Editor: Valrie Chambers, CPA, Ph.D.
The simplified employee pension (SEP) plan is a great tool for a self-employed person or small business owner to set aside funds for retirement. One favorable feature of SEPs is that there is no formal annual tax return reporting, but the lack of an annual filing requirement does not give the taxpayer a free pass from examination. In fact, if IRS examiners discover that a taxpayer has failed to adhere to SEP rules, the consequences can be severe, as the true story of one CPA firm client illustrates.
Background on SEP plans
Before describing this client's audit situation, a refresher on SEPs may be helpful. As noted, one advantage of SEPs is that the employer itself generally has no filing requirements. The annual reporting required for qualified plans (Form 5500, Annual Return/Report of Employee Benefit Plan) is normally not required for SEPs. The financial institution that holds the plan's SEP-IRAs handles most of the paperwork, including issuing an annual document (Form 5498, IRA Contribution Information) to report information to the IRS about amounts contributed to the SEP-IRAs.
There are three basic steps in establishing a SEP:
- Execute a formal written agreement to provide benefits to all eligible employees;
- Give employees certain information about the SEP; and
- Set up a SEP-IRA for each eligible employee.
The IRS examination process has technical guidelines that state the following regarding a formal plan:
The SEP . . . must be part of a written arrangement. [Prop. Regs. Sec.] 1.408-7(b) holds that the employer must execute a written instrument within the time prescribed for making deductible contributions (that is, no later than the due date for filing, including extensions, of the employer's income tax return for the year). The written instrument must include: the name of the employer, the requirements for employee participation, the signature of a responsible officer, and a definite allocation formula. [Internal Revenue Manual (IRM) §220.127.116.11] An employer may generally use Form 5305-SEP or Form 5305A-SEP, whichever is applicable, to satisfy the written arrangement requirement. [IRM §18.104.22.168.1(1)] An employer may also use a prototype SEP document provided by a financial institution or other sponsoring organizations. [IRM §22.214.171.124.1(2)]
Generally, any employee who performs services for the business must be included in a SEP. Under Sec. 408(k)(2), every employee is a participant who:
- Has attained age 21;
- Has performed service for the employer during at least three of the immediately preceding five years; and
- Has received at least $600 in 2019 or 2020 ($650 in 2021) in compensation (within the meaning of Sec. 414(q)(4)) from the employer for the year.
Employees may be excluded from a SEP if they:
- Have not worked for the company during three out of the last five years;
- Have not reached age 21;
- Are covered by a union agreement with retirement benefits that were bargained for in good faith by the company and the employees' union;
- Are nonresident alien employees who have received no U.S.-source wages, salaries, or other personal-services compensation from the company; or
- Received less than $600 (in 2019 or 2020, or $650 in 2021) in compensation.
The SEP is funded by employer contributions. The SEP plan document will indicate the amounts that can be contributed. The amount can be discretionary, including zero. SEP contributions must be calculated using a uniform relationship to compensation. The uniform relationship must represent the same percentage of compensation for each participating employee. The compensation taken into account in determining the amount of a SEP contribution for an employee cannot exceed $285,000 for 2020, or $290,000 for 2021. An employee's compensation is generally the gross wages reported on his or her Form W-2, Wage and Tax Statement.
Not paying attention to the rules and details of the SEP plan can be devastating to the unknowing taxpayer, as the example below illustrates. Taxpayers could be left with disallowed retirement contributions and could be subject to personal income tax liability for excess retirement contributions, excise tax, sanctions, and penalties.
To make the point of how easy it is to run afoul of the rules of Sec. 408(k), the following is based on a true story of one CPA firm's client examination.
The situation leading up to the examination
A married couple, both entrepreneurs, have two separate S corporations, each employing fewer than 12 employees. The husband has a very stable business with very little turnover and has highly paid employees. The husband is the sole owner of his S corporation. The husband is not an employee of the wife's business and has no involvement in the management of the wife's business. The husband does not have a SEP plan, does have an IRA, and is not a shareholder of his wife's company. The husband never received a paycheck from his wife's company and was not a signer on the wife's company's checking account.
The wife runs a business with part-time (under 1,000 hours per year), mostly lower-paid employees. The wife (who is over 59½) is a 90% owner, and her daughter (under 59½) is a 10% owner. The wife (president) and daughter (vice president) are full-time employees, and some of their part-time employees qualify for SEP coverage. The wife's company established separate SEP accounts for the wife and the daughter at a large investment house in 2011. The wife did not sign or receive a copy of the SEP plan from the large investment house.
