1. Failure of Deferral Percentage Test
The amount each highly compensated employee (HCE) may defer is limited. The deferral percentage test for a SARSEP compares the deferral percentage of each HCE with the average of the deferral percentages of all other eligible employees. For details on how to perform this test, please refer to the plan document, or the Instructions for Form 5305A-SEP, or IRS Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans).
Average Deferral Percentage Test:
SARSEPs are subject to a nondiscrimination test similar to the annual test imposed on section 401(k) plans. This test limits the amount highly compensated employees can defer based on what nonhighly compensated employees defer. The deferral percentage limit for the highly compensated employees is computed by first averaging the deferral percentages for the nonhighly compensated employees for the year and then multiplying this result by 1.25. The deferral percentage limitation must be computed each year. See the Instructions for Form 5305A-SEP for this computation.
The deferral percentage test for SARSEPs compares the deferral percentage of each HCE with the average of the deferral percentages of all other employees - not the average of the deferral percentages of all HCEs with the average of all other employees (as in a 401(k) plan). Further, unlike section 401(k) plans, nonelective contributions from the employer cannot be used to help the SARSEP satisfy the annual test.
If an employee who elects to defer compensation under the SARSEP has exceeded the deferral percentage limit for a year, the employee must withdraw those excess contributions by April 15 following the calendar year in which the employee is notified. Excess contributions not withdrawn by April 15 will be subject to the IRA contribution limits of sections 219 and 408 and may be considered excess contributions to the employee’s IRA. For the employee, these excess contributions are subject to a 6% tax on excess contributions under section 4973. Income on excess elective deferrals is includible in the employee’s income in the year it is withdrawn from the IRA. The income must also be withdrawn by April 15 following the calendar year of notification. If the income is withdrawn after that date and the recipient is not 59 ½ years of age, it may be subject to the 10% tax on early distributions under section 72(t).
If the deferral percentage limitation is exceeded, each affected employee must be notified by March 15th of the following year of:
- The amount of the excess contributions to their SEP-IRA for the preceding calendar year,
- The calendar year the excess contributions and earnings are includible in gross income,
- Information stating that the employee must withdraw the excess contributions (and earnings), and
- An explanation of the tax consequences if the employee does not withdraw such amounts.
See the Instructions for Form 5305A-SEP for a detailed description of the notification procedures.
Highly compensated employee. A highly compensated employee is an individual who:
2. Failure To Make the Required Top-Heavy Contribution
Most SARSEPs, including all model SARSEPs (Form 5305A-SEP), require top-heavy contributions. In general, the employer is required to make a 3% minimum top-heavy contribution for each eligible non-key employee. Non-key employees are generally employees who are not owners or high-paid officers.
Top Heavy Minimum:
A SARSEP is top-heavy when more than 60% of all employer contributions go to key employees. But since many SARSEPs are always top-heavy, SARSEPs are often drafted to operate as if they were always top-heavy, thereby eliminating the need to make the annual 60% determination.
For purposes of determining if a plan is top-heavy, employee elective deferrals are considered employer contributions. Employee elective deferrals may not be used, however, to satisfy the minimum contribution requirements for top-heavy plans. For purposes of determining the top-heavy minimum contribution, employee elective deferrals made by key employees must be counted.
The employer will satisfy the top-heavy requirements by making a minimum contribution each year to the SEP-IRA of each employee eligible to participate in this SARSEP. This minimum contribution is not required for key employees. This contribution, in combination with other nonelective contributions, is equal to the lesser of:
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3% of each eligible non-key employee’s compensation or
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The percentage of compensation at which elective (not including catch-up contributions) and nonelective contributions are made under this SARSEP (and any other SEP maintained by the employer) for the year for the key employee with the highest percentage for the year.
A key employee is any employee who, at any time during the preceding year was:
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An officer of the employer with compensation greater than $150,000 in 2008 ($160,000 in 2009 and subject to cost-of-living adjustments thereafter);
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A 5% owner of the employer, as defined in section 416(i)(1)(B)(i) of the Internal Revenue Code; or
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A 1% owner of the employer with compensation greater than $150,000.
