntary Correction Program, or VCP. This permits a
plan sponsor to, any time before audit, pay a fee and receive the IRS’s
approval for correction of plan mistakes. Using the car analogy, this is more
like taking your car into the shop to get the brakes fixed.
Under
Voluntary Correction, the plan sponsor identifies the mistakes, and proposes
corrections using the general correction principles described in Section 6 of
the EPCRS Revenue Procedure. The plan sponsor proposes changes to its
administrative procedures to ensure the mistakes do not recur, and pay the
compliance fee to the IRS of $250. The IRS issues a compliance statement, which
details the qualification mistakes identified by the plan sponsor, and the
correction approved by the IRS.
The
plan sponsor corrects the identified mistakes within 150 days of the compliance
statement, and while the submission is pending, Employee Plans will not examine
the plan, except under unusual circumstances.
The
third program is the Audit Closing Agreement Program, or Audit CAP. This
permits a plan sponsor to pay a sanction, and correct the plan mistake while
the plan is under audit. The plan sponsor will pay a sanction, which has been
negotiated with the IRS and is based on the sum for all open taxable years of
the:1. Additional income tax, including any interest and penalties that the
employees would have to pay if contributions to the SEP-IRA were included in
their income. This would also include any tax, including interest and penalties
on distributions that the employees rolled over to other IRAs and additional
tax from the 6% tax on excess contribution to IRAs. So, again, that’s the
maximum payment amount, and then it would be negotiated from there between the
agent, yourself and your client.
The
sanction paid under Audit CAP will most likely always be greater than the fee
paid under Voluntary Correction. Using the car analogy, envision your car
breaking down on the freeway and being towed to the shop. And for those of you
that do have the handout, we included a picture of a snake biting a man, and
the reason why we do that -- more times than not on audit, when we show them how
we found the mistake, a lot of times we hear, “Hey, if that was a snake, it
would have bit me.” So it’s just important to take the time to go in and look
over the plan yourself.
Let’s
move on now to the potential errors. Again, we have five potential mistakes
that we commonly find in SEPs. The first potential mistake is, “Has your SEP
been amended for current law?” Laws related to retirement plans change quite
frequently. Now, there are statutory deadlines which many provisions must
become effective. The IRS generally establishes a firm deadline for adopting
these changes. Also, these law changes might mean your client can simplify some
areas of plan administration, or improve benefits. Your client will need to
change plan language, and then operate it accordingly to keep the plan within
the law.
How
to find this mistake? At some point during the plan’s existence, your client
may be asked to demonstrate if the plan is compliant with current and prior
law. This request can come from many places. It could be a financial
institution, a third-party administrator, another plan service provider, or
from the IRS during an audit. Earlier we talked about some of the ways that the
employer can adopt a SEP, first, using the model Form 5305-SEP, or a prototype
plan; both of which have already been reviewed favorably by the IRS. If the
plan is a model Form 5305-SEP and the revision date on it is December 2004,
which can be found in the upper left-hand corner of the form, you can be
assured that it complies with the law. If the plan is a prototype plan, you
have a high-level of assurance, not as high as the model form, but a high-level
of assurance that the plan has been updated for current law.
We
also talked about individually designed SEPs. They must also be updated for law
changes.
How
to fix this mistake? If you find your client has not amended its plan timely
for the various law changes, your client should adopt amendments for the law
changes it has missed. Your client can do this by adopting a prototype plan
approved for EGTRRA, or a current IRS Form 5305-SEP, again, which has the
revision date of December 2004. You will need to confirm that the plan’s
operation is consistent with the terms of the updated plan.
Let
me give you an example. We have an employer who established a SEP in 1995 using
a prototype plan, and never subsequently amended for any law changes. Starting
in 2002, the plan began using the increased contribution limits of EGTRRA. Due
to the changes made by EGTRRA and other laws, the IRS issued revised model Form
5305-SEP documents in 2002. If an employer was using the pre-EGTRRA model SEP,
and wanted to take advantage of the EGTRRA changes in 2002 plan year, then it
should have adopted the revised Form 5305-SEP by the end of the 2002 plan year.
The
rules for prototype adopters are a bit different. The employer should have
adopted the EGTRRA-approved document within 180 days after the IRS issued a
favorable EGTRRA Opinion Letter to the sponsoring organization of the prototype
SEP. Now, the employer in this example would have to adopt an EGTRRA-revised
document within 180 days after the IRS issued a favorable EGTRRA Opinion Letter
to the sponsoring organization of the prototype SEP. If any of these conditions
were not satisfied, then EPCRS would have to be used to correct the mistake by
adopting the proper document.