The company started funding the maximum amount of contributions for the wife and her daughter, 20% of total compensation, without including the part-time employees. The wife was under the impression that part-time employees were not included in the SEP plan. The wife and daughter had no involvement in the husband's business and were the sole decision-makers in the wife's company.
Over the years, the husband would electronically file the corporate annual report for both companies with the secretary of state. The husband would list himself as an officer (vice president), director, and registered agent of the wife's corporation, although he was not involved in his wife's corporation. Annual corporate and individual tax returns were prepared by an outside accounting firm. Many years of funding with the maximum amount to the SEP continued until the wife's company received notice of an IRS examination from the Exempt Plan unit.
Here were the noted problems with the taxpayers' situation:
- The SEP investment accounts were set up in the names of the wife and the daughter. The taxpayers believed the establishment of the two accounts would suffice as a plan document. The wife never signed or received a copy of the SEP plan. The investment company did not require or provide a copy of the SEP plan when the plan was established.
- There was also a problem with the participants. The plan was set up for only those employees who were full-timers (over 1,000 hours per plan year, which included the wife and the daughter). Part-time employees were not included in the plan. In addition, the plan did not include the husband or employees of the husband's business, ignoring the attribution rules. The couple believed that the attribution rules did not apply since the corporations were in different industries and the husband and wife did not share employees and were not involved in each other's businesses. Nonetheless, attribution rules applied, as discussed in more detail below.
There were other issues raised in the examination:
- The plan sponsor failed to obtain a written arrangement and update the SEP plan document from inception of the plan in 2011 through the current plan year, as required by Prop. Regs. Sec. 1.408-7(b).
- The plan failed eligibility and participation rules under the terms of the plan and Sec. 408(k)(2) because the employer was part of a controlled group. The wife's and husband's corporations were treated as a controlled group under Secs. 414(b) and 414(c) because they constituted a brother-sister controlled group according to the rules of Sec. 1563.
- The plan sponsor failed to include eligible employees of the wife's company and husband's company in the plan as per Sec. 408(k). Both companies had significant numbers of rank-and-file employees who met the plan's eligibility requirements but were not included in the plan from inception though the date of the examination.
Unfortunately, sometimes even the biggest investment houses will set up a SEP account and gladly take the funds, while not requiring a written plan signed by the employer. Thus, the IRS can argue in such cases that no SEP plan existed since there was no plan document, leaving the taxpayer in a quandary.
The parties' positions
The IRS's position here was that the two corporations were considered a brother-sister controlled group as described in Sec. 1563(a)(2), since through spousal attribution under Sec. 1563(e)(5), both the husband and the wife owned over 50% of the voting power and value of the two corporations. For purposes of Sec. 408(k), all employees of all corporations that are members of a controlled group of corporations, trades or businesses under common control, or an affiliated service group are treated as employed by a single employer. Since SEPs must generally cover all employees, the employer sponsoring the SEP must cover employees of such related employers (IRM §126.96.36.199.1). Thus, employees in both corporations should have been included in the SEP plan.
The taxpayers' position was that both corporations satisfied the exception to the brother-sister controlled group attribution rules under Sec. 1563(e)(5) and therefore were not subject to the controlled-group rules under Sec. 1563(a)(2) as a brother-sister controlled group. The Sec. 1563(e)(5) exception applies where:
- The individual does not, at any time during the tax year, own directly any stock in the corporation;
- The individual is not a director or employee and does not participate in the management of the corporation at any time during the tax year;
- Not more than 50% of the corporation's gross income for the tax year was derived from royalties, rent, dividends, interest, and annuities; and
- Stock in the corporation is not, any time during the tax year, subject to conditions that substantially restrict or limit the spouse's right to dispose of the stock and that run in favor of the individual or his or her children who have not attained age 21.
The IRS examiner performed a comprehensive business report for both businesses and determined that, according to the records of the secretary of state, the husband was listed as an officer of the wife's corporation. Though the husband did not participate in the wife's business and was not a paid employee, his listing as an officer of the wife's corporation meant that the husband failed to meet the requirement in Sec. 1563(e)(5)(B) and Regs. Sec. 1.1563-3(b)(5)(ii)(B). Therefore, the shares of the husband's business were attributable, and the two businesses were required to include all the employees who would be qualified participants in the SEP.