3. Violation of the No More Than 25 Eligible Employees Rule
If the employer had more than 25 eligible employees at any time during the prior year, it cannot accept deferrals in the current year.
Salary reduction contributions cannot be made to a SARSEP for a year if there were more than 25 employees who were eligible to participate at any time during the preceding year.
The 25-employee rule is a look-back rule. It is a year-by-year rule. For example, if there were 23 eligible employees in year 2006, but 27 eligible employees in year 2007, salary reduction contributions may be made to the SEP-IRAs of the 27 employees for 2007. However, in year 2008, no salary reduction contributions may be made.
All Employees:
All eligible employees must be allowed to participate, including part-time employees and seasonal employees An eligible employee is an employee who:
The term “employee” includes a self-employed individual who has earned income and a working business owner.
Certain leased employees must be treated as “employees.”
The SARSEP document can provide for less restrictive eligibility requirements (but not more restrictive ones). “Service” means any work performed for the employer for any period of time, however short. A SARSEP may not impose an hours-of-service requirement.
Excludable Employees:
The following employees do not need to be covered under a SARSEP:
Example 1: Employer X maintains a calendar year SARSEP. Under the SARSEP, an employee must perform service in at least 3 of the immediately preceding 5 years, reach age 21, and earn the minimum amount of compensation during the current year. Employee A worked for Employer X during his summer breaks from school in 2003, 2004, and 2005 but never more than 34 days in any year. In July 2006, Employee A turns 21. In August 2006, Employee A begins working for Employer X on a full-time basis. Employee A is an eligible employee in 2006 because he has met the minimum age requirement, has worked for Employer X in 3 of the 5 preceding years, and has met the minimum compensation requirement for 2006.
Example 2: Employer Y designs its SARSEP to provide for immediate participation regardless of age, service or compensation. Employee B is age 18, and begins working part-time for Employer Y in 2006. Employee B is an eligible employee for 2006.
“Employee” under this SARSEP includes all employees of all related employers. Related employers include controlled groups of corporations that include the employer, trades or businesses under common control with the employer, and affiliated service groups that include the employer. This means, for example, that if the owner and/or his/her 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 a SARSEP.
4. Violation of the 50% Rule
At least 50% of all eligible employees must elect to make deferrals to the plan in any year, or all deferrals in that year are disallowed.
Violation of the 50% Rule:
If fewer than 50% of the eligible employees choose to make employee deferrals to the SARSEP for a year, all employee deferrals made for that year are disallowed and must be withdrawn from the employees’ SEP-IRAs. By March 15th of the following year, each affected employee must be notified of:
- The amount of the disallowed deferrals to their SEP-IRA for the preceding calendar year,
- The calendar year the disallowed deferrals and earnings are includible in gross income,
- Information stating that the employee must withdraw the excess contributions (and earnings), and
- An explanation of the tax consequences if the employee does not withdraw such amounts.
See the Instructions for Form 5305A-SEP for detailed information on how to treat disallowed deferrals.
This is a year-by-year rule. Each year the 50% rule is not met, employee elective deferrals for that year cannot remain in the employees’ SEP-IRAs.
5. Violation of Deductible Employer Contribution Limit
Employer contributions are limited to 25% of each eligible employee’s compensation.
Contributions:
The SARSEP rules permit the employer to contribute a limited amount of money each year to each employee’s SEP-IRA. A self-employed individual can contribute to his/her own SEP-IRA. Contributions must be in the form of money (cash, check, or money order).
Property cannot be contributed, except in a rollover. See Publication 590 for more information about rollovers.
Depending on the terms of the SARSEP, the employer may be able to make nonelective contributions in addition to employee elective deferrals to the SEP-IRAs of the employees, subject to an annual limit.
Once a SARSEP contribution is made to an employee’s SEP-IRA, it is owned by the employee and cannot be made subject to a vesting schedule or taken back.
Compensation:
The maximum compensation used for figuring contributions and benefits is $230,000 for 2008 and $245,000 for 2009. This amount is subject to cost-of-living adjustments after 2009.
Compensation will be defined in the SARSEP plan document. Compensation generally includes the pay a participant received from the employer for personal services for a year including:
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Wages and salaries.
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Fees for professional services.
