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SEP; improper deferrals

Guest Gerry Hedgcock

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Guest Gerry Hedgcock

I am dealing with a SEP established using a model 5305-SEP form. The employer has been making an annual 7.5% contribution. Two years ago, the employer began permitting elective deferrals not realizing this was prohibited. Now, the participants have individual custodial accounts holding valid employer contributions and invalid deferrals. I understand that the VCR program is only for qualified plans and thus not available to a SEP. The employer could qualify under a 457 program and prior employer/employee deferrals would have been valid with the exception of one employee. I would appreciate any ideas on dealing with the problem.

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You don't have a valid 457 plan. You do have a SEP with an employer contribution. The contribution does not satisfy the "uniform" contribution requirment. In a sense, the lowest contribution rate is used and applied to all participants; resulting in excesses for some. None of the amounts are treated as elective deferrals. Here goes--

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From the SIMPLE, SEP, and SARSEP Answer Book (5th Edition), Question 5:24.

To the extent that employer contributions do not satisfy the written allocation formula, the contributions are generally deemed to be contributions that are not made under a SEP arrangement. [Prop Treas Reg § 1.408-7(f)(1)] Instead, such contributions are deemed to be made to an IRA not maintained as part of a SEP. [Prop Treas Reg § 1.408-7(f)(2)] Elective contributions are not treated as employer contributions for allocation purposes.

Employer contributions that exceed the amounts called for under the written allocation formula for the SEP arrangement are treated as if made to the employee's individual retirement account or individual retirement annuity, maintained outside the employee's SEP. It is contemplated that the employer will notify the employee of the amount of the non-SEP contribution made in excess of the allocation formula when it discovers the erroneous contribution. [Prop Treas Reg § 1.408-7, Preamble] Because this amount may result in an excess contribution when made, the employee may wish to take appropriate action in order to avoid IRA penalties. The normal IRA rules under Code Section 219 apply in such a situation and prevent the entire SEP arrangement from being disqualified due to an inadvertent error on the part of the employer, such as an incorrect calculation of employee compensation. Under Code Section 408(k), the entire SEP arrangement could be disqualified on account of the excess contribution. The rule treating the amounts as IRA contributions provides relief in such cases. Similarly, other contributions such as voluntary contributions made by the employee, or on behalf of the employee by the employer as the agent for the employee (such as by payroll withholding to a "payroll deduction IRA"), are treated as employee contributions and not employer contributions for allocation purposes.

Example. In 1999 Weed Corporation adopts a SEP arrangement. The arrangement calls for Weed to contribute the same percentage of each participant's compensation exclusive of SEP contributions to a SEP (allocation compensation). Weed has three employees, Al, Bill, and Carl, who satisfy the participation requirements of the SEP arrangement. The compensation, the contributions to the SEP for each employee, and the varying treatment of the contributions are set forth in the following table.

(1) Employee

(2) Gross Income

(3) Net Compensation Before

(4) ContributionSEP/IRA Contribution

(5) % of Net Compensation

(1) (2) (3) (4) (5)

Al $11,000 $10,000 $ 1,000 10

Bill 11,500 10,000 1,500 15

Carl 57,500 50,000 7,500 15

Total $80,000 $70,000 $10,000

Because only 10 percent of compensation was allocated to Al, and the allocation formula provides that the same percentage must be allocated to each participant, portions of the contribution under the SEP are deemed to be made to Bill and Carl's IRAs that are not part of the SEP arrangement.

To determine Bill and Carl's allocation compensation, the respective total compensation included in their gross income must be divided by 1.10 (1 plus the percentage of allocation compensation contributed to Al under the SEP arrangement). The excess of compensation included in gross income over the allocation compensation is considered to be a contribution under the SEP arrangement. The following table shows the result of this calculation.


Gross Income

Allocation Compensation*

SEP/IRA Contribution

Deemed IRA Contribution**

Al $11,000 $10,000 $1,000 $ 0

Bill 11,500 10,455 1,045 455

Carl 57,500 52,273 5,227 2,273

Total $80,000 $72,728 $7,272 $2,728

Under Code Section 404(h), for purposes of computing Weed Corporation's deduction, only the $7,272 is considered to be a contribution to a SEP arrangement described in Code Section 408(k). The allowable Section 404(h) deduction of $10,909 (15 percent of the excess of total compensation of $80,000 over the SEP contribution of $7,272 or 15 percent of $72,728) is not exceeded. The $2,728 amount is treated as a payment of compensation and subject to the deduction rules of Code Section 162 or 212 (see Q 10:2). Code Section 404(h)(1) treats employer SEP contributions as if they are made to a plan subject to the requirements of Code Section 404. Code Section 404(a) provides special rules for deducting contributions and limitations on amounts that "would otherwise be deductible." Similarly, the deemed IRA contribution of $2,728 would not be considered as an employer SEP contribution for purposes of exemption from FICA and FUTA taxes under Code Sections 3121 and 3306.

The effect of treating the $2,273 as a contribution to a SEP arrangement for purposes of Code Section 408(a)(1), 408(B)(2)(B), and 408(d)(5) is to prevent disqualifying Carl's IRA for accepting non-SEP contributions in excess of the annual $2,000 individual IRA limit [iRC § 219(B)(1)] and to allow Carl to withdraw the excess contribution of $2,273 without including that amount in income under Code Section 408(d)(1). The deemed IRA contribution should be included on Carl's Form W-2 as wages for 1999.

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