Guest Article

SEPs Get a Boost from Technical Corrections But SARSEPs Still Have Problems

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by Judy Tarpley
PenServ, Inc.
903-455-5135

In a Saturday morning rose garden ceremony on March 9th, President Bush signed the Job Creation and Worker Assistance Act of 2002. This legislation contains numerous technical corrections to the Economic Growth and Tax Relief Reconciliation Act of 2001.

This article focuses on the changes under the technical corrections with respect to SEPs and SARSEPs. Briefly: regular SEPs are "fixed"; SARSEPs still have a few problems. The effective date for these amendments is as if they were included in the original law. Thus, the following corrections to SEPs and SARSEPs are effective retroactively to January 1, 2002.

There are three sections of the Internal Revenue Code that are interrelated in understanding the maximum SEP contribution: §415(c), §404(h) and §402(h).

§415(c) governs the maximum limitation on additions that can be allocated to a particular participant under a defined contribution plan. For purposes of this overall additions limit, SEPs are treated as a defined contribution plan.

§404(h) governs the employer's maximum deduction for SEP contributions, including salary reduction contributions under a SARSEP. If employer contributions exceed this limit, the employer is subject to the 10% excise tax applicable to nondeductible employer contributions under §4972.

§402(h) is a section exclusively applicable to SEPs. This section is often referred to as the "exclusionary limit" for SEP contributions. It governs the maximum contribution that any SEP or SARSEP participant can exclude from his or her gross income. If the total SEP contributions made on behalf of a participant for a year, including salary reduction contributions under a SARSEP, exceed this "exclusionary limit", the participant must:

1. Include the excess as wage income on his or her Form 1040; and

2. Such excess amount is then treated as a regular IRA contribution. If these amounts create an excess IRA contribution permitted under §219, the participant is subject to the 6% excise tax under §4973, unless a timely corrective distribution is made under the rules of §408(d)(4).

The following technical explanation describes the coordination of these three code sections with respect to regular SEPs and SARSEPs before EGTRRA, after EGTRRA and finally the effects of the technical corrections.

Regular SEPs

Regular SEPs are those where the entire contribution is being funded by the employer maintaining the plan. A regular SEP, therefore, does not contain a salary reduction feature.

SEPs Before EGTRRA

Prior to 2002, the maximum SEP contribution and deduction limits were as follows:

1. §415(c) Limitation on Annual Additions per participant was the lesser of 25% of the participant's compensation not to exceed $35,000. However, under a SEP, the $35,000 limit of this section could not be reached because of the other limits described below.

2. §404(h) Limit on Employer Deductions for SEP contributions was limited to 15% of the participant's compensation. Also, since the maximum compensation limit prior to 2002 was $170,000, this section had the effect of limiting SEP contributions to $25,500 (15% X $170,000).

3. §402(h) Limit on the Employee's Exclusion from Income was limited to 15% of the participant's compensation.

Consequently, prior to 2002, in order for the employer to deduct SEP contributions and for the employee to exclude SEP contributions from current income, the maximum SEP contribution was 15% of each participant's first $170,000 in compensation.

SEPs After EGTRRA

When EGTRRA was passed in June of 2001, the original law did not make all of the changes necessary to coordinate these three code sections for SEPs. The original EGTRRA provided that, effective with respect to SEP contributions made for 2002 and forward, the maximum SEP contribution and deduction limits were as follows:

1. §415(c) Limitation on Annual Additions per participant under a defined contribution plan was increased to the lesser of 100% of compensation not to exceed $40,000. However, this section does not mean that a SEP contribution alone could reach this 100% of compensation limit because of the other limits described below.

2. §404(h) Limit on Employer Deductions for SEP contributions was increased to 25% of the participant's compensation. However, because of the next section, an employer would not have been able to actually contribute 25% of compensation.

3. §402(h) Limit on the Employee's Exclusion from Income remained at 15% of compensation. This had the effect of limiting the employer's contribution and deduction to only 15% of the participant's compensation.

SEPs After the Technical Corrections

Regular SEPs have now been better coordinated between the three code sections as follows:

1. §415(c) Limitation on Annual Additions per participant remains as originally changed by EGTRRA.

2. §404(h) Limit on Employer Deductions remains as originally changed by EGTRRA with respect to regular SEPs (but see the explanation for this section's effect on SARSEPs).

3. §402(h) Limit on the Employee's Exclusion from Income is increased to 25% of the participant's compensation.

Conclusion for Regular SEPs: This change under the technical corrections to §402(h) makes it possible for an employer to contribute and deduct up to 25% of the participant's compensation to a regular SEP AND the employee to be able to exclude the entire SEP contribution from current income.

Also, since compensation for 2002 SEP contributions is the participant's first $200,000, the maximum $40,000 under §415(c) can be reached (25% X $200,000 = $50,000, capped at $40,000).

This change also makes regular SEPs comparable to profit sharing qualified plans. Until the technical corrections, SEPs were not as attractive as profit sharing plans. Employers will now be able to achieve the same contribution and deduction limits with a regular SEP as he would with a profit sharing plan. And as we all know, SEPs generally have less administrative requirements than qualified plans.