So
if your client has this mistake, which of the three correction programs are
available? First, the Self-Correction. Your client may not correct this type of
mistake under Self-Correction. As I stated earlier, the Self-Correction Program
is limited to operational problems. And, this mistake is a result of not
keeping the plan language up-to-date.
In
order to retain plan qualification, your client must correct this mistake under
VCP. So, your client can make a VCP submission to the IRS identifying the
mistake. The fee for correcting this mistake would be $250.
If
the IRS discovers this mistake on audit, your client may correct it under Audit
CAP. The method of correcting this mistake would be the same as under VCP or
Audit CAP, but the sanction under Audit CAP is a percentage of the maximum
payment amount, and it would be greater than $250.
So
we’ve talked about the find, the fix. Lastly, how can you help your client
avoid this mistake? There are a few ways:
- Do an annual review of the plan
document.
- When the plan document is
amended, check the language against the old document, noting any
differences.
- Knowing the plan has been
properly updated may not be a simple process; certain plans must be
individually amended for each change, while others might have a prototype
document that is amended. We recommend that your client maintain regular
contact with the company that sold it the plan, if applicable. If the
company sends your client a set of amendments to formally adopt, make
certain it timely executes the documents per their instructions. Keep
signed and dated documents of the plan document and any amendments for
your client’s records.
The
next potential mistake: Are all eligible employees participating in the SEP?
Your client must allow all eligible employees to participate -- and we’re
talking about part-time employees, seasonal employees, employees who die or
terminate employment during the year.
An
eligible employee is an employee who is at least age 21 and has performed
service for your client in at least three of the immediately preceding five
years. The term “employee” includes a self-employed individual who has earned
income and a working business owner. In addition, certain leased employees are
employees.
The
SEP document can provide for less restrictive eligibility requirements, but not
more restrictive. For example, if your client would like to use age 18, that is
not a problem. If they want to use age 23, that would be a problem. The highest
they could go is age 21.
Service
means any work performed for your client for any time, however short. You may
have heard in 401(k) plans or profit-sharing plans that there’s a 1,000
hours-of-service requirement. This is not the case in SEP. SEPs may not impose
any hours-of-service requirement.
There
are also employees who the employer does not need to cover under a SEP. They
are employees covered by a union agreement, whose retirement benefits were
bargained for in good faith by your client and their union, non-resident alien
employees who didn’t earn U.S. income from your client and employees who
received less than $550 in compensation during the year. This $550 is subject
to the cost-of-living adjustments.
When
your client determines which employees should be in the SEP, remember that
employees includes all employees of all related employers, including controlled
groups of corporations that include your client’s business, trades or
businesses under common control with your client’s business and affiliated
service groups that include your client’s business.
This
means, for example, that if your client and/or his or her family members own a
controlling interest in another business, employees of that other business are
considered employees for purposes of determining who is eligible to participate
in the SEP.
Again,
let me give you a couple of examples. We have an employer who maintains a
calendar-year SEP where the employee must perform service in at least three of
the immediately preceding five years, reach age 21 and earn the minimum amount
of compensation during the current year. And we have Ann, who worked for this
employer during her summer breaks from college in 2005, 2006 and 2007, but
never more than a few days in any year. In July of 2008, Ann turned 21. In
August 2008, Ann began working for the employer on a full-time basis, earning
$12,000 in 2008. Ann would be an eligible employee in 2008, because she met the
minimum age requirement of 21, worked for the employer three of the five
preceding years and met the minimum compensation requirement for 2008.
Another
example, an employer designed its SEP to provide for immediate participation,
regardless of age, service or compensation. So when Bob turns 18-years-old and
begins working part-time for the employer in 2008, Bob would be an eligible
employee. Again, an example of having a document that has less restrictive
eligibility requirements. Not a problem.
Okay,
how would you find this mistake? We suggest you complete the following steps:
- Review the section of the plan
document concerning eligibility and participation.
- Check when employees are
actually entering the plan.
- Make a list of all employees
who received a W-2.
- Compare their dates of hire and
annual compensation against the eligibility and participation requirements
in the plan document. Next, determine when each employee is entitled to
become a participant in the plan according to the plan document, and inspect
payroll and plan records to make certain the employees entered the plan
timely.
Moving
along on how to fix this mistake. Generally, if your client did not provide an
employee the opportunity to participate in its SEP plan, it must make a fully
vested contribution to the plan for the employee that compensates for the
missed contribution. This corrective contribution is an employer contribution
that is intended to place the employee in the same position had he participated
in the plan timely.
