LLC, K-1 and SEP

[Guest dbvail]

We have a peospective client who is an LLC, but all employees havee their income reported as K-1. The client wants to establish a 401(k) plan. So far so good.

But now I am informed that several of the employees have set up SEP's for themselves based on the K-1 income from the LLC. Am I missing something? If what they really have are IRA's that's ok, but it was expressed to me that these were SEP's.

Does this seem a tad bad? Any thoughts are appreciated.

[Mike Preston]

If they are paid via anything other than W-2, then they aren't being treated as employees.

And if they really are employees, the employer is in a world of hurt.

Way too much to unwind simply, so suggest an ERISA lawyer.

I wouldn't touch a 401(k) for this plan sponsor until they confirm that there are truly no employees (in which case those folks don't get to participate in the plan) or until they are paid as employees.

[Guest dbvail]

If they are paid via anything other than W-2, then they aren't being treated as employees.

And if they really are employees, the employer is in a world of hurt.

Way too much to unwind simply, so suggest an ERISA lawyer.

I wouldn't touch a 401(k) for this plan sponsor until they confirm that there are truly no employees (in which case those folks don't get to participate in the plan) or until they are paid as employees.

[Guest dbvail]

Mike,

Thanks, and I truly share the concern.

As I am to understand it these are are all partners in the LLC, there are no common law employees. It is taxed as a partnership.

My real concern is that the SEP arrangements were iffy in that the employer did not sponsor a plan.

My gut says the individual SEPs were invalid as they were not sponsored by the ER as a 'plan'.

After 25 years in the business this is a new twist.

Thanks

[Jim Norman]

I'll disagree with Mr. Preston a bit (YES!, its been a long time!). If the LLC is taxed as a partnership and its members are receiving K-1s that include self-employment income, then these members are considered employees of the LLC for plan purposes (401©(4)). They are being treated as employees just as any partner who receives a K-1 instead of a W-2 (which partners are not supposed to get).

Assuming this is the case, the individual members are not eligible SEP sponsors with respect to their K-1 income. [Editorial comment: Of course there are probably 10s of thousands of "partners" doing this very thing and IRS doesn't seem to mind, but this doesn't change what the code says.]

Again, if the LLC is taxed as a partnership and these members are getting SE income on the K-1, setting up the 401(k) is straightforward. For plan purposes you have a partnership with partners. They may "defer" during the year, but their ultimate plan compensation will derive from their K-1 income adjusted for SE tax deduction, 179, unreimbursed partnership expenses, employer contribution, etc.

The SEPs have multiple problems. The deductions would not be allowable (since the SEP did not cover all employees of the employer (the LLC)), no doubt not everyone received the same % contribution, and the employer (the LLC) did not adopt the SEP in the first place. In addition to loss of deductions IRS would likely assess 6% excess IRA contribution excise tax.

[Mike Preston]

Jim, that isn't a "bit". No matter. I was focused on the wrong thing. As you note, if they are partners, then they are treated as employees for plan purposes. All is good. You are right.

In my defense, if they are employees and being paid with a K-1 (and not partners) I assume you would agree with me that things are FUBARed.

I think the IRS doesn't challenge these things because a partner has the "right" to sign things on behalf of the partnership. The problem comes, of course, if they don't all set up a single SEP. Separate SEP's will end up with "bad" (disqualified?) SEP's for all.

[Jim Norman]

In my defense, if they are employees and being paid with a K-1 (and not partners) I assume you would agree with me that things are FUBARed.

Oh yeah, major FUBAR in this case!

[Gary Lesser]

If there were common-law employees (getting W-2s) in addition to the partners receiving K-1s, the IRS might entertain at fix under the EPCRS (Rev. Proc. 2008-50).

If so, by year--how many nonowners were excluded (eligible to participate) and how many owners had SEPs and how many didn't?

As a side question, did any partner with a SEP have any ouside earned income AND would that outside business be treated as a controlled or related employer with the LLC? Most plans provide that they cover "controlled and related employers" so there may be some wiggle room to fix an otherwise faulty adoption. [Practititioners that I have assisted with in submitting SEP EPCRS applications have contacts they can call and discuss "hypothetical" fact patterns.]

It is the "employer" that must sponsor the plan; that's the LLC.

Thus, contributions were not made under a SEP and all (employer and elective) contributions are excess contributions in the IRA.

The real problem may be in correcting those excesses for prior years (not made in 2010) as the return due date has probably passed. Under Code Section 408(d)(5)(A) the amount corrected in not suject to tax, but only to the extent the excess doesn't exceed the $5,000/$6,000 traditional IRA limitation. Thus, amounts may be subject to tax when withdrawn. Under normal circumstance this limit is increased for SEP contributions (of which there were--technically--none).

Since the 6 percent penalty on excess contributions is cummulative; a correction method need to be chosen (as the problem just gets worse with each passing year).

SEPs are very unforgiving creatures.

Hope this helps.

[Guest dbvail]

Many thanks to all. Ask Ricky said to Lucy, 'you have some 'splainin to do'. I will be in touch with our maybe not prospect next week.

Again, thanks.