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Other amounts received (cash or non-cash) for personal services actually rendered by an employee, including, but not limited to, the following items.
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Commissions and tips.
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Fringe benefits.
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Bonuses.
Compensation of Self-Employed Individuals:
For a self-employed individual, compensation means his/her earned income, or net earnings from self-employment from a business in which his/her services materially helped to produce the income.
Lesser of 25% of Compensation or $40,000:
The annual contribution limit is the lesser of 25% of the employee’s compensation limited to $230,000 for 2008 ($245,000 for 2009 and subject to cost-of-living adjustments for later years) or $46,000 for 2008 ($49,000 for 2009 and subject to cost-of-living adjustments for later years). In determining this limit, the amounts deferred by the employee and the nonelective contributions made to the SEP-IRA must be included. In addition, contributions made on behalf of an employee to another defined contribution plan the employer sponsors must be included for purposes of the annual contribution limit. The same rule applies to contributions made by a self-employed individual to his/her own SEP-IRA.
The most that may be deducted on the business’ tax return for contributions to the employees’ SEP-IRAs is the lesser of the employer’s contributions or 25% of compensation. For this purpose, compensation is limited to $230,000 for 2008 ($245,000 for 2009 and subject to cost-of-living adjustments for later years). For a self-employed individual, when figuring the deduction for contributions made to his/her SEP-IRA, compensation is his/her net earnings from self-employment which takes into account the following deductions; (a) the deduction for one-half of his/her self-employment tax and (b) the deduction for contributions to his/her own SEP-IRA. See Publication 560 for details on determining the deduction. If the SARSEP plan document specifies lower contribution limits, then the lower limits control.
6. Failure to Timely Amend Plan Document
SARSEPs generally must be amended to keep current with the latest tax law changes. For those employers that use the model Form 5305A-SEP as their SARSEP plan document, the most current version of the form must be used. Note: The revision date is located in the upper left-hand corner of the form.
Current Law:
A SARSEP must be a written arrangement. As with regular SEPs, SARSEPs can be adopted using a model form, a prototype document or an individually designed document. Form 5305A-SEP is the model SARSEP issued by the IRS. If a SARSEP is individually designed, it must have language that satisfies Internal Revenue Code section 408(k)(6).
The Economic Growth & Tax Relief Reconciliation Act of 2001 (EGTRRA) changed many of the Code’s requirements and limits for qualified plans and IRAs. In order to maintain tax-advantaged status and benefit under these new provisions, SARSEP prototype and individually designed plans must be amended for current law. In order for employers with model SARSEPs to maintain tax-advantaged status and to avail themselves of new law changes they must adopt the current version of the model Form 5305A-SEP. The current model Form 5305A-SEP has a revision date of June 2006.
The administrator of an amended SARSEP must furnish each participant - within 30 days of the amendment - a copy of the amendment and an explanation of its effects.
7. Failure to Limit Employee Elective Deferrals
Salary deferrals are limited to $15,500 for 2008 and $16,500 for 2009. For employees age 50 or over, additional catch-up contribution may be made of up to $5,000 for 2008 and $5,500 for 2009.
Employee Elective Deferrals:
As in section 401(k) plans, contributions funded pursuant to salary reduction elections are called “elective deferrals” or “employee elective deferrals” because the contributions are made at the election of the employee and because the principal tax effect is to defer payment of income taxes until the money is actually distributed to the employee from the SEP-IRA.
Appropriate Limit:
Limit on Employee Elective Deferrals:
The most a participant can choose to defer for the 2008 calendar year is the lesser of:
1. 25% of the participant’s compensation (limited to $230,000), or
2. $15,500.
The compensation limit in (1) is $245,000 in 2009 and the dollar limitation in (2) is $16,500 for 2009 (both are subject to cost-of-living adjustments for later years). The $16,500 limit applies to the total employee elective deferrals the employee makes for the year to a SARSEP and any of the following:
Overall Limit on SARSEP Contributions:
The total of the nonelective and elective contributions for any participant cannot exceed the lesser of 25% of the employee’s compensation or $46,000 for 2008 ($49,000 for 2098 and subject to cost-of-living adjustments for later years). For figuring the 25% limit on elective deferrals, compensation does not include SARSEP contributions, including elective deferrals or other amounts deferred in certain employee benefit plans.
