S-Corp K-1 Income no W-2 wages

[Guest jpetrancosta]

Facts:

1. 100% owner operated S-corp with independent contractors in the past.

2. Owner takes distributions only, no W-2 wages.

3. Owner establishes SEP in current year with 1 year of preceding 5 years service requirement, age 21 and current compensation limit.

4. Owner hires independent contractors in current year and pays on W-2.

Q1: Are the new employees (which are the previous independent contractors) eligible for the contribution? I think not, because they were not employees in any one of the PREVIOUS five years.

Q2: Is the owner eligible to receive a contribution, and if so, based on what? This seems tricky to me. Since the owner doesn't have W-2 wages, how does he distinguish himself from the independent contractors of the past as it relates to meeting the service requirment for the current year?

[Gary Lesser]

The term "service" for SEP purposes has never been defined. It does not appear to require the payment of compensation nor require that the status of the individual be that of an "employee" for purposes of satisfying the service requirement.

So for eligibility to participate, I think all periods of service sd be considered. Only an individual that is an employee in the current year wd receive a contribution.

The owner, unfortunately, has no compensation upon which a contribution can be based. A distribution from a S Corp of profits or dividends is not treated as plan compensation. If it isn't on the W-2, it will not be treated as compensation. [Durando v US 19 EBC 219 (9th Cir, 1995)

[Guest jpetrancosta]

Gary,

Two quick follow-up questions.

1. You don't think the service requirment implies service as an employee?

and

2. In the absence of wages, S-Corp income doesn't count as self-employment income in the same way a partnership income would?

Thank you for your quick reply.

[Gary Lesser]

That's right. Employment does not seem to be required for initial eligibility, but would apply in the current year for eligibility to receive a contribution. Thus, only employees may participate, but eligibility only requires that "services" be performed for the employer. It does not appear that an employer-employee relationship is required for this purpose. That all being said, this would be a good point for a private letter ruling request.

Since the entity is not a partnership, the partnership (or sole-prop) rules do not apply. The Durando case points this distinction out and holds that S Corp dividends (or other similar payments) are not treated as plan compensation.

[Guest jpetrancosta]

Thank you for your help.