Description/Scope

3.3 Reporting Requirements

3.4 Examination Steps

(These proposed guidelines were announced in IRS Announcement 9742, 1997-17IRB 19.)

These issues all relate to the qualification of, contributions to, and distributions from Simplified Employee Pensions (SEPs), as defined in section 408(k) of the Internal Revenue Code of 1986.

These guidelines are not intended to be all inclusive; consequently the techniques identified may be modified based on the actual examination issues encountered. It is expected that the guidelines will help the examining specialist decide on which areas to concentrate and what issues to raise with respect to the particular SEPs. Given the purpose of these guidelines, they cannot be, nor are they intended to be a precedential or comprehensive statement of the Service's legal position on the issues covered herein. They are not to be relied upon or cited as authority to taxpayers. These guidelines are being issued for the sole purpose of assisting the examining specialist in performing an examination of certain issues for which it was believed guidelines would be helpful. It is not expected that each issue discussed in these guidelines will be relevant in every examination.

(1) New Law Changes: These guidelines do not provide guidance on the Small Business Job Protection Act of 1996 (SBJPA). For example, the SBJPArepealed SARSEPs; no new SARSEPs can be established after December 31, 1996. However, SARSEPs established prior to January 1, 1997 can continue to receive contributions under present law rules.

(2) Section 408(k) of the Internal Revenue Code governs the Simplified Employee Pensions (SEPs) requirements. A SEP is a written arrangement (a plan) that allows an employer to make contributions towards its employees' retirement without becoming involved in more complex retirement plans.

(3) A self-employed individual may also establish a SEP for himself/herself and his/her employees. The contributions are made to Individual Retirement Arrangements (IRAs) of the plan participants. Under a SEP, IRAs are set up for each qualifying employee. lRAs may have to be set up for leased employees. They do not have to be set up for excludable employees. These terms are defined below.

(4) A SEP must provide total coverage, meaning that each and every employee who satisfies the definition of "qualifying employee" must be covered.

1.1.2 Written Arrangement

(1) The SEP must be part of a written arrangement. Contributions to the SEP must be made under a definite written allocation formula. The formula must specify the requirements an employee must satisfy to get an allocation and the manner in which the allocation is computed.

(1) An employer may use Form 5305-SEP, Simplified Employee Pension-Individual Retirement Accounts Contribution Agreement, or Form 5305A-SEP, Salary Reduction and Other Elective SEP-IRAs Contribution Agreement, to satisfy the written arrangement requirement for a SEP. See subsection 2.3 for a further explanation on SAR-SEPs.

(2) Form 5305-SEP is a Model SEP. In completing the agreement, the employer agrees to provide benefits for all employees under a SEP described in IRC 408(k). This form is not filed with the Service but is retained in the employer's records.

(3) Generally, this form may not be used by an employer who -

a. Maintains any other qualified retirement plan;

b. Has ever maintained a defined benefit plan, even if now terminated;

c. Has eligible employee(s) who have not established an IRA; or

d. Uses the services of leased employees, or is a member of an affiliated service group.

(4) For additional information on Model-SEPs, refer to Form 5305-SEP and instructions.

(1) Alternatively, an employer may use an individually designed plan to establish the SEP. See IRC 408(k)((5) and Prop. Reg. 1.408-7(b).

(2) An employer can request an opinion letter for a prototype SEP from the Service stating that a SEP agreement is acceptable in form. See Rev. Proc. 87-50, 1987-2 C.B. 647.

(1) The terms relating to SEPS are defined below.

(1) A self-employed individual is an employee for SEP purposes. He/she is also the employer. Even if the self-employed individual is the only qualifying employee, he/she can have a SEP-IRA. See IRC 408(k)(2) and Reg. 1.408-7(d)(2).

(2) A qualifying employee is one who:

a. is at least 21 years old

 

b. has worked for the employer during at least 3 of the 5 years immediately preceding the tax year, and

 

c. has received from the employer at least $400 (in 1996) in compensation for the tax year.

The amount of compensation is indexed and subject to yearly adjustments. See IRC 408(k)(8).

(3) An employer can set less restrictive participation requirements for its employees than those listed, but not more restrictive ones.

(1) The person or firm for whom services are performed may have to include in a SEP plan any "leased employee" who is treated as an employee of the recipient. A leased employee is any person who is not an employee of the recipient and who is hired by a leasing organization, but who performs services for another (the recipient of the services). See IRC 414(n).

(2) An employee is a leased employee if:

a. services are provided under an agreement between the recipient and the leasing organization,

 

b. services are performed for the recipient or the recipient and related persons on a substantially full-time basis for a period of at least one year, and

 

c. the services are of a type historically performed by employees in the recipient's field of business.

