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Mistaken Salary Deferrals to a SEP


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Employer purchases business and agrees to continue SARSEP retirement benefits employees had received with predecessor company: 5% salary deferral and 10% employer matching contribution. However, employer later learns that predecessor maintained only a SEP, not a SARSEP. IRA custodian has been depositing deferrals and matches into IRA as undifferentiated lump sums.

Is there any way to convert this arrangement to a SIMPLE IRA so as to preserve the salary deferral feature? If not, and employer maintains SEP, what is the best way, from a tax reporting standpoint, to make the employee whole?

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a) To the extent the employer's contribution is less than $2,000, the employee can deposit the difference into the SEP-IRA. b) On the payroll records of the employer, You may want to re-classify the employee's contributions as employer contributions (no one got more then 15% of pay in your facts) and repay the employee deferrals as additional income. The employer would get the benefit of clasifying and deducting the employee's erroneous defferals as employer contributions. Then you would have to true-up the overall employer contribution to comply with the allocation fomula in the SEP document. But this should make everyone whole, albeit you may end up with an employer contribution greater than desired. c) Another choice may be to withdraw all the employees' deferrals as contributed erroneously and then adjust everyone's payroll records to reflect the eliminated deduction. This may be trickier (or easier) than choice one because of the various possible legal issues and the required reporting on IRA distributions (1099 etc.)that the trustee must file and the employees must explain on their individual tax returns.

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The salary deferrals were not validly deferred thus they are "wages" for the taxable year and should be treated as W-2 income. [A SIMPLE IRA can only defer compensation earned after the effective date of a valid SIMPLE IRA election form; thus it is too late for this approach.] On the other hand and assuming a valid SEP, the amounts could arguably be claimed as SEP contributions. [if there was a SEP, the amounts are not excess SEP contributions (if within the 15% individual and 15% employer limits). They can't be treated as excess SARSEP contributions since no such plan ever existed.] This still leaves open the matter of the employees being owed an amount of wages equal to the amount they each deferred AND the possibility of unequal allocations being made to the plan because of the 10% matching contribution (not allowed in a SEP) and different deferral percentages or amounts. Plan eligibility may also have to be rethunk! Looks like the employer will need some software (like QP-SEP Illustrator). Is the plan integrated too, is there a document???

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  • 2 weeks later...
Originally posted by Gary Lesser

. . .  Is the plan integrated too, is there a document???

No integration; sketchy plan document (silent on eligibility requirements).

If decision is made to recharacterize deferrals as employer contributions and repay compensation that was deferred, do the tax reporting requirements permit this to happen after year-end??

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The best way would be to treat the amount as excess elective contributions since that is what they were (arguably in box 1 of Form W-2, but not in box 13). A notice to affected employees would be nice (and telling them to remove the excess and the pre- and post- due date penalty rules, and that it was taxable in 2000 (for this year's portion)). The employees could use the notice when requesting a correcting distribution from the trustee / custodian of the IRA. THEN, make contribution with new funds. THIS WAY AVOIDS ALLOCATION PROBLEMS AND AVOIDS PLAN ADOPTION AND CONTRIBUTION ISSUES, AS WELL AS IRA TRUSTEE CODING ISSUES.

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