Catch-Up Contributions:
In the case of an eligible employee who is 50 or older before the end of the calendar year, an additional amount of compensation (“catch-up elective deferral contributions”) may be deferred during the year. The limit on catch-up employee elective deferral contributions is $5,000 for 2008 and $5,500 for 2009. After 2009, the limit is subject to cost-of-living adjustments.
Employee elective deferrals are not treated as catch-up contributions until they exceed the elective deferral limit the lesser of 25% of compensation or $15,500 for 2008 and $16,500 for 2009 (subject to cost-of-living adjustments thereafter), the SARSEP Average Deferral Percentage test limit, or the plan limit (if any). However, the catch-up contributions a participant can make for a year cannot exceed the lesser of the following amounts:
Catch-up contributions are not subject to the elective deferral limit (the lesser of 25% of compensation or $15,500 for 2008 and $16,500 for 2009, indexed for cost-of-living adjustments thereafter).
8. Failure to Timely Deposit Employee Elective Deferrals
Employee deferrals must be remitted to the appropriate financial institution as soon as possible, but in any event, no later than 15 days following the month in which the employee would have otherwise received the money.
Timely Deposit:
Employee elective deferrals must be forwarded to the financial institution as soon as they can be reasonably segregated from the employer's general assets, but in no event later than 15 business days following the month they were withheld from the employee's paycheck. See Department of Labor Regulation Section 2510.3-102.
9. Failure to Notify Participants of Any Changes in the SARSEP
Participants must be given notice before changes go into effect.
Notice Requirements:
Disclosure to Employees:
1. The employer must furnish the following information to an eligible employee within a reasonable time after the later of the date the SARSEP is adopted and the date the employee becomes employed.
a. Notice that the SARSEP has been adopted,
b. Requirements an employee must meet to receive a contribution, and
c. The basis upon which the employer's contributions will be allocated.
2. Failure to furnish the above information within a reasonable time subjects the employer to a $50 penalty per failure, unless the failure is due to reasonable cause.
Annual Statements:
Each year, the employer must furnish an annual statement to each employee participating in the SARSEP that shows the amount contributed to their SEP-IRA for that year. This annual reporting must be provided to the employee no later than the January 31 following the calendar year for which the report relates. Note: Often Form 5498, IRA Contribution Information, is used for this purpose.
Failure to furnish an annual statement showing the amount contributed subjects the employer to a $50 penalty per failure, unless the failure is due to reasonable cause.
General Reporting Requirements:
In addition to the employee notification requirements above, the bank, insurance company or other trustee or issuer of the SEP-IRAs must comply with the following general reporting requirements:
1. Form 5498, IRA Contribution Information, must be submitted to the IRS by the trustee or issuer of a SEP-IRA to report contributions to the SEP-IRA. A separate Form 5498 must be submitted for each SEP participant. This form or other statement of fair market value and account activity must also be given to participants.
2. Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. is used to report distributions from a SEP-IRA. Distributions from a SEP-IRA are subject to the same withholding rules that apply to distributions from traditional IRAs. See Publication 590, Individual Retirement Arrangements (IRAs), for details on IRA distribution rules.
3. SARSEP contributions by corporate employers are deducted on Form 1120. Employers who are sole proprietors may deduct contributions on Schedule C of Form 1040 and deduct contributions made for themselves on Form 1040. Partnerships deduct contributions made for common-law employees on Form 1065; but report on Schedule K-1 contributions made for partners, who deduct such contributions on their own returns.
SARSEP Notice and Reporting Requirements:
In addition to the notice and reporting requirements described above, SARSEPs have special notice and reporting requirements when the IRC section 408(k)(6) limits on employee elective deferrals are not satisfied. Notice 89-32 (1989-1 C.B. 671.) sets forth the reporting requirements in these situations.
Form 5500:
The Form 5500, that is required to be filed by most qualified retirement plans is generally not required for SARSEPs. SARSEPs are also generally exempt from the Department of Labor's reporting and disclosure requirements provided the employer satisfies certain employee notice requirements and does not impose investment restrictions on monies contributed to employees' SEP-IRAs.
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