Armanino Blog

Three Things to Remember About SEPs

by Gary Wyatt
March 30, 2017
Simplified employee pension (SEP) plans are a great retirement savings (and tax deferral) tool for some taxpayers. Substantial contributions may be made and deducted. There is little administration, since all participants have a separate account, and there is no required annual report (Form 5500 series). There are some rules, however, and there are three areas where companies often make mistakes:
  • Sponsor
  • Type of income
  • Coverage
SEPs may be sponsored by sole proprietors, corporations or partnerships, including LLCs. The key is having the right sponsor for the source of compensation. One common mistake is when an individual partner (or LLC member) sponsors a SEP on the basis of partnership income. Receipt of a Form K-1 does not entitle an individual to sponsor a SEP. The partnership (or LLC) from which the individual received Form K-1 may sponsor a SEP.

Type of income
Only earned income may be used as the basis for a SEP contribution. This may be Form W-2 wages or earned income from self-employment. Although there are some obscure exceptions, the easy way to remember this is that the income generally must have been subjected to Medicare tax. Thus, for partnership and LLC income (Form K-1 for Form 1065) to be counted as compensation eligible for SEP contribution, the amount must have been included on line 14 of Form K-1. Compensation is limited to Form W-2 wages for S corporation shareholders.

Although standards may be more liberal, generally an employer must include all employees over age 21 who have worked for the employer in three of the past five years.

One common problem is that business owners often want to establish a service criterion for other employees that they cannot meet themselves. That does not work. If owner A establishes a new business and hires assistant B at the outset, the criterion for SEP participation for that first year cannot be three years of service, because neither A nor B would meet the condition.

A second problem is that taxpayers (and sometimes their advisors) fail to understand what is meant by “employer.” As used in this area of tax law, employer means all entities commonly controlled or affiliated, under Code sections 414(b), (c), (m), or (o). Thus, if personal service corporation X is owned by individual A and the business of X is managing another service business Y, X may not contribute to a SEP for the benefit of A without also contributing for eligible employees of Y.

To learn more about using SEPs, contact your local Armanino expert.

March 30, 2017

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