Let
me give you an example. We have an employer who maintains a SEP plan that
provides for discretionary employer contributions that is on a
comp-to-total-comp basis. For 2007, this employer contributed a fixed dollar
amount to the plan. However, this employer inadvertently excluded Joe, who met
the eligibility requirements for participating in the plan. Joe had terminated
during the plan year and did not receive an allocation of the contributions.
The contribution resulted in an allocation for each of the eligible employees,
other than Joe, equal to 10% of compensation. Now if Joe had shared in the
original allocations, each employee would have received an allocation of 9% of
compensation.
So
when we turn to the EPCRS Revenue Procedure, they provide two different methods
for correcting the exclusion of eligible employees. Only one of these methods,
the contribution method, is proper for SEPs in most cases, since the assets of
the plans are held in IRAs. And what the contribution method requires is that
the employer make a corrective contribution based on the excluded employee’s
compensation to the plan. The corrective contribution must be adjusted for
earnings. No adjustments are made to the employees who shared in the prior
allocations, even if their allocations would have been different had the
excluded employee not been excluded.
So
going back to the example, the employer would contribute an amount that equals
10% of Joe’s compensation for the 2007 year, adjusted for earnings, and will
not adjust whatsoever the 10% allocations that were made to the other
employees.
So
which of the three correction programs are available for this mistake? Well,
the example I just gave illustrates an insignificant operational problem in
that the employer failed to follow the terms of the plan by not giving one
employee an allocation of the contribution to the plan for the 2007 year.
Therefore, if the other eligibility requirements of Self-Correction are
satisfied, this employer can use SCP to correct the mistake.
A
reminder -- there are no fees for Self-Correction and the employer must have
practices and procedures in place. This correction is also eligible for
Voluntary Correction and the correction would be the same. The employer would
make the submission to the IRS and pay the fee of $250. And, as always, it’s
eligible for Audit CAP. If the IRS would come out and find this during
examination, the employer and IRS would enter into the closing agreement,
outlining the corrective action, and again, negotiate a sanction based on the
maximum payment amount.
Finally,
how can you advise your clients to avoid this mistake? Your clients should
review the participation status of all employees at least once a year. The
person assigned this task should have a good understanding of the eligibility requirements
of the plan and have access to the employment and payroll records necessary to
make eligibility decisions for all employees.
Moving
on to the third mistake. Is the business that the SEP covers the only business
that your client owns? As I previously stated, employees, for purposes of
determining who is an eligible employee under a SEP, includes all employees of
all related employers to your client’s business. This would include control
groups of corporations, trades or businesses under common control, and
affiliated service groups. This means, for example, if your client or your
client’s family members own a controlling interest in another business,
employees of that other business are employees for purposes of determining who
is eligible to participate in the SEP. You may think I’m being repetitive, but
we see this issue a lot, and that’s why we’re being that way.
How
to find this mistake? All owners or partners of your client’s business should
identify any companies that they own or with which they have a financial
relationship. If any of these companies or relationships exist, the
requirements of the following Code sections should be scrutinized to ensure
that all required employees are included in the plan. These Code sections are
Code Sections 414(b), (c) and (m).
Going
on to how to fix this mistake. Generally, if your client did not provide an
employee the opportunity to participate in its SEP plan, your client must make
a fully vested contribution to the plan for the employee that compensates for
the missed contribution. The corrective contribution is an employer
contribution that is intended to place the employee in the same position had he
or she participated in the plan timely.
Again,
let’s take a look at an example. We have an employer who owns a restaurant that
has 40 employees. The employer also owns a computer store that has 30
employees. The employer established a SEP plan in 2007, and only the eligible
employees from the restaurant were included in the plan. Applying the control
group rules, the 30 employees of the computer store would be eligible employees
because the employer owns both the restaurant and the computer store. Because
the computer store employees were improperly excluded, they would have to
receive allocations using the contribution method described in the earlier
mistake regarding the eligible employees participating or an alternative
correction method that satisfies general correction principles in the EPCRS
Revenue Procedure.
Now
which correction programs are available for this mistake? This example would be
a significant operational problem, in that the employer improperly excluded all
of the computer store employees, almost 50% of his employees. Because this
example was a significant operational failure, Self-Correction is not available
for this mistake and the employer must go to Voluntary Correction or to Audit
CAP.
Again,
the same things apply under VCP. Correction would be the corrective
contribution to all excluded employees, file a submission to the IRS and pay
the fee of $250. Under Audit CAP correction would be the same. The employer and
the IRS would enter into the closing agreement, and negotiate a sanction based
on the maximum payment amount.
