My Client Wants to Adopt a SEP Plan

It is important for the employer to know the differences between an IRS model 5305-SEP or a prototype simplified employee pension (SEP) plan for a number of reasons. Do they have another plan? Do they want to provide the same percentage of contributions for all employees? Does the Employer “own” more than one business?

 

Once that decision is made, the employer can adopt a formal written SEP Agreement and then communicate the plan provisions to the employees.

 

Let’s compare the IRS model form 5305-SEP and an IRS approved prototype SEP plan. When reviewing the model SEP, you will notice three things very quickly: it’s amazingly short, very little to complete but also very restrictive.

 

 

IRS Form 5305-SEP is a model SEP plan document drafted by the IRS but is rather restrictive in its design. The form is not available to all employers; it may not be used by an employer that:

 

 

An IRS-approved Prototype SEP plan document generally allows more flexibility than the IRS Model Form 5305-SEP. Financial organizations can obtain a prototype SEP from a document provider or mass submitter for relatively little cost. Each financial organization would receive an opinion letter from the IRS that has been requested by the document provider/mass submitter firm. 

 

Depending upon the terms and provisions of the prototype SEP document, an employer could:

However, even with a prototype SEP plan document, if the employer is a member of an affiliated service group, a controlled group of corporations, trades or businesses under common control, the employer must cover each eligible employee of all such groups, trades, or businesses under the SEP.

 

Also keep in mind that if the employer already has a 403(b) plan and wishes to make employer contributions under a SEP, a prototype SEP must be adopted.

 

 

In addition to the requirement that the employer execute a SEP plan document, each eligible employee (including the business owner) must establish an IRA into which the employer will make the SEP contribution. The trustee or custodian simply has each eligible employee execute its normal traditional IRA documents, including giving the person the IRA disclosure statement.

 

The regulations (Treas. Reg. §1.408-7) and IRS Announcement 80-112 require that an IRA be established, even if the employee is unable (i.e., dead or unable to locate) or unwilling to establish an IRA. In such case, the employer is permitted to execute the IRA documents on behalf of the employee. Without this rule, the SEP would be invalid and all employees would be taxed on the amount in their traditional IRA.

 

Keep in mind that since the traditional IRA is the “investment vehicle” for the employer’s SEP-IRA plan, all of the basic IRA rules will apply for distributions, and any document requirements, including the financial disclosure requirements that come with the IRA rules.

 

 

The employer is required to make the SEP contribution into each eligible employee's IRA. In other words, the employee should not be given a check from the employer to deposit into his or her IRA.

 

 

1. Employer. The employer (i.e., sole proprietor, partnership or corporation) that establishes the SEP plan document. The employer is totally responsible for determining who is eligible to participate under the plan, the amount of employer contributions to be made each year under the plan’s formula, and for all proper disclosure to the employees as discussed above. Unlike qualified plans, a trust is not established in connection with the SEP plan document. While there could be a “prototype sponsor” (see below) with respect to a prototype SEP plan document, it does not alter the employer’s responsibilities noted above.

 

2. IRA Trustee/Custodian. Since all SEP contributions are made directly into the employee’s IRA (including the owner of the business), the IRA trustee/custodian assumes its normal role for regular IRAs. The IRA trustee/custodian is responsible only to the owner of the IRA. Because an employee can immediately withdraw an employer’s SEP contribution, subject to income tax and possible premature distribution penalties, the IRA trustee/custodian should be aware of the IRA owner’s right of privacy with respect to his or her own account. The IRA trustee/custodian is not responsible with respect to the proper operation of the SEP plan or whether the amounts contributed are within the SEP plan's allocation formula for the year.

 

The IRA Trustee/Custodian is also the “payer” which means that they are also responsible for reporting to the IRA on Form 5498 (the IRA and the SEP contributions; and also reporting distributions with the proper codes on a Form 1099R).

 

3. Prototype Sponsor. The prototype sponsor is the organization whose name appears on the opinion letter issued by the IRS. In most cases, the investment firm obtains a prototype SEP from an IRS approved mass submitter. However, your firm, as prototype sponsor, must furnish all adopting employers with copies of all IRS National Office opinion letters, including those covering any amendments, if applicable.

 

 

1. Discuss with your tax advisor which SEP agreement is best suited for your business, the model 5305-SEP or an IRS-approved prototype.

 

2. If your business is a corporation, obtain approval of the board of directors and record minutes adopting the SEP plan.

 

3. Complete all blanks on the selected SEP agreement (the 5305-SEP or a prototype) and sign and date the plan document. Keep the original completed and signed SEP agreement in your file; do not file the plan agreement with the IRS.

 

4. Determine which employees are eligible to receive a SEP contribution based upon the eligibility requirements you selected on your completed SEP agreement.

 

Note: Remember, each employee meeting your eligibility requirements must receive the SEP contribution. This requirement includes employees who may no longer be employed, employees who have died, or employees who for some reason refuse to open an IRA. In such cases, you, the employer, may sign any necessary IRA documents so that the SEP contribution may be deposited into an IRA for the benefit of such employee.

 

5. Give each eligible employee a copy of the completed and signed SEP agreement, including the employer's disclosure.

 

6. Instruct each eligible employee to provide information to you in writing with respect to where his or her IRA is or will be opened. Each employee (including yourself) will sign normal IRA agreements from the trustee or custodian who will also give each employee the appropriate IRA disclosure statement.

 

Note: If your selected SEP agreement is the 5305-SEP, each employee must be permitted to select his or her own IRA trustee or custodian, and therefore, you will possibly have several different IRA trustees or custodians to deliver the SEP contribution (see below). If your selected SEP agreement is an IRS-approved prototype, then the financial organization that sponsors the prototype SEP agreement may require that all IRAs be opened initially at the one institution. In this case, you will only need to write one check in order to deliver to the IRA trustee or custodian that year's SEP contribution (see below). However, once the initial SEP contribution is made, the employee may then request to have that IRA transferred directly into another IRA at another institution if he or she wishes to do so.

 

7. Provide in writing to each eligible employee your allocation formula for the year. For example, if you are going to contribute 10% of each participant’s compensation, then this information must be given to each affected individual.

 

8. Determine each eligible employee’s SEP contribution for the year based upon that employee’s compensation throughout the entire year for which the contribution is being made.

 

Note: If your business is not a corporation (i.e., sole proprietor or partnership), your own SEP contribution is determined by using the earned income calculation. Your accountant should be able to assist you in this calculation, or you may obtain more information by ordering Publication 560 from the IRS.

 

9. Write a company check to the IRA trustee or custodian denoting the specific amount being contributed on behalf of each eligible employee so that the IRA trustee or custodian can deposit the correct amount into each individual’s IRA. (Remember, you may be dealing with just one IRA trustee or custodian, or several. See Item #6 above.)

 

10. You must deliver the check (or checks as the case may be) directly to the IRA trustee or custodian. Do not give the check to the employee for delivery to the IRA.

 

11. Provide in writing to each employee the actual dollar amount of that employee’s SEP contribution that you have given to the IRA trustee or custodian.

 

12. Provide to your accountant the total amount of that year's SEP contributions that have been made (including your own contribution) so that proper deductions may be made on your business’ tax return.

 

Note: If your business is a corporation, all SEP contributions (including your own) will be deductible on the corporate tax return, Form 1120 or Form 1120S. If your business is not a corporation, SEP contributions on behalf of the employees are deductible on your Schedule C (for sole proprietors) or on your Form 1065 (for partnerships). The SEP contribution on behalf of the sole proprietor or partner is deductible in the Adjustments to Income section on the individual's personal income tax return, Form 1040.