 

(1) The following employees can be excluded from coverage under a SEP. See IRC 408(k)(2).

a. Employees covered by a union agreement and whose retirement benefits were bargained for in good faith by their union and their employer, and

 

b. Nonresident alien employees who have no U. S. source earned income from their employer.

 

(1) Check if the employer has a written plan document, such as Form 5305-SEP, and see if there is any approval letter issued by the National Office.

(2) Does the plan document contain provisions relating to (a) participation requirements (e.g., age and service), (b) contribution/allocation formula (c) top heavy minimum contribution requirements, etc?

(3) Are there resolutions, minutes, and any other documentation relating to the original adoption, subsequent amendment or termination amendment relating to the SEP document?

(4) Determine if any other plans are maintained by the employer. Verify filing of any Form 5500 series return, and applicable schedules (if any).

(5) Determine if any other plan was ever maintained by the employer, and if so, develop information as to plan type, effective date and date of termination, if applicable.

(6) Check the payroll records and census information used to determine employees eligible to participate in the plan. Check, if available, dates of birth, hire, participation, and termination and any reason for non-participation, if applicable. Insure that all employees who were required to receive contributions did so.

(1) Contributions to a SEP must be made for all employees who satisfy the definition of "qualified employee". Unlike qualified plans, there are no exclusions or percentages of employees that have to be covered. All qualifying employees must be covered, and receive the appropriate contribution.

Note: The SEP plan under which contributions are made can be set up after the close of the year for which contributions are made. However, the plan must exist at the time the contributions are made and they must be made within the time limit.

(1) To deduct contributions for a year, the employer must make the contributions not later than the due date (including extensions) of the employer's return for the year. See IRC 404(h)(1).

(2) Contributions to a SEP are discretionary, i.e., the employer who signs a SEP agreement is not required to make contributions to the SEP-IRAs. But if the employer does make contributions, the contributions must be based on a written allocation formula and must not discriminate in favor of highly compensated employees (HCE). See IRC 408(k)(5).

(1) A HCE is an employee who during the year or preceding year:

a. owns more than 5% of the capital or profits interest in the employer (if not a corporation); or more than 5% of the outstanding stock or more than 5% of the total voting power of all stock of the employer corporation;

 

b. received annual compensation from the employer of more than $100,000 (for 1996);

 

c. received annual compensation from the employer of more than $66,000 and was a member of the top-paid group (20%) of employees during the year;

 

d. is an officer whose annual compensation exceeds $60,000 (for 1996). See IRC 416(i).

 

(2) The dollar amounts in items b., c., and d. are indexed annually. See IRC 408(k)(8).

(1) An employer may contribute and deduct each year to each participating employee's SEP-IRA up to 15% ofthe employees' compensation. See IRC 404(h)(1)(C).

(1) For purposes of determining the 15% limit, compensation is generally limited to $150,000, not including the employer's contribution to the SEP-IRA. See IRC 408(k)(3)(C).

(1) All employees must receive the same (uniform) rate of contribution. However, a rate of contribution which decreases as compensation increases is considered uniform. See IRC 408(k)(3)(D) and 401(1) and the regulations thereunder.

(2) The only exceptions to this rule are --

a. the dollar limits that apply to all contributions to a defined contribution plan under IRC 415(c), and

 

b. any applicable limits (permitted disparity) allowed under IRC 401 (l).

 

Example 1: John's employer has a SEP for its employees. John's compensation, before his employer's contribution to John's SEP was $160,000. John's employer can contribute up to $22,500 (15% x $150,000) to John's SEP-IRA.

 

(3) Except in the case of salary reduction SEPS (SAR-SEPs, discussed below), the plan formula may take into account permitted disparity (integration). Because SEPs are considered to be defined contribution plans, the limits of IRC 401(1)(2) apply. Thus, in general, the present permitted disparity for a plan that uses the social security wage base as the integration level is the lesser of 5.7% or the base contribution percentage.

a. The plan formula must specifically state the integration level, i.e., the level of compensation at which the rates of contribution change.

 

Example 2: The plan formula for the SEP-IRA established by John's employer provides for an 8% contribution of each participant's total compensation (compensation both above and below the integration level, i.e., the wage base). The plan also provides that each participant who has "excess compensation," income in excess of the integration level, will receive an allocation of 5% of the amount of excess compensation. The base contribution percentage is equal to 8%. The excess contribution percentage is equal to 13% (8% plus 5%). Because 13% exceeds the base contribution by not more than 5.7%, this formula satisfies the permitted disparity requirements. In addition, because the formula does not exceed 15% of compensation, it satisfies the overall limits for SEP-IRA contributions.

 

(1) Special rules apply for a self-employed individual when figuring the maximum deduction. See IRC 401(c)(2)(A)

a. For determining the 15% limit on contributions, compensation means "net earnings from self-employment".