And
how would you advise your client on how to avoid making this mistake? I would
suggest that your client follow the steps described earlier in the earlier
mistake, mistake #2, and should include determining if all owners or partners
in your client’s business owned any other business. Again, just a yearly check
just to make sure everything is still running smooth.
Moving
onto the next mistake. Is your client determining each eligible employee’s
compensation using the definition in its SEP document? A plan’s definition of
compensation is very important in determining the amount of contributions
because they are often based on a percentage of compensation. Compensation
generally includes the pay an employee receives from your client for personal
services for a year including wages and salaries, fees for professional
services and other amounts received, whether it be cash or non-cash, for
personal services actually rendered by an employee. The amount of compensation
taken into account under the plan cannot exceed $245,000 in 2012, and is
subject to the cost-of-living adjustments for later years.
Your
client must follow the definition of compensation stated in the plan document
in the operation of the plan. And that’s very important. If you’ve seen some
prototype adoption agreements, sometimes there’s 10 or more items listed in
what can be or cannot be included in compensation and it’s very important that
your client follows and knows what’s stated in the plan so that he or she can
do the same thing operationally.
How
to find this mistake? To determine if your client is using the proper
compensation for allocations, you’ll need to refer to the plan document. Spot
check allocations to see if your client is using the correct compensation. Some
of these definitions get very complicated, as I mentioned, with expense
reimbursements, car allowances, bonuses, commissions, overtime pay that is
included or not included in the definition of compensation.
If
the plan has a complicated definition of compensation, our suggestion is
develop a worksheet to calculate the correct amounts. If your client is using
the Form 5305-SEP, make sure he’s basing allocations on total compensation.
Going
on to fixing this mistake, your client would have to make a corrective
contribution, including earnings, for the affected employees. Again, another
example. We have an employer who operates a restaurant with 15 employees. Under
the terms of a SEP document, compensation for determining allocations of the
employer contribution is defined as total wages earned, including bonuses, tips
and other income reported on the form W-2. Since the inception of the plan, the
employer included bonuses and other income for the contribution allocation, but
did not include tips. So, the employer should correct the allocations using the
same contribution method discussed earlier in the eligible employees
participating mistake.
Which
correction programs are available for this mistake? This example illustrates an
operational problem, in that the employer failed to follow the plan’s
definition of compensation by not including tips, and used an incorrect amount
to determine allocations under the plan. Therefore, if the other eligibility
requirements of SCP are satisfied, the employer can use Self-Correction to
correct this mistake. Again, remember there are no fees and the employer must
have practices and procedures in place.
The
VCP correction is the same and all of the procedures are the same and the same
$250. Under Audit CAP, the correction is the same and remember they would just
enter into a closing agreement and negotiate a sanction based on the maximum
payment amount.
Finally,
how to avoid this mistake? Three easy words: Read the plan. But when
calculating these allocations, it’s important for your client to review the
terms yearly to ensure it’s using the correct amounts of compensation. And we
have seen some software out there that can put it in the payroll program and
creates an account that accumulates the proper compensation figures for plan
purposes.
The
last potential mistake is: Are SEP contributions to each employee’s IRA limited
as required by the Internal Revenue Code? All SEP contributions are employer
contributions. Section 415 of the Code limits the amount of contributions made
to an employee’s SEP-IRA to the lesser of $50,000 in 2012, and again, remember
that’s subject to the cost-of-living adjustments for later years, or 25% of the
eligible employee’s compensation. The amount of compensation taken into account
is limited to $245,000 for 2012, and, again, subject to cost-of-living
adjustments in later years.
Now
if the SEP plan document specifies lower contribution limits then the lower
limits control. Let me repeat that, because it’s very important. If the SEP
plan document specifies lower contribution limits, the lower limits control.
There
are special rules if an individual is self-employed. When calculating the
deduction for contributions made to a self-employed individual’s SEP-IRA,
compensation is the individual’s net earnings from self-employment, which is
reduced by both the deduction for half of his or her self-employment tax and
the deduction for contributions to his or her own SEP-IRA. For this reason, you
determine the deduction for contributions to a self-employed individual’s
SEP-IRA indirectly by reducing the contribution rate called for in the plan.
For
more information on the deduction limitations for self-employed individuals,
see our Publication 560, which is called, “Retirement Plans for Small
Businesses, (SEP, SIMPLE, and Qualified Plans).”
How
to find this mistake? The easy way, calculate 25% of each employee’s
compensation, and compare the total contribution made for the employee to the
lesser of that amount or the dollar limitation for that year; again, $50,000
this year. The not-so-easy way, unfortunately, is to review the special
calculations in the Publication 560 for the self-employed individuals.
