Simplified employee pensions: the best plan for a small business.by Knight, Lee G.
The IRS has tried to make it easy to establish a SEP. If its model plan is used, there is very little up-front administration in getting the plan started. As with all employee benefits, the rules for participation, contribution, and integration can get quite complex. But on balance, many small companies may want to explore the possibilities.
The high administrative cost of maintaining a defined benefit pension plan is causing the typical small business to search for an alternative. One alternative--simplified employee pensions (SEPs)--suits the needs of employers with few employees and limited financial resources who do not want to take on the financial commitment inherent in a defined benefit pension plan. In addition, SEPs are useful for employers concerned about the potential fiduciary liability of regular ERISA plans and for those reluctant to undertake burdensome bookkeeping and reporting requirements.
Types of SEPs
A SEP is a combined defined contribution plan/individual retirement account (IRA) that provides for employer contributions on behalf of participating employees. It allows for simplified administration-- provided the IRS's model SEP is adopted. Annual contributions to SEPs are made at the employer's discretion (i.e., employer contributions need not be made in any given year), although they cannot discriminate in favor of the highly compensated.
A SEP is a qualified, employer-funded IRA into which an employer makes contributions for all eligible employees. Each employee has their own IRA account, and annual contributions by the employer are limited to the lesser of 15% of compensation (subject to limitation) for each employee or $30,000. SEPs may be established by corporations, self-employed individuals, or partnerships. Self-employed participants and partners are treated under the plan as employees and are generally subject to the same rules as other employees.
The IRS recognizes four types of SEPs, the model SEP, the prototype SEP, the individually designed SEP, and the salary reduction SEP (SARSEP). The easiest to establish and administer are the model and prototype SEPs. The model SEP is established by simply completing an IRS Form 5305-SEP. Model SEPs, if adopted by an employer without modification, are not required to be filed with the IRS--employers may simply begin making contributions to the employee accounts (Rev. Proc. 87-50). In most cases, employers would be well advised to use the model SEP; however, there are some circumstances in which the model SEP cannot be used. For instance, if an employer already maintains another qualified plan or has maintained a defined benefit plan in the past, the employer is ineligible to use the model SEP. Also, if the employer is a member of an affiliated service group or a commonly controlled business, the employer cannot use the model SEP unless all employees of the group of businesses are covered under the SEP. An affiliated service group is a group of organizations (individuals or entities) that owns or performs services for third parties through another organization in which they have a common ownership interest. Finally, the model SEP cannot be used by employers who intend to integrate SEP contributions with Social Security taxes.
The prototype SEP is also easy to establish and administer, and start-up costs are usually $100 or less. Prototype SEPs are developed by banks, savings and loans, Federally insured credit unions, investment companies, or professional societies that have already received approval from the IRS for their SEPs. The businesses or associations generally make these pre-approved SEPs available to their customers or members for a nominal fee. Like the model SEP, prototype SEPs may not be used by employers who maintain a qualified plan or have maintained a defined benefit plan in the past.
Individually designed plans must be drafted by an attorney to meet the employer's specific needs. These SEPs carry with them the establishment costs of attorney's fees and a certain amount of risk in that the IRS will not issue letter rulings on individually designed SEPs. However, letter rulings may be obtained concerning the plan's qualifications (Rev. Proc. 87-50). Many of the advantages inherent in the model and prototype SEP are diminished with the individually designed SEP such as the ease with which the plans can be established, the low cost of start- up, and administration. Unfortunately, for employers who already have a qualified plan or have had a defined benefit plan in the past, this is the only type of SEP available.
Salary reduction SEPs (SARSEPs) are a special type of SEP that are similar to 401(k) plans in that they permit employees to make contributions to their employer-established IRA accounts from their pre- tax income.
To qualify as a SEP, a plan must cover all "eligible employees" including part-time, seasonal, and shared employees. For a SEP to be tax qualified, employer contributions must be made on behalf of each employee who has:
* Reached age 21;
* Performed services for the employer during at least three of the immediately preceding five years; and
* Received at least $300 in compensation, as adjusted for inflation ($385 for 1993), from the employer for the year.
Further, each eligible employee must participate. If an employee refuses to participate, the employer must establish a SEP-IRA on that employee's behalf and make the required contributions.
As with other tax-qualified plans, SEPs must show they do not discriminate, either in contributions or deferrals, in favor of highly compensated employees. To avoid discriminating, the employer must make contributions to the SEP that bear a "uniform relationship" to the compensation of the participating employees. In SARSEPs, deferrals by highly compensated employees, as a percentage of pay, cannot exceed 125% of the average deferral percentage of all non-highly compensated employees eligible to participate in the plan.
