SARSEP Fix-It Guide - Contributions to participant’s SEP-IRAs were miscalculated because you used the wrong definition of compensation
|Mistake||Find the Mistake||Fix the Mistake||Avoid the Mistake|
|4) Contributions to participants’ SEP-IRAs were miscalculated because you used the wrong definition of compensation.||Review the plan document to determine if you’re using the proper compensation amount for allocations.||Correction of the failure is based on the terms of the plan at the time of the mistake.||Review the SARSEP plan terms to ensure that you're considering the correct amount of compensation when calculating contributions.|
A SARSEP plan’s definition of “compensation” must satisfy applicable rules for determining the amount of contributions. The amount of compensation taken into account under the plan cannot exceed $255,000 in 2013 and is subject to cost-of-living adjustments for later years.
You must follow the definition of compensation stated in the plan document in the operation of your plan. Compensation generally includes the pay an employee received from you for personal services for a year including:
- Wages and salaries
- Fees for professional services
- Other amounts received (cash or non-cash) for personal services actually rendered by an employee, including, but not limited to, the following items:
- Commissions and tips
- Fringe benefits
Compensation generally does not include any employer contributions, including elective deferrals made to the SARSEP.
Compensation, for purposes of the $550 rule, is the same, except it includes deferrals made to the SARSEP and any amount not includible in gross income under Internal Revenue Code Section 125 (cafeteria plans) or 132(f)(4) (certain qualified fringe benefits).
How to find the mistake:
To determine if you‘re using the proper compensation for allocations, you’ll need to review your SARSEP plan document.
You may not be aware your plan contains different definitions of compensation when calculating the DP test. In some cases, you or the plan administrator may use the incorrect definition of compensation when determining the compensation eligible for the employee to defer or the plan administrator may fail to limit compensation to $255,000 as required by the Internal Revenue Code.
Review the plan section that deals with allocations and deferrals. This section will have language that says, for example, “Employees may defer up to 15% of their Compensation.” You then have to go to the plan section containing definitions and find the “Compensation” definition.
Spot-check allocations to see if you're using the correct compensation as defined in your plan document. If you're using the Form 5305A-SEP, make sure you are basing allocations on total compensation. If you have a plan with a complicated definition of compensation, develop a worksheet to calculate the correct amounts.
How to fix the mistake:
If you've improperly determined elective deferrals by including compensation not allowed for by the plan, you have excess amounts that you should correct by using one of the following methods:
- Distribution Method. This method of correcting an excess amount is to effect distribution for the excess amount, as adjusted for earnings (See section 6.11(5)(a) of Revenue Procedure 2013-12). When the excess amount is because of elective deferrals, the amount may be distributed and reported (Form 1099-R) as taxable for the year in which the distribution is made. When the excess amount is because of employer contributions, the excess amount may be distributed to the plan sponsor rather than to the participants. If an excess amount because of employer contributions is distributed to the plan sponsor, it is still reported on a Form 1099-R issued to the participant, but the taxable amount is zero.
- Retention Method. In lieu of making a corrective distribution, excess amounts may be retained in the SEP-IRA. If the retention method is used, the plan sponsor is subject to a special fee of at least 10% of the excess amount (see section 12.05(2) of Revenue Procedure 2013-12). The special fee is in addition to the VCP submission fee.
Small excess amounts. If the total excess amount is $100 or less, distribution is not required and the special additional VCP fee does not apply if the excess amount is retained.
If you have improperly determined elective deferrals and employer contributions by excluding required compensation, you would make a contribution equal to (a) 50% of the employee’s salary deferral percentage under the plan times the excluded compensation (Note: unlike the mistake in #3, in this case, the participant’s salary deferral election is known) and (b) the employer’s original contribution rate under the plan times the excluded compensation. Adjust the amounts contributed for earnings to the date of correction.
Susan elected to make an elective deferral equal to 5% of compensation to the SARSEP plan. The plan’s terms require that the employer contribute 2% of compensation for each employee. However, when determining the elective deferral contribution and the required employer contribution, Susan’s employer didn’t include $1,000 of overtime income. Thus, Susan wasn’t able to make elective deferral contributions (based on her election of 5% of compensation) on overtime income, and her employer ignored overtime income for determining the employer contribution that Susan was entitled to under the plan’s terms.
The required corrective employer contribution must replace Susan’s missed opportunity to make elective deferral contributions with respect to the overtime income and any employer contributions that Susan would be entitled to under the plan’s terms.
- Missed deferral opportunity. Susan’s missed deferral, based on her election is 5% of $1,000 or $50. The required corrective employer contribution to replace Susan’s missed deferral opportunity, before adjusting for earnings, is 50% of $50 or $25.
- Employer contributions. Under the plan’s terms, Susan was also entitled to receive an employer contribution equal to 2% of compensation, and the overtime income of $1,000 should have been included in the compensation determination. Thus, to replace the missed employer contribution with respect to overtime income, the required corrective employer contribution is 2% of $1,000 or $20. The corrective contribution must also be adjusted for earnings.
The total corrective employer contribution for Susan is equal to the corrective contributions required to replace Susan’s missed deferral opportunity with respect to overtime compensation ($25 adjusted for earnings) and to replace the employer contributions that Susan would have been entitled to under the terms of the plan ($20 adjusted for earnings). If it isn’t feasible to determine what the actual investment results would have been, you may use a reasonable rate of interest (see Revenue Procedure 2013-12 sections 6.11(4) and 6.02(5)(a)).
Correction programs available:
The example illustrates an operational problem, because the employer failed to follow the terms of the SARSEP plan document by failing to include overtime income in compensation used to determine plan allocations. If the other eligibility requirements of SCP are satisfied, the employer may be able to use SCP to correct the mistake if no excess monies are allowed to remain in the affected participants’ IRAs. The employer would have to determine whether:
- Appropriate practices and procedures were originally in place to facilitate compliance with requirements regarding compensation and allocations under the plan.
- The failure is insignificant.
Voluntary Correction Program:
Under VCP, correction is the same as described above under “Corrective action.” The employer files a VCP submission in accordance with Revenue Procedure 2013-12, using the model documents, including Schedule 3 and Forms 8950 and 8951.The fee for the VCP submission is $250.
If the mistake includes excess amounts contributed to the employees' SEP-IRAs, VCP must be used if the employer wishes to allow the excess amounts to remain in the affected participants’ IRA. In this case, there will be an additional compliance fee equal to 10% of the excess amounts.
Audit Closing Agreement Program:
Under Audit CAP, correction is the same as described above under “Corrective action.” The employer and the IRS enter into a Closing Agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount.
How to avoid the mistake:
When calculating allocations, it‘s important for you to review the plan terms to ensure that you are using the correct amount of compensation. If necessary, you may wish to include in your payroll program an account that accumulates the proper compensation figures for all employees.