How
to fix this mistake? There are two methods to correct excess employer
contributions to employees. The first one is called the Distribution of Excess
Amounts Method. The plan sponsor may affect the distribution of the excess
amount, adjusted for earnings through the date of correction. The earnings
adjustment is based on the actual rate of return of the SEP-IRA from the date
the excess employer contribution was made through the date of correction. The
amount returned to your client is not includable in the gross income of the
affected employee. The plans sponsor would not be entitled to a deduction for
the excess contribution. Report the amount returned on Form 1099-R as a
distribution issued to the affected employee, indicating the taxable amount as
zero.
The
second method is called the retention method and the amount in excess of the
415 limit may be retained in the SEP-IRA. This correction method is available
under VCP and requires an additional fee. The fee is equal to at least 10% of
the excess amount, excluding earnings. The excess amount, adjusted for earnings
through the date of correction must reduce the affected employee’s 415 limit
for the year of correction and subsequent years until the excess is eliminated.
Again,
an example. An employer maintains a SEP plan. For the 2007 year, the
contributions made for two employees, Tom and Will, exceeded the 415 limit. Tom
had an excess of $3,000, and Will had an excess of $300. On January 1, 2008,
Will terminated his employment. Which correction programs are available for
this? Thinking back to the example, this illustrates an operational problem in
that this employer failed to follow the terms of the plan by exceeding the 415
limits in the plan document and in the Code.
Therefore,
if the other eligibility requirements of SCP are satisfied, the employer can
use SCP to correct the failure by using the distribution of excess amounts
correction method only. There would be no fee for the self-correction, and
again, you have to have the practices and procedures in place.
Under
VCP, correction under the distribution of excess amounts method is the same.
The employer would make a VCP submission to the IRS and pay the VCP submission
fee of $250.
Now,
if your client chooses to make correction under the retention method by
retaining the excess amounts in the SEP-IRA, the EPCRS Rev Proc imposes an
additional fee equal to at least 10% of the excess amount, excluding earnings,
in addition to the $250 submission fee. If it would happen to go under Audit
CAP, correction could be the same. There would be the closing agreement
negotiation based on the maximum payment amount.
How
to avoid this mistake? After the employer makes the initial calculation of
allocations based on the terms of the plan, your client should check to make
sure none of the proposed allocations would violate Code Section 415. Make the
calculation based on the plan language, check this against the 415 rules before
the actual allocation is made to the SEP. If there is a problem, your client
can adjust it before the transfer of the money into the SEP accounts.
I
have been talking a lot about the COLA increases. If you go to our main page,
again, www.irs.gov/ep, we do have the COLA limits on there for every year.
On
the next slide of the handout, I provided other SEP products that we have
besides the Fix-It Guide. The first one is Publication 4333. It is called “SEP
Retirement Plans for Small Businesses.” This is a joint publication with the
IRS and the Department of Labor. It has been revised. October 2009 is the
latest revision date. In here it gives you and your client some things to read
about. For instance, advantages of a SEP, how to establish, how to operate the
SEP, and if need be, how to terminate the SEP. It also gives some quick
checklists, talks a little bit about mistakes. Also gives other resources that
the IRS and the Department of Labor have on SEP plans. And it also includes the
model 5305-SEP Form that we discussed with that December 2004 revision date.
Everything you want to know about a SEP but were afraid to ask.
The
item on the right is a SEP checklist. It is important to review the
requirements for operating a SEP every year. And this checklist has been
designed as a diagnostic tool to help you and your clients keep the SEP in
compliance with important tax rules.
Now
this is kind of like the top 10 list. What I discussed today were the top five
errors, so there are some on here. For instance, have you made required
top-heavy minimum contributions to a SEP, and other ones, and they have yes or
no answers. This can be completed online, and if it is, some key terms are
underlined, and they provide links to a more detailed explanation of that item.
If
there is a “no” answer to any of the questions, there may be a mistake in the
operation of the SEP and we actually go to the Correcting Plan Errors Web page
and I’ll discuss that in a minute.
Now
when you and your client find a mistake, a decision has to be made on what to
do next. If you notice if you have the handout, the gentleman there is thinking
Self-Correct, VCP or do nothing. Hopefully, it’s never do nothing. I’ve
provided an overview of the three components of EPCRS earlier. I also gave you
several examples on when and how to use each one. For more information on
EPCRS, please visit our Correcting Plan Errors Web page. You’ll also find this
link on our main page, but the link is located on the top left portion of the
main page under the heading Retirement Plans Community Topics. On this page you
will find that is new in EPCRS, a detailed explanation of the three components,
tips on finding, fixing and avoiding plan errors and other resources available
to you. And there is no truth to the rumor that we automatically audit only
plans where the plan sponsor practitioner bookmarks this page.
