|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 all 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.
The IRS requires that you notify each highly compensated employee who exceeded the deferral percentage limit. The notice must contain:
- the amount of the employee’s excess contributions,
- which calendar year the excess contributions and earnings are includible in gross income,
- the requirement that the employee must withdraw the excess contributions (and earnings), and
- the 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 highly compensated employees within 2 ½ months after the end of the plan year (March 15 for calendar-year plans), you must pay a 10% excise tax on the excess contributions. File Form 5330 to report and pay the excise tax. If notification is made after the end of the plan year following the year in which the excess contributions were made then the SARSEP plan will no longer be considered a tax favored retirement plan.
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 (for 2019, $6,000; $7,000 if age 50 or over and for 2018 $5,500; $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 were made (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 by the individual IRA owner.
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.
Who is a 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 $125,000 in 2019 ($120,000 in 2018 – 2015) (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 methods require you to make a contribution to the plan for non-highly compensated employees.
Method 1 (retention) - Under EPCRS, Revenue Procedure 2016-51 Section 6.11(3)(a), you can correct the excess contribution without removing money from the SEP-IRAs of highly compensated employees:
- 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 (distribution) - Under EPCRS, Revenue Procedure 2016-51 Section 6.11(3)(b), you can correct the excess contribution using a combination of distributions from the SEP-IRAs of highly compensated employees plus contributions for non-highly compensated employees:
- Effect distribution of excess contributions, adjusted for earnings through the date of correction, made to SEP-IRAs of highly compensated employees. Report the distribution on Form 1099-R as taxable for the year the distribution is made. Use the Department of Labor’s Online Calculator to determine earnings if it is not feasible to determine actual earnings in the IRA account.
- Contribute an amount equal to the total amount distributed to highly compensated employees to the SEP-IRAs of one of the following groups of non-highly compensated employees:
- current employees who were non-highly compensated employees in the year of the failure, or
- 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.
Example of method 1 correction (retention):
Employer A has one highly compensated employee, Andrea, who is a 10% owner and participates in the SARSEP established by Employer A in 1995. Andrea’s compensation for 2014 was $100,000. Andrea deferred $6,000 in her SEP-IRA in 2014. 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%, then divide 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).
Employer A has not notified Andrea of her excess contribution and the excess contribution has not been corrected as of the end of 2015. Under EPCRS, in 2016, Employer A corrects the error by contributing an additional .8% of compensation to each account owned by the three current employees who were also non-highly compensated employees in 2014. Their revised average deferral percentages are now 4.8% (3.8% + 4.8% + 5.8% = 14.4%, then divide by 3). Andrea’s new maximum deferral percentage is thus 6% (4.8% times 1.25 = 6%), and she may keep her full $6,000 deferral in her SEP-IRA.
Example of method 2 correction (distribution):
Assume the same facts from the above example. Under the distribution correction method, Employer A would have Andrea distribute $1,000 adjusted for earnings through the date of correction from her SEP-IRA. At the time of correction in 2016, assume the amount distributed was $1,200 due to the adjustment for earnings. The distribution to Andrea would be reported on Form 1099-R as taxable for the year the distribution was made. Employer A would make a $1,200 contribution to the SARSEP where it would be allocated among the SEP-IRAs of the three current employees’ who were also non-highly compensated employees in 2014.
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 under “Corrective action.” Employer J files a VCP submission according to Revenue Procedure 2016-51, using Form 14568, Model VCP Compliance Statement. Include Forms 8950 and 8951. 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.
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 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:
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.