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Luke Bailey

Contributions to SEP that violate 415(c)

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Sole proprietor adopts SEP, contributes in compliant manner for a few  years. Has no employees. Later ceases to operate as a sole proprietor and becomes member of partnership and gets K-1. Keeps contributing to SEP as if K-1 were Schedule C income for several years. His only business income after joining the partnership is from the partnership, reported on the K-1 (i.e., individual does not have any non-partnership related Schedule C income after joins partnership). Assume partnership had no qualified plan and no non-5% owner employees. Partnership (i.e., other partners in their capacity as such) had no knowledge of SEP or that sole proprietor turned partner had continued to contribute to it. Assume also that SEP documents show individual's sole proprietorship as only adopting employer.

A couple of other practitioners have looked at this and opined that the contributions based on the K-1 income are simply excess contributions to an IRA (i.e., they exceed the individual's contribution limit), IRC sec. 4973 6% excise tax is owed, contributions must be withdrawn to stop further excise tax, individual will owe ordinary income tax on distributions reportable on 1099-R, and will be subject to 10% premature distributions tax under IRC sec. 72(t) because under 59-1/2, and IRC sec. 4972 tax on nondeductible contributions also applies.

However, EPCRS seems generally to treat SEPs analogously to qualified plans, and it seems that there has been a violation of 415(c) and we have excess amounts that under EPCRS need to be distributed to employer (which, admittedly, is the same individual) as a return of an excess amount, and that the returns for prior years should be amended to reflect nondeductibility, and the 1099-R will show "$0" as the distribution amount to individual. The IRC sec. 4972 tax would still need to be paid. See Section 6.11(5) of Rev. Proc. 2019-19. I don't see why the rule would apply differently just because a single participant sole proprietor SEP is involved. VCP would be required, since SEPs qualify for SCP only for insignificant failures, and anyway this is more than two full plan years old.

Anyone ever dealt with IRS on this or a very similar issue? Any other thoughts?

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I don't have experience but I'd take the position that they are excess IRA contributions...(thinking out loud)...no wait, you could roll money into a SEP-IRA but I don't think you could make "regular" IRA contributions to one so it doesn't seem to be a valid premise.  I'll go with your second option, but it's not based on anything other than looking at what you presented.

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I'll add my voice to the chorus or Excess IRA contribution.

The one twist would be if the checks or transfers to the SEP-IRA account were from a partnership account in which case you might have other issues.

Needless to say he "probably" deducted the contributions to the SEP and will likely have to file amended tax returns for those years.

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On 12/10/2019 at 9:57 AM, Bird said:

I don't have experience but I'd take the position that they are excess IRA contributions...(thinking out loud)...no wait, you could roll money into a SEP-IRA but I don't think you could make "regular" IRA contributions to one so it doesn't seem to be a valid premise.  I'll go with your second option, but it's not based on anything other than looking at what you presented.

Not that it is relevant, because clearly the following requirements were not met. You can make "employee" traditional IRA contributions to a SEP IRA account if the custodian allows them and you designate them as such. Once made, you can not "recharacterize" SEP IRA contributions as traditional IRA contributions.

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58 minutes ago, spiritrider said:

Not that it is relevant, because clearly the following requirements were not met. You can make "employee" traditional IRA contributions to a SEP IRA account if the custodian allows them and you designate them as such. Once made, you can not "recharacterize" SEP IRA contributions as traditional IRA contributions.

Thanks, spiritrider. That is very helpful.

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I am not too sure that the EPCRS 1099-R approach is appropriate given the abundance of Code fixes available. 

Since a SEP is statutorily required to have a written allocation formula, and because the 25 percent limit must be in the plan, if a contribution exceeds “25% of a participant’s compensation, the entire arrangement will be in non-compliance for the year.” [I.R.M. § 4.72.17.7.1, item 2, Contribution Limits (Oct. 28, 2018). The IRS has a procedures for IRA-based plans found to be in non-compliance and not resolved through a closing agreement. [I.R.M. § 4.71.17.6.1] So, in addition to the cumulative 6 percent tax, 72(t) tax, amended 1040s, there may be (is) a 10 percent tax on nondeductible employer contributions.

Although the "excess IRA constitutions generally can be used up, is a special rule about using up amounts from a closed year (not really mentioned) in a correction year. 

Hope this helps.

 

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