Now
there are two different ways you can discuss your questions with a retirement
plan specialist. If we cannot get to your questions today, for example, you can
call our Customer Accounts Services toll-free at (877) 829-5500. The call
center’s hours are from 8:30 to 4:30 p.m. Eastern Time. Or if you prefer, you
can e-mail your questions and the e-mail address is
retirementplanquestions@irs.gov. Our specialists must respond to all e-mail
questions by telephone, so please remember to include your phone number and a
customer service representative will call you with the answer to your
questions.
Finally,
we have two free, quarterly electronic newsletters you can subscribe to. The
first one is Employee Plans News. This newsletter is geared toward the
practitioner community and is more technical and involved than our newsletter
geared to our plan sponsors, Retirement News for Employers. Being a Web-based
product, the newsletters make an excellent reference guide as we fill them with
embedded links and source materials. And it gives you the latest and greatest
that we’re finding in [the] world of exam, rulings and agreements and voluntary
compliance.
Subscribing
to these newsletters will keep you and your clients current with the latest
news. Just go to “Newsletters” in the left- hand of our Web page, again, under
the heading of “Retirement Plans Community Topics.” Click on “Employee Plans
News” or “Retirement News For Employers.” You can subscribe to both if you
wish. Click on “Subscribe” and then provide the e-mail address and that’s all
it takes. You will receive a message in your inbox with a link directing you to
the newsletter when we post our latest issue. Again, it’s only a link. We won’t
fill your inbox with a large PDF document. We’ll take you to the link, we’ll
take you to that, because we know how some of the inboxes can get.
Questions and Answers
The
first is, “Can a customized SEP
exclude non-union employees, but include union employees?” There are
two points I need to make on this one. First, I strongly recommend regardless
of what your desire is, please do not customize SEP documents. The reason for
this is any time you change the terms—if you’re using the IRS form 5305, or you
change the terms of that form, or an IRS pre-approved plan document, you no
longer have reliance on that document. So basically you’ve taken that cushion
away of having IRS reliance on the plan document that you’re using to govern
your plan. So that right away could jeopardize the tax-favored status of your
plan as a whole, so recognize that risk.
This
particular question can be an illustration of why customizing plan documents
creates these problems. If you change the plan document to say I’m going to just
include union employees and exclude non-union employees, what you are doing is
basically, you’re excluding a class of employees for which whom you are not
allowed to exclude in the first place under the qualification requirement for
SEP. Remember when Mikio made his presentation earlier, he said that there were
certain excludable classes of employees, people who ….meet the age requirement
or didn’t work for a certain number of years, like three of the last five
years, people whose benefits were collectively bargained for. That is your
union employees, or your non-resident aliens with no U.S. income. These are
your only excludable classes of employees. So once you come to exclude any
other group, members of any other group aside from your excludable classes of
employees, your SEP is no good. So that’s one of the perils of customizing a
SEP document.
Related
question, “Can SEP model agreement be
amended in a subsequent year to increase the years of service performed for
eligibility purposes? For example, in the initial plan year, one-year prior
service is required and this would be increased to two prior years of service
in a subsequent year.” As long as you’re sticking within the parameters
of your SEP document, meaning it might provide certain blanks, such as you
could have an age requirement and then you can say perform service for blank
number of years not to exceed three and you select that option. What you’re
doing is, you’re changing that option but you’re sticking with the parameters
of that plan document. Yes, you should amend your plan document if you’re
changing the requirements and that amended plan document needs to be signed.
So
in a particular scenario where you had a service requirement which said that
the individual should have worked in one of the previous five years, you have
to stick with that requirement. And then if you want to change it going forward
to do something more stringent, such as having worked two of the prior five
years, then you can change the terms. You adopt a new adoption agreement or a
new 5305 first and then go ahead and implement those terms. You should always
administer the plan in accordance with the terms of your plan document with
that is, Form-5305 or an adoption agreement tied with a pre-approved plan.
Next
question, “A self-employed person with
no employees established a SEP over 20 years using IRS Form-5305. The same
person established a 401(k) plan when some solo K plans started becoming
popular a few years ago. The person did not realize that having both a SEP and
a qualified plan is not allowed when you’re using the Form-5305. Contributions
are made to both plans, 415 limits were not exceeded. How can this be corrected
through a Voluntary Compliance Program submission?” Here’s a case where
we may be able to help. What we might do, for example is, we might consider the
possibility of allowing the plan sponsor to correct the problem by
retroactively adopting a financial institution’s pre-approved document because
that pre-approved document may have parameters, which would allow two plans to
co-exist with each other. So you’re not a violating a set rule per se, you’re
just constrained by a plan document that didn’t allow you to have another plan.
