Exclusion Allowance

[Gary Lesser]

How do you (or plan sponsors that you work with) and interpret the 25 percent participant exclusion allowance under Code Section 402(h)?

Facts: An individual, and the only employee of X, has pre-plan compensation of $100,000 for 2003. The individual defers $14,000 ($2,000 of which is treated as a catch-up contribution). The plan is either (a) model SARSEP (see compensation definition below that excludes elective deferrals), or (b), a prototype SARSEP that defines compensation as including elective deferrals in the definition of compensation, but also contains the LRM required 25 percent allocation limit (see LRM language below)? Are the exclusion allowances under the model and prototye determined the same?--

(1) $24,000 -- .25 ($100,000 - $12,000) + $2,000

(2) $23,500 -- .25 ($100,000 - $12,000 - $2,000) + $2,000

If method "(2)" how is Section 414(v)(3)(A)(ii) resolved? That section provides for purposes of Code Section 402(h)--among other sections covered--that catch-up contributions are not "taken into account in applying such limitations to other contributions or benefits under such plan or any such plan." If catch-up reduces 402(h) compenation, it would appear that the individual gets $500 less overall. In a sense, the employer's maximum exludible contribution is lowered by considering the catch-up in the computation of the exclusion allowance.

From model SARSEP (3/2002, pg 3), it states:

Compensation does not include any employer SEP contributions, including elective deferrals. Compensation, for purposes of the $450* rule, is the same, except it includes deferrals made to this SEP and any amount not includible in gross income under section 125 or section 132(f)(4).

● The maximum an employee may elect to defer under this SEP for a year is the smaller of 25% of the employee’s compensation or the limitation under section 402(g), as explained below.

Note: The deferral limit is 25% of compensation (minus any employer SEP contributions, including elective deferrals). Compute this amount using the following formula: Compensation (before subtracting employer SEP contributions) X 20%.

● If you make nonelective contributions to this SEP for a calendar year, or maintain any other SEP to which contributions are made for that calendar year, then contributions to all such SEPs may not exceed the smaller of $40,000* or 25% of compensation for any employee.

● Catch-up elective deferral contributions ... are not subject to the 25% limit.

Aren't allocations required to be based on total compensation. Would allocations in excess of the T/H requiremet (assume 3 percent) have to be allocated any differntly then the first 3 percent?

From SEP PROTOTYPE LRM--(3/2002, page 5), it states:

In no event can the amount allocated to each participant's IRA exceed the lesser of 25% of the participant's compensation or $40,000, as adjusted under Code § 415(d). For purposes of the 25% limitation described in the preceding sentence, a participant's compensation does not include any elective deferral described in Code § 402(g)(3) or any amount that is contributed by the employer at the election of the employee and that is not includible in the gross income of the employee under Code §§ 125, 132(f)(4) or 457.

From SEP Model document--(3/2002, page 1) it states:

Is a catch-up contribution described in Code Sectrion 402(g)(3)?

Contribution limits. You may make an annual contribution of up to 25% of the employee’s compensation or $40,000*, whichever is less. Compensation, for this purpose, does not include employer contributions to the SEP or the employee’s

compensation in excess of $200,000*. If you also maintain a salary reduction SEP,

contributions to the two SEPs together may not exceed the smaller of $40,000* or 25% of compensation for any employee.

What is the result if a model SEP and model SARSEP are adopted? Which document is followed?