SARSEPs

Salary Reduction SEPs (or SARSEPs) are those where the employee may voluntarily elect to reduce his or her salary by making elective deferrals in addition to the employer's regular SEP contribution. SARSEPs can only be currently maintained by an employer who had an existing SARSEP as of December 31, 1996, and who still meets the requirements for being an eligible employer.

SARSEPs Before EGTRRA

Prior to 2002, the maximum SARSEP contributions (both the employee's deferral and the employer's regular SEP contribution) were as follows:

1. §415(c) Limitation on Annual Additions per participant was the lesser of 25% of the participant's compensation not to exceed $35,000. However, under a SARSEP, the $35,000 limit of this section could not be reached because of the other limits described below.

2. §404(h) Limit on Employer Deductions for SARSEP contributions was limited to 15% of the participant's compensation. Contributions include both the deferrals and the employer's regular SEP contribution. Compensation for this deduction limit was the participant's compensation after subtracting the employee's deferral. Also, since the maximum compensation limit prior to 2002 was $170,000, this section had the effect of limiting all contributions under the SARSEP to $25,500 (15% of the participant's reduced compensation X $170,000).

3. §402(h) Limit on the Employee's Exclusion from Income was also limited for all SARSEP contributions to 15% of the participant's reduced compensation (compensation after subtracting the employee's deferral).

Consequently, prior to 2002, in order for the employer to deduct SARSEP contributions (both the employee's deferral and the employer's regular SEP contribution) and for the employee to exclude all contributions from current income, the maximum SARSEP contribution was 15% of each participant's first $170,000 of reduced compensation (compensation after subtracting the deferrals).

SARSEPs After EGTRRA

The original EGTRRA provided that, effective for SARSEP contributions made for 2002 and forward, the maximum contribution and deduction limits were as follows:

1. §415(c) Limitation on Annual Additions per participant was increased to 100% of compensation not to exceed $40,000. Unlike §401(k)s, SARSEP participants could not defer 100% of compensation because of the other limits described below.

2. §404(h) Limit on Employer Deductions for SARSEP contributions was increased to 25% of the participant's compensation. However, compensation for this purpose was still compensation after subtracting the employee's deferral as it was prior to EGTRRA. The 25% limit included both deferrals and the employer's regular SEP contributions. Although the employer's deduction was increased under EGTRRA to 25%, SARSEP contributions could not have been made at that level because of the next section.

3. §402(h) Limit on the Employee's Exclusion from Income remained at 15% of compensation and included both the deferrals and the employer's regular SEP contributions. Also, this 15% of compensation was the participant's compensation after subtracting the deferrals. This had the effect of limiting all SARSEP contributions to only 15% of the participant's reduced compensation.

SARSEPs After the Technical Corrections

SARSEPs to some extent have been improved by the technical corrections, but problems still exist.

1. §415(c) Limitation on Annual Additions per participant remains as originally changed by EGTRRA. However, because of the next two sections, a SARSEP participant still cannot defer 100% of compensation as they possibly can under a §401(k) plan.

2. §404(h) Limit on Employer Deductions has been changed under the technical corrections to provide that the employer can deduct all of the employee's deferrals plus 25% of the participant's gross compensation (compensation including the deferrals) as the regular SEP contribution. Although the change to the employer's deduction limit for SARSEPs now parallels the deduction limit for §401(k) plans, there are still problems with the employee's exclusion from income limit described in the next paragraph.

3. §402(h) Limit on the Employee's Exclusion from Income is increased to 25% of the participant's compensation. However, for this purpose, compensation under this section is still compensation after subtracting the deferrals and the 25% limit includes both the deferrals and the employer's regular SEP contributions.

Conclusion for SARSEPs: SARSEPs are still not as good as §401(k) plans after EGTRRA and the technical corrections. Compensation for the employee's 25% exclusion from income limit is still determined after subtracting the deferrals and includes both the deferrals and the employer's regular SEP contributions. This means that the employer's deduction limit is actually higher than the maximum that the employee can receive and exclude from current income.

Also, the maximum compensation limit of $200,000 applies to SARSEPs. Compensation for this purpose is the participant's gross compensation, including the deferrals. Therefore, under a SARSEP a participant could possibly achieve the $40,000 contribution limit between the employer's regular SEP contribution and the employee's deferral (25% of reduced compensation X $200,000 gross compensation, capped at $40,000, with the deferral limit $11,000).

As a result of the differences in the definition of compensation between §404(h) and §402(h), plus the fact that the exclusion from income limit of 25% of reduced compensation includes both the deferrals and the employer's regular SEP contributions, additional guidance will hopefully be issued by the IRS to assist employers in determining the maximum contribution and deduction limits under the SARSEP. Also remember that SARSEPs must be tested with respect to the deferrals being made by highly compensated employees in relationship to the deferrals being made by nonhighly compensated employees. This article does not address the nondiscrimination requirements or the top heavy rules applicable to SARSEPs.

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Copyright 2002, Judy Tarpley

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