So
in that particular situation, we might consider the possibility of adopting a
new document that could accommodate that variation. And that way the employee
might be able to preserve his pre-tax benefits in both plans. So that’s a
possibility. Now if you do that, again, as we point out, it has to be in the
context of a Voluntary Compliance Program submission. You could do that on your
own without IRS approval.
Next
question, “If you have a partnership
with a SEP and also have a Schedule C, do you have two SEP investment accounts
if you’re relying on income from both to maximize the SEP or can you contribute
to the partnership SEP account for that individual?” The general answer
is if you have two separate employers, then each employer would be sponsoring
its own SEP. However, be cognizant of the following. If both your entities,
your partnership and your employer and your sole proprietorship are members of
the same control group or some of your service groups if you remember in
Mikio’s presentations earlier about the business entities and referring to
Sections 414(b), (c), (m), those are the factors you would need to consider and
take into account for determining whether you have a controlled group or an
affiliated service group.
And
then you have the case where both of these are really a single employer and it
would be a single SEP. Once you do that then, all employees of both entities
need to be considered for purposes of who’s includable in that SEP. So be aware
of that, but otherwise if you have two separate entities, each entity would
have its own SEP.
Another
scenario, “Sole practitioner has a
child working for him during the summer. The child has worked three of the last
five years and over the $550. Child …..is working in August 2009 to
return to school. Child turns 21 in November 2009 after he’s been working for
the employer. Does the child need to have a SEP contribution for 2009?” And
really what you do is you look at the situation as of the end of the year when
the allocations are being made. So as of the end of 2009, what are the two
requirements for participation then? He clearly met the work requirement. He
worked for three of the last five years. He made $550 during the year and also
during the year, the child obtained age 21. So all of the conditions for
participation were met. Therefore, the child would be entitled to an allocation
of the contribution.
I
know these get confusing because you have situations where you have
intermittent people who could work for part of the year and are not employed as
of the last day of the plan year. But you can’t have the last day of the plan
year conditions for a person receiving an allocation. So basically, you’re just
taking the snapshot as of the time the allocation is made and if you look and
you see both conditions are satisfied, then that person would be entitled to an
allocation.
Next
one, “An employer has been
contributing to a SEP for several years. Early in 2012 this employer realized
that an employee became eligible in the prior year. How would the catch-up
contributions, if you will, be made to this employee’s IRA? What is the tax
treatment in the year of the payment to both the employer and the employee?”
So here you have a situation where you have an employee who in 2009 was
eligible for an allocation of the SEP contribution, but didn’t receive that
allocation. So in that particular scenario, what you have is a failure to make
required contributions on behalf of an eligible employee.
One
possible option is you could use the Voluntary Correction Program and propose a
solution of making up the required contribution on behalf of the erroneously
excluded employee, plus earnings. And if we approve your correction, we issue a
compliance statement. And then you could show that compliance statement to the
financial institution and the financial institution would probably accept contributions
on behalf of the employee for both the prior year, as well as whatever is due
in the current year. And then tax consequences would be probably be something
along the following lines.
The
employer could claim deductions for the year in which the corrective
contribution is made, but it’s subject to the deductible limits for the current
year. So you have to take into account the current year deductible limits when
you’re figuring out how much the employer could deduct. So now you can have a
situation where the required contributions actually cause the plan to exceed
the deductible limit for the plan year. The result would be that your
nondeductible contributions, because you have to make those contributions in
order to keep your SEP qualified, but those excess contributions are subject to
excise taxes under Section 4972 of the Code. What you might want to do in that
situation is, you may as part of your application under VCP want to ask for
relief from the imposition of that 4972 excise tax because what the EPCRS
revenue procedure allows you to do is in situations where a corrective
contribution is required on behalf of employees as a part of a successful VCP
submission, those situations where you exceed the deductible limit as a result
of that, the service would entertain the prospect of approving relief from the
imposition of the 4972 excise tax, because we want you to make that corrective
contribution. Of course, you are still consigned to the deductible limits, as
far as how much you actually deduct. But at least you get relief from the
excise tax piece.
Next
one, the question is, this is a two-part question, so actually what I’ll do is,
I’ll do the second part first. Okay, here’s the total question. “I would like to know if A) must leased
employees be counted as an employee for purposes of the SEP plan or are they
counted from who gives them their paycheck?” Let’s deal with this first
part first. Generally, a leased employee is counted for purposes of determining
if he’s an employee of the employer and therefore should participate in the
employer SEP.
