Many small and midsize businesses looking for significant tax deductions come to realize the value in establishing a simplified employee pension plan, otherwise referred to as either a SEP or a SEP-IRA. Not only are SEPs easy to set up, they require no tax filings and can be set up as late as the due date (including extensions) of the business's income tax return for a tax year. This last feature provides even cash-basis taxpayers a valuable business deduction in the prior reporting period (unlike a qualified plan, which must be adopted by the last day of the tax year for which the deduction is claimed). At tax deadline time, establishing a SEP is often viewed as a perfect solution.
However, these businesses and their CPA advisers should seriously consider whether the newly created SEP is appropriate over the long term. As good as a SEP may be in the sprint to tax filing deadline time, many taxpayers will find they are too expensive over the long haul. And business owners who establish a SEP to get the benefits of having neither tax filings nor annual discrimination testing can find themselves in trouble with the IRS if they don't stick to the plan's terms.
For the self-employed individual, a SEP permits a maximum tax-deferred contribution of $55,000 per person in 2018, which is consistent with an individual 401(k) plan (not including the $6,000 catch-up contribution available to 401(k) plan participants who have attained age 50). However, because the maximum tax-deferred contribution in a 401(k) plan is a combination of an employee's deferral and a company contribution, the net business income for an individual needed to attain the maximum deduction is far less in a 401(k) than a SEP, $146,000 vs. $220,000 (401(k): ($55,000 − $18,500 maximum employee deferral) ÷ 25% (reflecting employer deferral percentage of 25% of total compensation) = $146,000; SEP: $55,000 ÷ 25% = $220,000).
Moreover, for an employer with staff, the rules governing SEP eligibility and contributions result in greater expense than a well-designed 401(k) plan. Although initial eligibility for SEP participation may be longer than for a 401(k) (minimal compensation in three out of five years, as opposed to one year of service), this feature may make it less flexible for the business as a whole. Once the initial age and years-of-service eligibility requirements are met, SEPs generally require that everyone receive the same percentage of pay (a customized SEP may use permitted disparity in its allocations). So if the owner must make a contribution of 25% of compensation to maximize his or her contribution, then every employee in the plan must receive a contribution of 25% of their pay, all with immediate vesting. Furthermore, an employee cannot make voluntary salary deferrals to a SEP or take loans and hardship withdrawals from one.
The rules for a 401(k) plan are more flexible and do not require universal eligibility or that all compensation will count when calculating a company contribution. For example, it is not uncommon to exclude highly paid salespeople entirely or to exclude their commissions and bonuses from the compensation definition, to minimize the amount of the company's contributions. Additionally, in certain cases, the employer can factor in relative ages in calculating a company contribution to benefit the ownership group. Finally, a discretionary company contribution can be made subject to a vesting schedule of up to six years. With this approach, the benefits of the plan can be targeted to accrue to the long-term employees.
While administration of a SEP is "simplified," that is a relative term. The failure to strictly adhere to the terms of the plan can cause serious financial repercussions. Our firm was asked to review a SEP for a small consulting practice. In its early years, the practice was a one-man operation. However, as time passed, it brought on additional staff. A SEP credits a full year of service to any individual paid $600 or more during the year. Under this standard, five employees met the three-out-of-five-years test for eligibility, none of whom had ever received a contribution, nor likely expected one at the time. The IRS required the employer to retroactively reallocate the historical contributions made to his personal SEP-IRA to the affected employees, which reduced the owner's SEP account balance from approximately $800,000 to $150,000.
A SEP does provide a benefit in the short term, no doubt. But over the long haul, it can be an inefficient structure even for a solo practitioner.
Thomas W. Hoens, CPA, CGMA, is COO of The MandMarblestone Group LLC in Philadelphia, which designs, administers, and consults on qualified retirement plans. To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.