SEP established incorrectly?

[Barbara]

This question is not exactly on point, but here goes:

An old SEP which was established incorrectly, into which an individual made contributions over many years totaling $66k improperly, but for which the accountant never took deductions (because he had advised his client NOT to make the contributions in the first place.) To clarify, the individual is a 1% partner in an LLC, and all of his income is from this LLC, which sponsors a 401(k) Plan for the partners and employees.

Client now wants to withdraw the $$ from the SEP, but custodian is insisting that they must issue a 1099, since the money is theoretically in a SEP.

Can anyone think of a way to convince the custodian not to issue the 1099?.

[Gary Lesser]

Never going to happen. Trustee or custodian MUST issue 1099-R if a distribution (serious penalties for not filing and another for not furnishing**). There was/is no employer and there is no SEP (because employer was ineligible). The distribution s being made from an IRA. His or her argument (basis) is with the IRS. The basis in an IRA is "[g]enerally...zero."" [See Conference Committee General Explanation,* ERISA Sec. 2002, see "Taxation of distributions--in general"]

But what about the 6% tax on excess contributions (on amounts over his allowable limits)?

The amount contributed over the amount "allowable" as a deduction ($0) may also be subject to the tax on nondeductible contributions (IRC 4972). But see 4972(C)(6) exception "[i}ndetermining the amount of nondeductible contributions for any taxable year, there shall not be taken into account—...so much of the contributions to a ... simplified employee pension (within the meaning of section 408(k)) which are not deductible when contributed solely because such contributions are not made in connection with a trade or business of the employer."

Under the EPCRS VCP there could be sanctions. The defect (ineligible employer) is not eligible for SCP. 

Hope this helps. ~~Gary

 

* See CCH, Pension Reform Act of 1974--Law and Explanation, p. 368.

** See  IRC 6721 and 6722.

 

[Luke Bailey]

I had a similar experience/issue with a 401(k) a few years ago. I think the right answer if the plan or SEP was NEVER qualified from the get go (which this one wasn't), is that there is no plan or SEP and so the person holding the funds (who is not a custodian because there is no plan or SEP) should just return them and report on a 1099-MISC. As Gary Lesser implies, probably will be difficult or impossible to get the custodian to agree.

[Barbara]

Thanks to both of you for the prompt responses.