Effect of Disallowed Deferrals on Employer Withholding Obligations

[Christine Roberts]

Presume a SARSEP fails the 50% minimum participation test two years in a row - 1999 and 2000. Upon discovery of the problem late in 2000, all deferrals are stopped. If I understand correctly, presuming timely notification to employees, and timely withdrawal of disallowed deferrals, the only tax consequences of unwinding are the additional income tax to employees - and, I am guessing, the additional employment taxes the employer must pay on the re-included income. But for the prior year, the employees must ALSO potentially pay excise taxes on disallowed deferrals and earnings under IRC Secs. 4973 and 72(t), respectively, and the employer must potentially pay a 10% excise tax for untimely notification of excess SEP contributions. Is that correct? And, in either year the SARSEP failed the 50% test, can the employees "keep back" $2,000 as a deductible IRA contribution for each year, or must all deferrals be withdrawn?

[Gary Lesser]

The employee can treat up to $2,000 as a traditional IRA contribution if they were deemed to have made it. If the excesses are included on form W-2 (as amended), then the employer would be off the hook (IMO) for the 10% penalty and the employee would have been deemed to have made the contributions into the IRA. Obviously, it is too late to withhold income taxes. Insofar as FICA and FUTA relating to any pure employer contributions, see, e.g., IRC 3121(a)(5).