Having
said that, though, there’s actually a precise definition for who a leased
employee is. And so what I would encourage you do to is look at, if you’re
looking at Code sections, look at section 414(n). If you are comfortable with
Pubs, look at the definition of leased employee and publication 550. It has a
real precise definition of who a leased employee is. So if you look at that
definition, that class of leased employees are includable in that employer’s
SEP plan. I won’t get into the angles of the definition of a leased employee
because that would be too complicated to talk about in this setting. So just
look at that definition and see if your leased employees fit within that
classification. And again, you could look at publication 560. I think it’s on
the third page of publication 560. Or if you are comfortable with going to the
Code, look at section 414(n) of the Code.
Then
the second part of the question is, “Would
intermittent employment count for purposes of the SEP plan and if so, is there
an amount any particular employee must make before they are eligible, like
SIMPLE IRA plans are?” So there are many pieces to this question. First
of all, in a SEP plan, you don’t have elective …deferrals, so you don’t have
employee contributions like you would in the case of a SIMPLE IRA plan. And as
far as intermittent employment goes, generally the answer would be yes because
all it takes, assuming the employee has met the age requirement, which would be
21 and worked [up to] three of the prior plan years, all it takes is a $550
compensation level in order for the employee to eligible. So you can have an
employee who worked for a relatively short period of time become eligible to
participate in your SEP plan. It doesn’t take too much time to earn [$550 in]
compensation. So the general answer to that would be yes, intermittent
employees would also be considered in your SEP plan. Both leased employees, as
well as intermittent employees would be considered for your SEP plan.
The
next one, “Regarding farmers who have
a March 1st filing deadline, if they file by March 1st, can they still pay into
a SEP by October 15th or do they have to be on extension to have the extended
contribution period? You have to contribute before filing.” ….
Extensions should have been filed in order for an employer to have an extended
contribution period. So if an employer actually files his return by the
original deadline and does not file for an extension, then you don’t have the
benefit of the extended period for purposes of making the SEP contribution.
Then you’re stuck with the original due date. So in order for the employer to
get the advantage of the extended due date, the employer actually has to file
an extension as opposed to just filing the return in order to make the required
contribution.
But
you could have a scenario, for example, where, say on March 1, you file the
extension. And so now that extends you to that extended due date. But then you
actually file your return before then. As long as you file the extension, you
can then take advantage of the extended due date for purposes of making the
actual required contribution to your SEP. So really it’s tied to whether you
file the extensions or not and then that will determine whether you can take
advantage of the extended due date.
This
one says, “Could you please explain
the multiple plan contribution algorithm? Most examples only deal with the SEP
being the single plan that the participant is a part of. The multiple plan
explains how one can contribute up to 100% of their earnings if they have
contributed to and a defined contribution plan, but haven’t exceeded the maximum
allowable contribution of $50,000.”
Okay, what this is talking about,
this is based on section 415 of the Internal Revenue Code. This is a total
limit for the employee. So you could have a situation where the employer has
multiple plans. What this represents is a total limit of what the employee
could receive under all defined contribution plans, including SEPs in a given year.
The limit is not just restricted to employer contributions, but a term called
annual additions. So the annual additions include both employer contributions,
as well as employee contributions and the third category called forfeitures. So
the sum of employer contributions and employee contributions and forfeiture
allocations made on behalf of the employee to all defined contributions
including a SEP in a given year cannot exceed the lesser of 100% of earnings or
the $50,000 limit. So it’s an overall limit.
And
so the practical impact of this is as follows.
If you just have a SEP standing
alone, the employer is probably constrained with respect to a particular
employee by the 100% of compensation or $50,000 limit, because there are no
other plans to coordinate with. Now if the employer also sponsored some other
defined contribution plans in which that employee is a participant, in that
situation what you have is a scenario where you would need to take into account
contributions made to those other plans.
So,
for example, if an employer also has a profit-sharing plan, and they make
$10,000 of contributions to that profit-sharing plan, and assuming there’s no
other contributions, then in your SEP, that limit is going to be reduced. And
let’s assume for the sake of simplicity that we’re talking about a $50,000
limit here and assuming that’s less than 100% of the compensation. And $10,000
is [contributed] to the profit-sharing plan, then your contribution limit to
the SEP is reduced from $50,000 to $40,000. So just recognize that this is an
overall limit that applies to the employee for contributions to all defined
contribution plans. And when we were talking about that, we’re not just talking
about employer contributions, but also employee contributions and forfeiture
allocations. So that’s what the multiple plan contribution requirement is.
End
of Question and Answers