For purposes of eligibility requirements, "employee" includes all members of a controlled group of corporations or trades or businesses under common control and all members of any affiliated service company. Any leased employees must also be covered--this includes persons provided to the employer over a 12-month period who have worked at least 1500 hours or 75% of the hours customarily worked by an employee in a similar position. All employees of a trade or business under common control are treated as employed by a single employer. Thus, employees who are shared by different employers may be considered eligible for a SEP sponsored by one employer if the other requirements are met. Even though part-time employees must be covered, two features of SEPs serve to mitigate the adverse effect of this requirement:
* Many part-time employees arc transient and are excluded from participation by the three year service rule: and
* In SEP plans in which the amount of contributions is based on a percentage of compensation, contributions for part-time employees will usually be low.
Unlike other qualified plans, employers may not set vesting requirements for SEP contributions made on behalf of their employees. Therefore, each employee is immediately vested in any employer contributions made on their behalf. At first glance, this immediate vesting feature may seem like a liability. However, with the change in vesting schedules for other forms of qualified plans (the vesting periods have been shortened), the SEP may still be attractive because of its three-year employment requirement.
An employer's deductible contribution to a SEP for a taxable year cannot exceed 15% of the compensation (subject to limitation) paid to all employees during the calendar year ending with or within the taxable year. However, excess contributions made by the employer may be carried forward and deducted in the next taxable year, subject to the aforementioned 15% limitation. In addition, if the employer has multiple plans, the deduction for the contribution to the SEP reduces the limitations on contributions to qualified profit sharing and stock bonus plans and the 25% limitation on deductible contributions to a combination of plans.
The term "permitted disparity" refers to the integration of the employer's contributions with Social Security withholdings. As with other qualified plans, SEPs (with the exception of the model SEP), can be structured to allow an employer to favor those employees earning more than the current Social Security wage base. Many professionals prefer to use this method to allow a greater overall contribution for professional employees who earn income well in excess of the Social Security wage base. Integration with Social Security is virtually the only method of permitted disparity for SEPs. However, the integration calculations are generally very complex and may require the assistance of outside professional plan administrators, thus increasing administrative cost. Furthermore, SEPs are covered by the "permitted disparity" rules of IRC Sec. 401(1), which limit the allowed disparity in contribution percentages applicable to compensation above and below the Social Security wage base. These are the same "permitted disparity" rules that apply to qualified plans.
Under IRC Sec. 408 (k) (3), the "top heavy" rules of IRC Sec. 416 generally apply to SEPs. In years when 60% or more of the total contributions go to key employees, a minimum contribution must be made on behalf of non-key employees. The minimum contribution is the lesser of three percent of compensation or the highest percentage of compensation contributed on behalf of a key employee. IRC Sec. 416(i) (1) generally defines a key employee as an equity owner or highly paid officer of a business.
The integration formula causes the total contribution to a top heavy SEP to be allocated among participants as follows:
First tier: Three percent of compensation is allocated to all participants.
Second tier: Up to six percent of compensation over $55,700 is allocated to each participant.
Third tier: Any remaining unallocated portion of the contribution is allocated among all participants in proportion to compensation.
Deductibility of SEP Contributions And Rollover Rules
Employer contributions to a SEP are tax deductible as long as they do not exceed the individual limitation of the lesser of 15% (13.0435% for self-employed) of compensation or $30,000 a year, or the overall limitation of 15% of total compensation. There are maximum amounts that can be taken into account in determining the amount of compensation. Through 1993 it was $200,000 adjusted for cost of living increases and amounted to $235,840 for 1993. RRA '93 reduced this amount to $150,000 for 1994. After 1994, this amount will be adjusted for inflation, but the amount will be rounded down to the next lowest multiple of $10,000. Contributions in excess of the individual limitation amounts can be carried over and deducted in the next taxable year as long as the contributions in that year do not exceed the 15%-$30,000 limitation. The excess contribution, however, is subject to a six percent penalty tax each year until it is corrected. A contribution of less than the maximum amount deductible has the effect of eliminating the excess contribution for purposes of the six percent penalty.
Excess contributions cannot be transferred or rolled over into another IRA. If the excess is not returned to the employee by April 15, the excess is subject to the six percent penalty. If the excess is thereafter withdrawn, the 10% early distribution penalty that applies to IRAs generally applies to each employee.
