Deferring income by adopting a SEP.
Envy Corporation is owned by two shareholders, Henry and Harvey, and is the only business maintained by them. The corporation does not have an employee benefit plan, nor has it had one in the past. It employs six people, including the two shareholders; the total compensation of all employees is $246,000. Henry and Harvey, who have each been there for six years, earn $95,000 and $85,000, respectively. The other employees have been with Envy from one year to six years, and their earnings range from $6,000 to $25,000.
Henry and Harvey would like to defer compensation (rather than increase current compensation) by having Envy make tax deductible contributions to an employee retirement plan; however, they do not want a fixed obligation for contributions nor are they willing to pay the high administration costs associated with many qualified plans. They have asked their tax adviser to recommend a low-cost plan.
The corporation's taxable income for the current year (before a deduction for retirement plan contributions) will be approximately $35,000. Henry and Harvey would like to reduce taxable income as much as possible.
What type of qualified retirement plan can Envy adopt that will meet Henry's and Harvey's objectives?
A simplified employee pension (SEP) plan can be set up and maintained with minimal administrative costs. (Procedures for setting up a SEP are discussed in the Forms, elections and emplementation section, below.) At the same time that the SEP is set up, each employee should set up a SEP-IRA account at a bank or other financial institution.
The amount a corporation can deduct in the current year as a contribution for each employee is limited to the lesser of 15% of that employee's compensation or $30,000. The maximum deduction for 1994 would be $34,650 [15% of the eligible compensation of $231,000 ($246,000-$15,000)!. The employee who has worked for Envy for one year is not included because she has not met the service requirement of Sec. 408(k)(2); she has not performed services for the corporation for at least three of the immediately preceding five years. Envy has no obligation to make the same contribution next year; it is completely at the corporation's discretion.
There are no annual filings with the IRS. Each of the employees is responsible for his own account. Each employee may contribute as much as $2,000 to his SEP-IRA account, subject to the regular rules for deductibility of IRAs.
The contribution is tax deductible to the corporation as a reasonable and necessary business expense and is not taxable to the employee until it is distributed from the IRA without being rolled over.
The tax adviser should recommend that Envy establish a SEP, which is useful when 100% vesting is not a problem. It is best suited for closely held businesses that have only a few employees and do not want to incur large plan administration costs. It is an ideal plan for corporations that might not have steady profits but want to make a one-time contribution or discretionary contributions.
Because Henry and Harvey want to reduce the corporation's taxable income of $35,000 as much as possible, the maximum amount ($34,650) should be contributed.
Forms, elections and implementation
Envy can set up a SEP by completing Form 5305-SEP, Simplified Employee Pension-Individual Retirement Accounts Contribution Agreement. Although this form does not have to be filed with the IRS, a copy must be provided to the employees.
The employer is not required to file any annual reports with the IRS.
Editor's note: This case study had been adapted from PPC Planning Guide Closely Held Corporations, 7th Edition, by Albert L. Grasso, R. Barry Johnson, Linda Ketter, Lewis A. Siegel Gray, Elizabeth DiTommaso and James D. Eversole, published by Practitioners Publishing Company, Fort Worth, Tex., 1994.
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|Title Annotation:||simplified employee pension|
|Author:||Ellentuck, Albert B.|
|Publication:||The Tax Adviser|
|Date:||Jan 1, 1995|
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