 

b. "Net earning from self-employment" for SEP purposes means gross income (net earnings) from his/her business minus allowable deductions for that business.

 

c. Allowable deductions include contributions to employees' SEP- IRAs. It also takes into account the deduction allowed for one-half of the self-employment tax and the deductions for contributions to his/her own SEP-IRA.

 

(2) For a detailed description on the deduction limitations for self-employed individuals, see the Examination Guidelines for Self- Employed Individuals, and in particular the discussion under deduction limits for one defined contribution plan. In addition, Publication 590. Individual Retirement Arrangements (IRAs), contains a Worksheet that can be used to calculate the proper deduction amount.

(1) Net earnings do not include tax-free items (or deductions related to them) but do include foreign earned income and housing cost amounts.

a. Net earnings include a partner's distributive share of partnership income or loss (other than separately treated items such as capital gains or losses).

 

b. If paid for services to or for a partnership, net earnings include guaranteed payments to a limited partner. They do not include distributions of income or loss to a limited partner.

 

(2) For SEP purposes, net earnings must take into account the deductions for contributions to his/her own SEP-IRA. Because the deduction amount and the net earnings amount are each dependent on the other, this adjustment presents a problem.

a. To solve this problem, adjustments are made indirectly by, in figuring the maximum deduction, reducing the contribution rate called for in the plan.

 

(1) For a self-employed individual, the amount of the deduction allowed under IRC 404 is limited to the amount of net earnings from self-employment, as described above. The same limitation applies to the amount contributed. Thus, the amount of the contribution to the IRA is subject to the same limitation that applies to the amount allowed as a deduction.

(1) If an employer, who also maintains a SEP, contributes to a defined contribution plan, annual additions to an account are limited to the lesser of $30,000 or 25% of the participant's compensation.

a. For purposes of these limits, contributions to more than one such plan must be added. Since a SEP is considered a defined contribution plan for purposes of these limits, employer contributions to a SEP must be considered with other contributions to defined contribution plans.

 

(1) A SEP may include a salary reduction arrangement. Under the arrangement, employees may elect to have the employer contribute part of an individual's compensation to his/her SEP-IRA. Only the remaining portion of the compensation is currently taxable. Rules similar to, but not identical with, IRC 401(k) apply to these salary reduction arrangements. See IRC 408(k)(6).

(1) Form 5305A-SEP can be used by an employer to set up such an arrangement. If the SAR-SEP is individually designed, it must have language that satisfies IRC 408(k)(6). The Service has provided a Model Amendment for prototype plans that satisfies the IRC 408(k)(6) requirements. See Rev. Proc. 91-44, 1991-2 C.B. 733.

(1) Elective deferrals can be chosen only if:

a. at least 50% of employees eligible to participate choose elective deferrals;

 

b. there were no more than 25 employees eligible to participate in the SEP at any time during the preceding year, and

 

c. the amount deferred each year by each eligible highly compensated employee as a percentage of pay is no more than 125% of all other eligible employees (ADP test). Generally, compensation in excess of $150,000 cannot be considered in figuring an employee's deferral percentage. See IRC 408(k)(6).

 

(2) Salary reduction allocation formulas CANNOT use permitted disparity.

(3) An elective deferral SEP arrangement is not available for a SEP maintained by a state or local government, or any of their political subdivisions, agencies or instrumentalities, or by a tax- exempt organization.

(1) In general, the total income that can be deferred under a salary reduction arrangement included in a SEP and certain other elective deferral arrangements is limited to $9,500 (for 1996; this amount is indexed annually). This limit applies only to the amounts that represent a reduction from the employee's salary, not to any contributions from employer funds. See IRC 408(k)(6)(A)(iv) referencing IRC 401(a)(30) which references IRC 402(g)(1) and (3).

(2) Elective deferrals, not exceeding the ADP test, made by the employer to the SEP-IRA are subject to the overall 15% of compensation limit (generally up to $150,000 for 1994-1996) or $30,000, whichever is less. See IRC 408(k)(6)(A)

(1) For purposes of determining if a plan is top heavy under IRC 416, elective deferrals are considered employer contributions. Elective deferrals may not be used, however, to satisfy the minimum contribution requirements under IRC 416. See IRC 416(i)(6).

(1) If the arrangement is a SAR-SEP, determine if the plan satisfies the deferral percentage of IRC 408(k)(6)(A)(iii); i.e., is the deferral percentage for each HCE less than or equal to the deferral percentage for the nonhighly compensated employees (NHCEs) multiplied by 1.25%.

(2) Verify whether the appropriate dollar/compensation limits were met.