The maximum contribution for the self-employed must be calculated using two restrictions. The earned income base must be reduced by the income tax deduction allowed for one-half of the self-employment tax. The contribution percentage must be calculated by dividing the contribution rate by one plus the contribution rate. For example, a self-employed who had $150,000 of earned income in 1994 would calculate his or her SEP contribution as follows:
SEPs may be established as late as the tax filing date (including extensions) for the prior tax year. Therefore, with the exception of the individually designed SEP, they require little pre-planning. With the model SEP or the prototype, setting up the plan is as simple as filling out a form and deciding what amount to contribute to the employees' IRA.
A small employer's SEP can provide for elective deferrals whereby the employee can choose to receive payments or have them contributed to the plan. Like a 401(k) plan, a salary reduction arrangement SEP (SARSEP) allows employees to make contributions from their pre-tax income to the employer-established IRA. The amount of these contributions is not included in the employees' gross income. Tax on the contribution is deferred until the money is withdrawn from the IRA account. The employee contribution is above and beyond the 15%-$30,000 limitation imposed on employer contributions. For tax years beginning in 1993, the cap on employee contributions is $8,994.
In theory at least, SARSEPs allow small businesses to obtain many benefits of 401(k) plans without the administrative burden and expense of a qualified plan. In reality, however, SARSEPs may be difficult to manage because of the monitoring requirements imposed by the IRS Form 5305A-SEP which the IRS has issued as the model for SARSEPs. SARSEPs need not be established using this form, but the cost of securing an individually designed plan, and to some extent a prototype SARSEP, cause most employers to use SARSEPs established by using Form 5305A-SEP. The Form 5305A-SEP requirements make use of a SARSEP difficult because it imposes notification requirements on the employer, makes the employer responsible for calculating whether contribution limits have been exceeded, and defines "compensation" more strictly than does the IRC.
To be eligible to use a SARSEP, an employer may not have employed more than 25 eligible employees during the tax year, and at least 50% of these employees must choose to participate in the plan. All employees who fit the SEP definition of qualified employees must be counted toward the 25 employee maximum, whether or not they choose to participate in the plan. Proprietors and partners are included in total employees. Use of coercive tactics such as conditioning employment or other benefits upon plan participation or making the employer funding of a pension plan contingent on employee contributions are expressly prohibited. Therefore, while an employer may attempt to "sell" his employees on the benefits of a SARSEP, he or she must be careful not to go to the extreme--i.e., from "selling" to "coercing" or "pressuring."
Although the IRC does not specify a minimum amount an employee must contribute to qualify as a participant, substantial contributions by every participant are necessary in the case of small businesses (e.g., professional associations), if the nondiscrimination standards are to be met. These nondiscrimination requirements dictate that the year's actual deferral percentage (ADP) of each eligible highly-compensated employee not exceed the average deferral percentage of the aggregate of non- highly compensated employees by more than 125%. The deferral percentage is the ratio of the elective deferral contribution to the employee's compensation for the year. For this purpose, compensation cannot exceed $235,840 for 1993 and $150,000 for 1994. "Highly compensated employees" are defined for SARSEP purposes as an employee who, during the year was:
* At any time a five-percent owner of the company;
* Received compensation from the employer in excess of $75,000;
* Received compensation from the employer in excess of $50,000 and was in the top-paid group of employees for such year (the top 20% of employees, by compensation); or
* Was at any time an officer and received compensation greater than 50% of the amount in effect under IRC Sec. 415(b) (1) (A) for such year.
The need to constantly monitor the SARSEP for ADP compliance diminishes the attractiveness of a SARSEP as a simplified 401(k), and makes self- administration of the SARSEP for the small business difficult. This monitoring requirement together with the requirements imposed by Form 5305A-SEP limit some of the practical utility of SARSEP. Thus, small professional firms with a number of highly compensated employees or with partners who have significantly disproportionate incomes to the incomes of the non-highly compensated employees must be aware of these burdens.
The nondiscrimination rules can limit the attractiveness of a SARSEP to small businesses by making it more expensive for the owners to make contributions on their own behalf. In addition, the 50% minimum participation rule will likely make it more difficult to qualify. However, notwithstanding these impediments, the SARSEP's flexibility offers a low-cost opportunity for the small business to offer its employees a self-financed pension plan.
Ray A. Knight, JD, CPA, and Lee G. Knight, PhD, are professors at Middle Tennessee State University. They have published numerous articles in professional publications, including The CPA Journal.
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