A SEP (Simplified Employee Pension) is designed to do one thing – make it easy for small businesses to offer a pension plan, where those businesses may not otherwise have the time or money to administer a more complex plan. But as with all simple things, there is often a price – and in this case, it’s strict compliance with the rules – or else!
In a recent Tax Court case, a husband/wife business owner team found out just how high the price can be, when two entire year’s worth of contributions were disallowed for failure to follow the rules.
In this particular instance, the couple owned and operated a mortgage brokerage, and were the only employees. Both pulled a small salary from the business. In 2004, they decided to set up a pension plan, and created an SEP account.
One of the requirements for SEPs is that the employer must agree to make a yearly contribution to the SEP on behalf of all employees who are 18 or older, and have worked for at least 6 months in the previous 5 years.
The couple in question made contributions for two years in a row, which were deducted from the husband’s salary. They filed a joint tax return, where they also claimed an additional contribution made by the wife to a separate IRA account. Yet the IRS disallowed both SEP contributions.
Why? Because the couple had forgotten the first rule of SEPs – everyone must participate. By making a contribution in only the husband’s name, they had breached that basic requirement. At trial, they argued that they filed a joint return, and under the IRS’s “attribution” rules, his contributions to an IRA would be treated as a contribution to her IRA, and they had met the rules.
Unfortunately the Tax Court disagreed. They said the rules on SEPs were very clear – a contribution must be made for each employee. By making a contribution to the husband’s SEP without making one to the wife’s SEP (even though she made an IRA contribution from her salary) they had broken the #1 SEP rule.
The problem with the attribution rule argument, said the Tax Court, was that it didn’t apply to IRA or SEP contributions. The attribution rule relates to the constructive ownership of stock (i.e., a spouse is considered to jointly own stock held directly or indirectly by the other spouse).
At the end of the day, the couple lost the case and the ability to take the preceding two years’ worth of SEP deductions.
What could they have done differently? Well, besides the obvious, they could also have considered a Solo 401(k) plan instead. This would have worked well for them because it is completely discretionary, and does not require matching contributions.