The procedures for correcting plan failures for employers that sponsor SEPs are explained in Section 6.11 of Rev. Proc. 2019-19:
- Under Rev. Proc. 2019-19, employers can self-correct insignificant operational failures under the Self-Correction Program and can apply to the IRS for correction of certain other failures under the Voluntary Correction Program.
- If a failure is first identified on audit, the employer may correct the failure and pay a sanction under the Audit Closing Agreement Program (Audit CAP).
In this example, the failures were caught in a random audit. Therefore, the method of correcting the failure and the associated sanction were determined under the Audit CAP. Two options were available to the taxpayers. The first option for the employer was to make multiyear required corrective contributions plus accumulated earnings for each excluded employee, which would have cost the wife's corporation over $350,000 plus sanctions. In addition, the plan sponsor would need to adopt a current amended prototype SEP document that would bring the plan into compliance with all applicable laws. All SEP-eligible employees would have to be retroactively placed in the same position that they would have been in had there been no operational plan failure.
A second option for the wife's corporation was to consider the plan as unqualified. The employer contributions and accumulated earnings then would be reclassified as income to the wife and daughter based on the wife's and daughter's last personal return filed (2018). Specifically:
- Step 1: The wife and daughter would be allowed to exclude from income and roll over the maximum amount had they contributed to an IRA in each of the years that they were included in the plan. The wife would be allowed to roll over $51,000 to an IRA account, and the daughter would be allowed to roll over $16,500 to an IRA.
- Step 2: The two individuals would be assessed a 6% excise tax penalty (Sec. 4973) compounded annually for each year.
- Step 3: The wife and daughter would be required to liquidate the SEP plan. A Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., would be issued in the year of distribution, 2020, but the distribution would be taxed according to the last return filed, which was the 2018 tax year. The daughter would not be subject to the early-withdrawal penalty due to the exception for COVID-19 rules. The wife would not be subject to the early-withdrawal penalty because she was over 59½ years old.
- Step 4: In addition, there would be late-payment interest as well as penalties for failure to pay and failure to file.
In this examination, the wife would have to include almost $180,000 in income, taxed at the 2018 tax rates, which would cost over $113,000 in tax and interest, excise tax, and a 10% sanction or penalty. The wife would be able to roll over $51,000 to an IRA account. The daughter would have to include over $70,000 in income, taxed at the 2018 tax rates, resulting in over $33,000 in income tax and interest, excise tax, and a 10% sanction or penalty. The daughter would be allowed to roll over $16,500 to an IRA.
The wife's corporation was not affected by considering the plan as unqualified since the excess amount was considered taxable income to the individual taxpayers. Therefore, the wife's corporation, in essence, was allowed the deduction of the retirement plan contribution from 2011-2018.
Taking the second option
The taxpayer took the second option. The first option of funding all the participants of the two businesses would have cost in excess of $400,000, while the tax, penalties, and sanctions to treat the plan as unqualified had a cost of approximately $147,000. The option for this taxpayer was clear in the end.
Avoiding the trap
To avoid a similar trap, tax preparers can take the following steps when preparing year-end tax returns for companies with a deduction for contributions to a SEP:
- Obtain a copy of the plan and maintain it in the permanent file;
- Request copies of Forms W-2 and employment start dates of all employees;
- Recalculate the SEP contribution;
- Review for related-corporation issues such as attribution issues;
- Review annual reports filed with the secretary of state, and note issues; and
- Make sure the SEP contribution was issued to the administrator in a timely manner.
By taking these steps, tax preparers can help businesses avoid examination misfortunes such as those described above.
Contributors Valrie Chambers, CPA, Ph.D., is an associate professor of accounting at Stetson University in Celebration, Fla. Byron E. Shinn, CPA, is a tax partner with Carr, Riggs & Ingram LLC in Bradenton, Fla., and Larry J. Wolfe, CPA, is the owner of Larry J. Wolfe Ltd. in Skokie, Ill. Mr. Shinn is a member and Mr. Wolfe is the chair of the AICPA Tax Practice & Procedures Committee. For more information on this article, contact firstname.lastname@example.org.
Valrie Chambers, CPA, Ph.D., is an associate professor of accounting at Stetson University in Celebration, Fla. Byron E. Shinn, CPA, is a tax partner with Carr, Riggs & Ingram LLC in Bradenton, Fla., and Larry J. Wolfe, CPA, is the owner of Larry J. Wolfe Ltd. in Skokie, Ill. Mr. Shinn is a member and Mr. Wolfe is the chair of the AICPA Tax Practice & Procedures Committee. For more information on this article, contact email@example.com.