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SEP Coverage Failure Consequences


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We have a client who established a regular SEP but failed to cover their two eligible employees for five years. We've advised the client how to correct using guidance from the IRS Fix-it Guide.  What are the consequences if the client does not make the corrections?  A regulation cite would be helpful if possible.

Thanks!

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How did you advise them to correct? VCP or SCP? If they were the only two eligible employees, and they were both excluded for 5 years, then I think you have to correct under VCP.

That aside, what are the possible consequences? Loss of deductions, penalties, and possible plan disqualification.

I don't have time to look for any citations for SEP's specifically, but for plans under 401(a), where you have an operational violation, see Martin Fireproofing Profit-Sharing Plan & Tr. v. Commissioner, or Michael C. Hollen, D.D.S., P.C. v. Commissioner. A plan that does not follow the terms of the plan document is not a "definite written program: as required under 1.401-1(a)(2.

Perhaps someone else here has a citation handy for a SEP.

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I don't think there are any regulations on point and don't know how much supporting infrastructure (e.g., Internal Revenue Manual or IRS training materials) there are dealing with consequences of SEP violations, but it seems similar principles as with 401(a) violations would apply. If you fail the coverage requirement, then your SEP fails 408(k)(2), with the consequence that, the IRS's view, you don't actually have a SEP, which means that you don't get the benefit of 402(h), which means inclusion under 83 when contributions are made (since SEP immediately vested), nor do you get the benefit of 404(h), although 83(h) should give you the deduction anyway. The other issue is the DOL issue. The boilerplate SEP document flat-out said the employees in question would be covered and get allocations. If the employees in question found out and made a claim, difficult to think of any possible defense other than statute of limitations.

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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The IRS provides a "fix it" guide for SARSEPs which describes the safe harbor correction for failure to cover eligible employees (should be equally applicable to a SEP), as follows:

 Revenue Procedure 2016-51 provides different safe harbor methods for correcting improperly excluded eligible employees. For SARSEPs, the plan sponsor must generally make corrective employer contributions because the plan assets reside in IRAs. This contribution method requires the employer to make a corrective contribution to the excluded employees’ SEP-IRAs. The corrective contribution is calculated using each excluded employee’s compensation. Adjust this amount for earnings through the date of correction.

This fix-it guide is at https://www.irs.gov/retirement-plans/sarsep-fix-it-guide-eligible-employees-were-excluded-from-participating-in-the-plan

 

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