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 are subject to a nondiscrimination test similar to the annual test imposed on 401(k) plans. This test limits the amount highly compensated employees can defer based on what nonhighly compensated employees defer into the SARSEP. Compute the deferral percentage (DP) limit for HCE employees by averaging the DPs for the NHCEs for the year and then multiplying this result by 1.25. You must compute the DP limitation each year. See the Instructions for Form 5305A-SEP for this computation.
The DP test for SARSEPs compares the DP of each HCE with the average of the DPs of all other employees – not the average of the DPs of all HCEs with the average of all other employees (as in a 401(k) plan). Further, unlike 401(k) plans, nonelective contributions from the employer cannot be used to help the SARSEP satisfy the annual test.
If an HCE has exceeded the DP limit for a year, you must notify each affected employee by 2 ½ months from the end of the plan year (March 15 for calendar-year plans) of:
- The amount of the preceding year's excess contributions to the employee’s SEP-IRA,
- The calendar year the excess contributions and earnings are includible in gross income,
- Information stating that the employee must withdraw the excess contributions (and earnings), and
- An explanation of the tax consequences if the employee doesn’t withdraw the amounts.
See the Instructions for Form 5305A-SEP for a detailed description of the notification 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 Excess contributions not withdrawn by April 15 will be subject to the IRA contribution limits ($5,500 in 2013; $6,500 if age 50 or over) and may be considered excess contributions to the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 of age, 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
- For the preceding year (2012) received compensation from you of more than $115,000 (subject to cost-of-living adjustments for later years), and, if your SARSEP document so 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 HCEs and NHCEs for purposes of the DP nondiscrimination test. Third party administrators should pay special attention to:
- Prior year compensation
- The attribution rules related to ownership when identifying 5% owners.
- TPAs need access to ownership documents to identify 5% owners.
- Take care to identify family members of the owners, since many will have different last names, which may warrant further review for proper attribution.
Also, review the rules and definitions in your plan document for:
- Properly determining HCEs
- DP testing
An HCE or NHCE includes 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 DP test and you don’t timely notify the affected HCEs, it will result in plan disqualification. If the data used for the original testing is incorrect, then you may need to rerun the DP test. If the original or corrected test fails, then corrective action is required to rectify the excess contributions made to the HCEs.
- By regulations, corrective action described in the plan document must be taken within 12 months following the end of the plan year to which the excess DP contributions relate. If this is done, EPCRS isn’t needed.
- If 12 months have elapsed since the close of the plan year, you may pursue corrective action through EPCRS.
There are two methods of correcting DP testing mistakes. You may choose whichever method you prefer. Both require a contribution to the plan for NHCEs.
Method 1 - Under EPCRS, Appendix A, section .03 of Revenue Procedure 2013-12, the permitted correction method is to:
- Determine the amount necessary to raise the average of the DPs of the NHCEs to the percentage needed to pass the test.
- Contribute (to the extent permitted by section 415) for all eligible NHCEs as necessary to raise the DP to pass the test. Calculate this amount to provide the same percentage rate for all NHCEs regardless of the SARSEP terms.
Method 2 - Under EPCRS, Appendix B, section 2.01, an alternative permitted correction method is referred to as the one-to-one method.
- You may effect distribution of excess contributions, adjusted for earnings through the date of correction, to HCEs to correct the failure. You must also contribute to the SEP-IRA an amount equal to the total amount distributed. This amount must be allocated to:
- current employees who were NHCEs in the year of the failure,
- current NHCEs who were NHCEs in the year of the failure, or
- current and former employees who were NHCEs in the year of the failure.
Employer A has one HCE, Andrea, who is a participant in the SARSEP. Andrea’s compensation for 2011 is $100,000. Andrea defers $6,000 into the SARSEP. Andrea’s deferral percentage is 6% (6,000/100,000). Employer A also has three NHCEs who contributed deferral percentages of 3%, 4% and 5%. The average deferral percentage for the NHCEs is 4% (3%+4%+5%/3). The maximum deferral percentage Andrea could have made is 5% (4% times 1.25). The amount of Andrea’s excess is $1,000 or 1% of her salary (6% - 5% times $100,000.)
Correction programs available:
The example illustrates an operational problem, because Employer A failed to follow the plan’s terms relating to nondiscrimination testing. Therefore, if the other eligibility requirements of SCP are satisfied, Employer A may be able to use SCP to correct the failure. Employer A would have to determine whether:
- Appropriate practices and procedures were originally in place to facilitate compliance with requirements regarding 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 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.
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:
Consider terminating the SARSEP and establish, in a subsequent year, a SIMPLE IRA plan, which isn’t subject to the discrimination testing. Communicate with the plan administrator to ensure proper employee classification. Ensure that both you and the plan administrator are familiar with the terms of the SARSEP plan document. Perform an annual DP test in accordance with the instructions provided in the plan document. Compare the figures in the test with the payroll records, verify proper classification of employees as either HCE or NHCE and ensure that the results meet the required limits.