SEP

I am writing pursuant to our recent conversation in which you requested that I supply you with information concerning the federal income tax treatment of Simplified Employee Pensions (SEPs).

1. In General

Congress enacted the SEP rules to provide a simplified, cost-effective means for employers to provide retirement benefits for their employees (and for employees to save for their own retirement) where the employer does not wish to incur the costs and the administrative burdens associated with maintaining a traditional tax-qualified retirement plan.

A SEP is treated as a defined contribution plan, in that it has individual accounts for each participant. Under a SEP arrangement, the employer contributes to individual IRAs for covered employees. Self-employed individuals are treated as employees for this purpose. Employees may also make their own IRA contributions to these accounts. As in the case of qualified plans, employer contributions, subject to certain limits, are deductible when made, but employees need not include their benefits in gross income until they receive them. SEP assets, like qualified plan assets, grow tax-free.

Unlike traditional qualified plans, however, SEPs are subject to certain simplified qualification and reporting requirements that make them easier to administer, although some what less flexible, than qualified plans. SEPs are often maintained under model arrangements between employers and banks or similar institutions which act as SEP custodians. Where a model SEP meets the employer's needs, all the employer has to do is execute the applicable form and open the relevant accounts. No IRS application for approval is necessary if the employer uses the IRS' model language. Further, when the tax law changes, generally the bank or other custodian will make sure that the proper changes are made to the plan, again sparing the employer the cost of applying for a new IRS ruling.

2. Qualification Requirements

As indicated above, a SEP is, basically, an arrangement that includes individual retirement accounts or individual retirement annuities for covered employees and satisfies certain requirements. SEPs may be maintained on a calendar-year basis or on the basis of the employer's taxable year. A SEP must cover any employee who, for the year, has attained age 21 and has performed any service for the employer during at least three of the immediately preceding five calendar years, provided the employee received at least $300 (as adjusted for inflation) in compensation from the employer for the year.

Contributions to a SEP may not discriminate in favor of highly compensated employees. For this purpose, employees covered by a union contract or nonresident aliens without U.S. source earned income for the year may be disregarded.

All SEP contributions must be fully vested when made. Thus, when an employer wishes to tie vesting to the performance of future services, a SEP may not be suitable.

SEP contributions must, generally, bear a uniform relation to the compensation of all covered employees. For this purpose, only the first $150,000 (as of 1994 and adjusted for inflation thereafter) of an employee's annual compensation is considered. A SEP may be integrated with Social Security in the same manner as a regular defined contribution plan, but integration may not be taken into account in determining whether the actual deferral percentage (ADP) tests are met for a salary reduction SEP (discussed below).

If more than 60% of a SEP's assets go to certain highly paid individuals known as "key employees," the qualified plan "top-heavy" rules will apply to it. Since a SEP is treated as a defined contribution plan, the employer will have to satisfy the requirements for top-heavy defined contribution plans. Generally, a SEP will satisfy these requirements where each non-key employee who participates receives an annual contribution that is at least equal to 3% of his salary or, if the key employee who receives the largest contribution under the plan expressed as a percentage of compensation receives less than 3%, such lesser percentage.

A SEP must permit withdrawals of employer contributions by employees; the employer contribution must not be premised upon an employee's leaving these amounts in the SEP. SEP contributions must be made pursuant to a written allocation formula in the plan document.

SEP distributions are generally subject to the same rules as apply to IRAs. Thus, certain early distributions may give rise to a 10% penalty tax in addition to the regular income tax. SEP distributions, like IRA distributions, are not eligible for favorable forward averaging treatment, but can be rolled over to certain qualified recipient plans.

The limit on annual additions to an employee's SEP account is effectively the lesser of $30,000 or 15% of the employee's compensation from the employer included in gross income for the employer's taxable year (determined without regard to the SEP contribution). Employers maintaining SEPs may contribute up to 15% of participants' salary on a deductible basis. Contributions made up to return filing time including extensions may relate back to the previous taxable year if they are so designated on the employer's tax return.

3. Salary Reduction SEPs (SARSEPs)

Before January 1, 1997, certain small employers could establish SEPs that are funded with employee salary reduction contributions, called "SARSEPs." An employer could only maintain a SARSEP if at no time during the preceding year it had more than 25 employees and if 50% or more of its employees elected to make salary reduction contributions.

In general, SIMPLE plans have replaced SARSEPs after December 31, 1996. If your business established a SARSEP before January 1, 1997, however, it can continue to make contributions under the SARSEP rules, and employees hired after December 31, 1996, can become participants in such a preexisting SARSEP and be covered under the SARSEP rules. A business, however, cannot establish a new SARSEP after December 31, 1996. Further, since a SARSEP is a type of employer-sponsored retirement plan, an employer cannot maintain both a SARSEP and a SIMPLE plan.

Salary reduction deferrals under a SARSEP are subject to "actual deferral percentage" limits similar to those that apply to §401(k) cash or deferred arrangements. These rules are somewhat more stringent when applied to a SARSEP than to a §401(k) plan, however.Where contributions in excess of these limits are made to the accounts of highly compensated employees, they may be distributed in a correcting distribution under rules similar to those that apply to §401(k) plans.

Elective deferrals under a SARSEP are subject to the Code's annual dollar limit on elective deferrals that applies to §401(k) plans. Section 401(k)401(k) salary reduction deferrals for the year by the employee reduce this limit dollar-for-dollar.