(3) Determine if all applicable Notices were provided, particularly in the case of (a) any excess contributions to HCEs, or (b) disallowed deferrals if the SEP failed to satisfy the 50% test.

(4) Determine if the SEP was top heavy, and if so, whether the appropriate contributions were made. Verify that elective contributions were not used to satisfy the top heavy minimums.

(5) See if the $150,000 compensation limits as well as any applicable 402(g) limits were met.

(1) An employer cannot prohibit withdrawals from a SEP-IRA.

a. An employer cannot condition contributions to a SEP-IRA on keeping any part of them in the account. See IRC 408(k)(4).

 

b. In a SAR-SEP, transfer or rollover of contributions is prohibited before a determination as to whether the deferral percentage test, (described above), has been satisfied. See IRC 408(d)(7).

 

(2) Distributions (withdrawals) from a SEP-IRA are subject to the IRA rules. They are subject to the same tax treatment on distribution, tax-free rollovers, required distributions and income tax withholding, as any other IRA.

IRS Publication S90 provides an overview and some detailed information on IRA distributions.

(1) The employer is required to report excess SEP contributions in the manner described in Notice 89-32 1989-1 C.B. 671. This Notice modified Notice 87-77, 1987-2 C.B. 385 and Notice 88-33, 1988-1 C.B. 513. See also, Rev. Proc. 91-44, 1991-2 C.B. 735.

(1) Elective deferrals by a HCE must satisfy the deferral limitation percentage under IRC 408(k)(6). Amounts in excess of the deferral percentage limits will be deemed excess SEP contributions on behalf of the affected HCE(s). See IRC 408(k)(6)(C) referencing IRC 401(k)(8).

(2) The employer must notify each affected HCE within 2-1/2 months following the end ofthe plan year to which the excess SEP contributions relate, of any excess SEP contributions to the HCE's SEP-IRA for the applicable year. The notice must specify the amount of the excess SEP contribution, and the calendar year in which the contributions are includible in income and provide an explanation of applicable penalties if the excess contributions are not withdrawn in a timely manner. See IRC 4979(f).

(1) If more than half of the eligible employees chose not to make elective deferrals ALL elective deferrals made by all employees are considered "disallowed deferrals" i.e., they are not SEP-IRA contributions.

(2) The employer must notify each affected employee within 2- 1/2 months following the end of the plan year to which the disallowed deferrals relate, that his/her deferrals are no longer considered SEP-1RA contributions. The disallowed deferrals are includible in the employees gross income in the calendar year as of the earliest date that any elective deferrals by the employee during the plan year would have been received by the employee had he/she originally elected to receive the amounts in cash. Income allocable to the disallowed deferrals is includible in the employee's gross income in the year of withdrawal from the IRA.

Example 3: Employer K discovers at the end of calendar plan year 1995 that more than half of his eligible employees chose not to make elective deferrals for that year. Employer K must notify all his employees by March 15, 1996 (2-1/2 months after the end of the calendar plan year) that the deferrals are disallowed deferrals. Employer K makes this notification on March 1, 1996. Each affected employee must include the disallowed deferrals in income in 1995. Any earnings (income) allocable to the disallowed deferrals are included in income in the year withdrawn from the IRA. The amounts must be withdrawn by April 15, 1996.

 

(1) The applicable box on Form 1040, (1995 Form 1040, line 27), indicates the deduction for contributions to a SEP. The box should be checked if a self-employed individual is maintaining the SEP.

(2) Generally, distributions from an IRA or SEP-IRA are reported on Form 1099-R, and are treated similar to any other IRA distribution. Withdrawal of contributions under IRC 408(d)(4), is NOT treated as a taxable "distribution" from an IRA, although the amount withdrawn is reported on Form 1099-R.

(1) At the present time, SEPs are not covered by either the Closing Agreement (CAP) or Voluntary Compliance Resolution (VCR) programs. Some Districts have used the general delegation order dealing with Closing Agreements, D.O. 97, to deal with defects discovered in SEPs, rather than the Employee Plans' CAP.

(1) See if the appropriate Form 941 and Form 940 (if applicable) were filed. Also, check if W-2 and W-3 forms were correctly prepared and timely filed.

(2) Determine if Forms 1099 were correctly prepared and filed. Verify with any cancelled checks. Determine if appropriate information regarding any distributions was provided to participants.

(3) If the employer is self-employed and files Form 1040, verify the amount deducted. If there is any discrepancy, ask for an explanation.

(4) Check documentation that would verify the establishment of IRAs, or amounts of contributions, etc., such as a copy of any bank or other institutional statement (e.g., broker statements, etc.).

(5) Check if the SEP was top heavy, and if so, whether the appropriate contributions were made. Verify that elective contributions were not used to satisfy the top heavy minimums.