Simplified Employee Pension (SEP)
A simplified employee pension (SEP) is a traditional individual retirement account or individual retirement annuity that may accept an expanded rate of contributions from one or more employers. IRC §408(k). It is owned by the employee, who may be self-employed.
In order for an IRA to be a SEP, certain requirements must be satisfied:
- The employer must contribute to the SEP of each employee (including certain “leased” employees who is at least 21 years old, has performed services for the employer during the year for which the contribution is made (including any such employee who, because of death or termination of employment, is no longer employed on the date contributions are actually made), and for at least three of the immediately preceding five years has received at least $450 in compensation (in 2005) from the employer for the year. IRC §408(k)(2)(C); Notice 2004-72, 2004-46 IRB 840. (See Appendix E for earlier years.) The employer may not require that an employee be employed as of a particular date in the year. Prop. Treas. Reg. §1.408-7(d)(3). Employees covered by a collective bargaining agreement may be excluded from participation if retirement benefits have been the subject of good faith bargaining. Similarly, nonresident aliens may be excluded if they received no income from the employer that is considered to be from U.S. sources. IRC §408(k)(2).
Employer contributions must not discriminate in favor of any highly compensated employee. Employees who are excluded from participation as nonresident aliens, or because they are covered by a collective bargaining agreement, are not considered for purposes of determining whether there is discrimination. IRC §408(k)(3).
Unless employer contributions bear a uniform relationship to total compensation (or earned income in the case of self-employed individuals) they will be discriminatory. However, compensation or earned income in excess of $210,000 (in 2005) is not to be taken into account. IRC §408(k)(3)(C); Notice 2004-72, 2004-46 IRB 840. This compensation limit is indexed for inflation in increments of $5,000. (See Appendix E for the indexed amounts for earlier years.) IRC Secs. 408(k)(8), 401(a)(17). Presumably, a constant percentage of compensation would meet the nondiscrimination requirement. A rate of contribution that decreases as compensation increases will be considered uniform. Prop. Treas. Reg. §1.408-8(c). The IRS has informally approved a method of contribution that in effect required that an identical dollar amount be contributed on behalf of all participants. See Let. Rul. 8824019.
SEPs can be integrated under the rules applicable to qualified plans. IRC §408(k)(3)(D); TAMRA ’88, §1011(f)(7).
- Employer contributions must be determined under a definite written allocation formula that specifies the manner in which the allocation is computed and what requirements an employee must satisfy to share in the allocation. However, the employer may vary the allocation formula from year to year so long as there is a timely amendment to the plan that indicates the new formula. Prop. Treas. Reg. §1.408-7(e). No minimum funding standards are imposed.
- The employer contribution may not be conditioned on the employee’s keeping any part of it in the pension and the employer may not prohibit withdrawals from the plan. IRC §408(k)(4).
- If the SEP is top-heavy, it is subject to the minimum contribution rules applicable to such plans. IRC Secs. 408(k)(1)(B), 416(c)(2). Employer contributions to a SEP may be taken into account in determining whether qualified plans of the employer are top-heavy.
Should an eligible employee or former employee not have an IRA on the date contributions are made, the employer is required to establish one on the employee’s behalf. See Prop. Treas. Reg. §1.408-7(d)(2). A SEP plan need not be established until the contribution is made for the year (i.e., it may be established after the end of the year—see “Employer’s Deduction,” below).
A controlled group of corporations or employers under common control or employers composing an “affiliated service group” are treated as a single employer. Thus, if contributions are made to SEPs for employees in one business, they may have to be made for employees of another business if the two are under common control or constitute an affiliated service group. IRC Secs. 414(b), 414(c), 414(m); Let. Rul. 8041045.
SEPs are treated as defined contribution plans for purposes of the overall limits on employer contributions. IRC §415(a)(2)(C). For plan years beginning in 2005, the annual additions limit is the lesser of $42,000 or 100% of compensation. IRC §415(c)(2). Any contribution by an employer to a SEP must be aggregated with all other employer contributions by that employer to defined contribution plans for purposes of the $42,000/100% limit (in 2005) on annual additions. For purposes of the foregoing rules, the definition of compensation set forth in §414(s) applies. IRC §408(k)(7)(B).
Treatment of Contributions
An employee may treat his SEP account as a traditional IRA and make deductible or nondeductible contributions to it under the rules.
Exclusion. Contributions made by an employer on behalf of an employee to a SEP are excludable from the employee’s income to the extent that they do not exceed the lesser of 25% of compensation from the employer (determined without regard to that employer’s contribution to the SEP) or $42,000. IRC Secs. 402(h)(2), 415(c)(1)(A). Consequently, taking into account the $210,000 limit on compensation, the Code would effectively limit SEP contributions to $42,000 for 2005 ($42,000 is less than ($210,000 × 25%). However, as a result of an apparent oversight by Congress, compensation, for this purpose only, is includable compensation (i.e., not including elective deferrals). See IRC §402(h)(2)(A).
If an individual is employed by more than one employer (other than employers who are under common control or compose a controlled or affiliated service group) during the tax year, the 25% limit is applied separately to each employer. See IRC §219(b)(2). Under proposed regulations, contributions by (and compensation received from) employers who are under common control or who are members of a controlled group must be aggregated for purposes of this limit. See Prop. Treas. Reg. §1.219-3(c). It would seem that the IRS may also require such aggregation where the employers are members of an affiliated service group.
If an individual is self-employed with respect to more than one trade or business, the maximum contribution will be the lesser of the amount determined by applying the limit separately to each trade or business or the amount determined by applying the limit as if the trades or businesses constituted one employer. See Prop. Treas. Reg. §1.219-3(c)(2). In an integrated plan, the 415 dollar limit must be reduced in the case of a highly compensated employee. IRC §402(h)(2)(B). Contributions are not subject to income tax withholding, FICA or FUTA. IRC Secs. 3401(a)(12)(C), 3121(a)(5)(C), 3306(b)(5)(C). See also Rev. Rul. 65-209, 1965-2 CB 414.
The Employer’s Deduction
Employer contributions for a calendar year are deductible, under IRC §404, for the tax year in which the calendar year ends. An employer may elect to use its taxable year instead of the calendar year for purposes of determining contributions to a SEP. IRC §404(h)(1)(A). Employer contributions made on account of a calendar year or an employer’s taxable year may be made as late as the due date (plus extensions) of the employer’s tax return for such year and be treated as if contributed on the last day of that year. IRC §404(h)(1)(B). The due date for C corporations is 2 ½ months following the close of such year and for self-employed individuals is 3 ½ months following the close of such year. IRC Secs. 6012(a), 6072.
The maximum employer deduction amount is 25% of compensation for the calendar year (or, if applicable, the taxable year). IRC §404(h)(1)(C). (For years before 2002, the maximum was 15%.) “Compensation,” for this purpose, includes elective deferrals and certain other contributions made on a pre-tax basis. See IRC §404(a)(12), 404(n).
Contributions in excess of the 25% deductible limit may be carried over and deducted in succeeding years. See IRC §404(h)(1)(C). However, the employer is subject to an excise tax on nondeductible contributions. If the employer also contributes to a qualified profit sharing or stock bonus plan, the 25% deductible limit for that plan is reduced by the amount of the allowable deduction for contributions to the SEPs with respect to participants in the stock bonus or profit sharing plan. IRC §404(h)(2). If the employer also contributes to any other type of qualified plan, the SEP is treated as a separate profit sharing or stock bonus plan for purposes of applying the combination deduction limit of IRC §404(a)(7). IRC §404