|Mistake||Find the Mistake||Fix the Mistake||Avoid the Mistake|
|4) Contributions to participants’ IRAs associated with the SARSEP were miscalculated because you used the wrong definition of compensation.||Review the SARSEP plan document to determine if you’re using the correct compensation amount for allocations.||Correct the failure by following the terms of the SARSEP plan in effect 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 definition of “compensation” must satisfy rules for determining the amount a participant receives in contributions. The amount of compensation you may consider for each participant under the plan is limited.
You must follow your plan definition of compensation when operating 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 including, but not limited to:
- Commissions and tips
- Fringe benefits
Compensation generally doesn't include any employer contributions, including elective deferrals, that either you or your employees made to the SARSEP.
Compensation, for purposes of the $600 rule (see question #3) is the same, except it includes deferrals the participant made to the SARSEP and any amount that the employee doesn’t include in gross income under Internal Revenue Code Section 125 (cafeteria plans) or 132(f)(4) (certain qualified fringe benefits).
You may use an alternative definition of compensation, permitted under Internal Revenue Code Section 414(s) that excludes some of the above listed items but these compensation exclusions must be specified in your plan document.
If you are a self-employed person sponsoring a SARSEP, the compensation on which you calculate your maximum contribution is your net earnings from self-employment. Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans), has a worksheet for this calculation.
How to find the mistake:
To determine if you‘re using the correct 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 deferral percentage 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
- fail to limit compensation to the annual amount ($280,000 in 2019 and $275,000 in 2018)
Review the plan section on allocations and deferrals, which 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 and/or employer contributions by basing them on compensation that your plan doesn’t allow, you have excess amounts that you should correct by using either the:
- Distribution Method - effects distribution for the excess amount, as adjusted for earnings (Revenue Procedure 2016-51, section 6.11(5)(a)). Use the Department of Labor’s Online Calculator to determine earnings if it is not feasible to determine actual earnings in the IRA account.
- When the excess amount is caused by contributing excess elective deferrals, the amount may be distributed and reported (Form 1099-R) as taxable for the year the distribution is made.
- When the excess amount is caused by contributing excess employer contributions, the excess amount may be distributed to the plan sponsor rather than to the participants. If an excess amount caused by excess 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 – retains excess amounts 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 (Revenue Procedure 2016-51, section 12.06). The 10% special fee is in addition to the Voluntary Correction Program user fee.
Small excess amounts. If the total excess amount is $100 or less, you aren’t required to distribute the excess and aren’t subject to the special additional VCP fee if the excess amount is retained.
If you improperly determined elective deferrals and employer contributions because you excluded part of a participant’s compensation, you would contribute:
- 50% of the employee’s salary deferral percentage based upon their salary reduction form times the employee’s excluded compensation (Note: unlike mistake #3, in this case, the participant’s salary deferral election is known), and
- the employer’s original contribution rate under the plan times the excluded compensation. Adjust the amounts contributed for earnings to the date you correct. If it isn’t feasible to determine what the actual investment results would have been, you may use a reasonable rate of interest. Consider using the Department of Labor’s Department of Labor’s Online Calculator for this purpose.
For 2015, Susan elected to make an elective deferral equal to 5% of her compensation to her employer’s SARSEP plan. The plan terms require that the employer contribute 2% of compensation for each employee. However, when determining Susan’s elective deferral and required employer contributions, her employer didn’t include $1,000 of her 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 terms.
The required corrective employer contribution must replace Susan’s missed opportunity to make elective deferral contributions on her overtime income and any employer contribution that Susan would be entitled to under the plan 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 her missed deferral opportunity, before adjusting for earnings, is 50% of $50, or $25.
- Employer contributions. Under the plan terms, Susan was entitled to an employer contribution equal to 2% of the excluded overtime income of $1,000. To correct the missed employer contribution for Susan’s overtime income, her employer must make a corrective contribution of $20 (2% of $1,000). The corrective contribution must be adjusted for earnings through the date of correction.
The total corrective employer contribution for Susan is a corrective contribution to replace Susan’s missed deferral opportunity for her overtime compensation ($25 adjusted for earnings) and to replace the employer contributions that Susan would have been entitled to under 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.
Plan sponsors have the option to reduce the corrective contribution for the missed deferral opportunity from 50% of missed deferrals to 25% under certain conditions:
- The excluded employee must be currently employed by the employer at the time of correction
- Correct deferrals finally begin by the first payment of compensation made on or after the earlier of:
- the last day of the second plan year after the plan year in which the failure first began for the affected employee, or
- the last day of the month after the month the affected eligible employee first notified the plan sponsor.
- Within 45 days of being given the opportunity to make salary reduction contributions, the affected participant must receive a special notice. See Appendix A.09 discussed in Rev. Proc. 2016–51 for details as to the specific content that must be in this notice. If the participant terminates employment before the notice is provided then this requirement has not been met.
- All corrective contributions must be paid to the excluded employee’s IRA before the end of the 2nd plan year beginning after the initial year of the failure.
Correction programs available:
The example illustrates an operational problem, because the employer failed to follow the SARSEP plan document terms 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 for 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 according to Revenue Procedure 2016-51. Consider, using Form 14568, Model VCP Compliance Statement, including Form 14568-C, Model VCP Compliance Statement - Schedule 3: SEPs and SARSEPs. Include Forms 8950 and 8951. Note that the 25% correction method for missed deferral opportunity is not part of Form 14568-C. Beginning in 2018, the user fee for VCP submissions is generally based upon the current value of all IRAs that are associated with the SARSEP plan. For example, if the value is between $0 and $500,000, the user fee is $1,500. If the value of all IRAs exceeds $500,000, the user fee will be higher.
If the mistake includes excess amounts contributed to the employees' IRAs associated with the SARSEP, the employer must use, VCP if the employer wishes to allow the excess amounts to remain in the affected participants’ IRAs. If this correction method is used a special additional payment of at least 10% of the excess amount will apply. This is in addition to the VCP submission user fee.
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 that is not excessive, considers facts and circumstances, and bears a reasonable relationship to the nature, extent and severity of the failures, based upon all relevant factors described in section 14 of Rev. Proc. 2016-51.
How to avoid the mistake:
When calculating allocations of employer contributions and salary reduction contributions, it’s important to review plan terms to ensure that you’re using the correct amount of compensation. Consider including in your payroll program an account that lists all of a participant’s compensation as defined in the plan.