SARSEP Fix-It Guide - You didn’t pass the annual deferral percentage test
|Mistake||Find the Mistake||Fix the Mistake||Avoid the Mistake|
|9) You didn’t pass the annual deferral percentage test.||Perform and review the test for each year in which deferrals were made.||Two possible correction methods:
a. Distribution method
b. Retention method
|Communicate with plan administrator to ensure proper employee classification. Ensure that both you and the plan administrator are familiar with the terms of the plan.
Consider converting to a SIMPLE IRA plan.
SARSEPs must pass a nondiscrimination test similar to the annual test that 401(k) plans must pass. This test limits the amount highly compensated employees can defer based on what non-highly compensated employees defer into the SARSEP. Compute the deferral percentage (DP) limit for highly compensated employees by averaging the deferral percentages for the non-highly compensated employees for the year and then multiplying this result by 1.25. You must compute the DP limit each year. See the Instructions for Form 5305A-SEP for this computation.
The DP test for SARSEPs compares the deferral percentage of each highly compensated employee (not the average deferral percentage of all HCEs) with the average of the deferral percentages of all non-highly compensated employees. Unlike 401(k) plans, nonelective contributions from the employer can’t be used to help the SARSEP satisfy the annual test.
If a highly compensated employee exceeded the deferral percentage limit for a year, you must notify each affected employee within 2 ½ months after the end of the plan year (March 15 for calendar-year plans) of the:
- amount of the employee’s excess contributions,
- calendar year the excess contributions and earnings are includible in gross income,
- requirement that the employee must withdraw the excess contributions (and earnings), and
- tax consequences if the employee doesn’t withdraw the amounts.
See the Instructions for Form 5305A-SEP for a detailed description of the notice procedures.
If you don't notify the affected employees within this time period, you must pay a 10% tax on the excess.
The employee must withdraw those excess contributions by April 15 following the year in which the employee is notified. Excess contributions not withdrawn by April 15 will be subject to the IRA contribution limits ($5,500 in 2014; $6,500 if age 50 or over) and may be considered excess contributions to the employee’s IRA. For the employee, these excess contributions are subject to a 6% tax on excess contributions under Internal Revenue Code Section 4973. Income earned on excess elective deferrals for the year contributed is includible in the employee’s income in the year it is withdrawn from the IRA. The income must also be withdrawn by April 15 following the year of notification. If the excess elective deferral and related income is withdrawn after that date and the recipient is not 59½ years old, it may be subject to the 10% tax on early distributions.
If you don’t notify your employees within 12 months following the end of the plan year in which the excess SARSEP contributions arose (December 31st for calendar-year plans), the SARSEP will no longer be treated as meeting the rules of Internal Revenue Code Section 408(k)(6). In this case, any contribution to an employee’s SEP-IRA will be subject to the IRA contribution limits and may be considered an excess contribution.
Excess SARSEP contributions of an HCE who is age 50 or older before the end of the calendar year don't have to be removed from the employee’s SEP-IRA to the extent the amount of the excess contribution is less than the catch-up elective deferral contribution limit (see 402(g) limit) reduced by any catch-up elective deferral contributions already made for the year.
Highly compensated employee: An HCE is an employee who:
- Owned more than 5% of the capital or profits in your business at any time during the year or the preceding year, or
- In the preceding year, received more than $115,000 (subject to cost-of-living adjustments) in compensation from you and, if your SARSEP document provides, was in the top 20% of employees when ranked by compensation.
How to find the mistake:
Complete an independent review to determine if you properly classified highly compensated and non-highly compensated employees for the deferral percentage test. Third party administrators should pay special attention to:
- Prior year compensation.
- The ownership attribution rules when identifying 5% owners.
- TPAs need access to ownership documents to identify 5% owners.
- Take care to identify family members of the owners, because some may have different last names and may need to be included under the attribution rules.
Also, review the rules and definitions in your plan document for:
- Highly compensated employees
- Deferral percentage testing
Highly or non-highly compensated employees include all employees eligible to make an elective deferral, even if they choose not to make one for the plan year.
How to fix the mistake:
If a SARSEP plan fails to satisfy the deferral percentage test and you don’t timely notify the affected highly compensated employees, it will result in plan disqualification. If you used incorrect data for testing, you may need to rerun the deferral percentage. If the original or corrected test fails, then you’re required to correct the highly compensated employees’ excess contributions.
- By regulations, you must correct this error according to your plan document within 12 months following the end of the plan year in which highly compensated employees made excess contributions.
- If you haven’t corrected this error within 12 months after the end of the plan year of the excess contributions, you may use EPCRS to correct this failure.
There are two methods to correct deferral percentage testing mistakes. You may choose whichever method you prefer. Both require you to make a contribution to the plan for non-highly compensated employees.
Method 1 - Under EPCRS, Appendix A, section .03 of Revenue Procedure 2013-12, the permitted correction method is to:
- Determine the amount needed to raise the non-highly compensated employees’ average deferral percentage to the percentage needed to pass the test.
- Contribute (to the extent permitted by Internal Revenue Code Section 415) to all eligible non-highly compensated employees an amount necessary to raise the deferral percentage to pass the test. Calculate this amount to provide the same percentage rate for all non-highly compensated employees regardless of the SARSEP terms.
Method 2 - Under EPCRS, Appendix B, section 2.01, another correction method is the one-to-one method.
- Effect distribution of excess contributions, adjusted for earnings through the date of correction, to highly compensated employees. Report on Form 1099-R as taxable for the year the distribution is made.
- Contribute an amount equal to the total amount distributed to the SEP-IRAs of:
- current employees who were non-highly compensated employees in the year of the failure,
- current non-highly compensated employees who were non-highly compensated employees in the year of the failure, or
- current and former employees who were non-highly compensated employees in the year of the failure.
Employer A has one highly compensated employee, Andrea, who is a participant in the SARSEP. Andrea’s compensation for 2012 was $100,000. Andrea deferred $6,000 into the SARSEP. Andrea’s deferral percentage is 6% (6,000/100,000). Employer A also has three non-highly compensated employees who contributed deferral percentages of 3%, 4% and 5%. The average deferral percentage for the non-highly compensated employees is 4% (3%+4%+5% = 12% divided by 3). The maximum deferral percentage Andrea could have made is 5% (4% times 1.25). Andrea’s excess contribution is $1,000 (6% - 5% times $100,000).
Correction programs available:
The example illustrates an operational problem, because Employer A failed to follow the plan terms for nondiscrimination testing. Therefore, if the other eligibility requirements of SCP are satisfied, Employer A may be able to use this program to correct the failure. Employer A would have to determine whether:
- Appropriate practices and procedures were originally in place to facilitate compliance with requirements for the deferral percentage test.
- The failure is insignificant.
Voluntary Correction Program:
Under VCP, correction is the same as described above. Employer A files a VCP submission according to Revenue Procedure 2013-12, using the model documents, including Schedule 3 and Forms 8950 and 8951. The fee for the VCP submission is $250.
Audit Closing Agreement Program:
Under Audit CAP, correction is the same as described above under VCP. Employer A 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:
Ensure that both you and your plan administrator are familiar with your SARSEP plan document terms. Perform an annual deferral percentage test according to the instructions in your plan document. Compare the figures in the test with your payroll records, verify proper classification of employees as either highly or non-highly compensated and ensure that the results meet the required limits.
Consider terminating the SARSEP and establish, in a subsequent year, a SIMPLE IRA plan, which isn’t subject to the discrimination testing.