In about two weeks, most business owners and self employed individuals will be writing checks to the IRS to cover taxes due on their 2008 taxes. This may be particularly upsetting in light of the fact that these same individuals may suffer losses during 2009. If you are in this category, you may be able to reduce your 2008 taxes as long as you act soon.
Unlike other employer-funded retirement plans which must be established prior to year end, a Simplified Employee Pension (“SEP”) may be established and funded up to the time of the tax filing deadline, including valid extensions. This means that you have until April 15, 2009 (or September 15, 2009 or October 15, 2009 if an extension is filed) to establish and fund a SEP. Since all contributions to the SEP are fully tax deductible, this can provide a valuable tax planning tool for businesses and self-employed individuals looking for deductions after the close of the business year.
A SEP is a written arrangement that allows an employer to make contributions to individual retirement arrangements (referred to as SEP-IRAs) established by (or on the behalf of) each qualifying employee. By establishing a SEP, an employer can make contributions toward its employees’ retirement greater than the $5,000 limit (for 2008) for IRA contributions without having to deal with the complex (and costly) compliance and reporting rules that apply to qualified retirement plans. Although designed for small businesses, any employer (sole proprietorship, partnership, limited liability company, or corporation) regardless of its size or number of employees may generally establish and maintain a SEP. SEPs are established at the employer level, rather than the employee level. Although partners deduct their SEP contributions on their Form 1040, the partnership is the employer. Thus, the partnership must establish the plan and make contributions to the plan. The deduction is based on earned income derived from the trade or business that establishes the plan
SEPs are relatively easy to establish and administer. They are not subject to the complex vesting, participation, nondiscrimination, reporting, and other rules applying to qualified plans. However, to receive favorable tax benefits, SEPs must meet cover all employees who are at least age 21, worked for the employer during any 3 of the prior 5 years and earned at least $500 during 2008. In addition, a SEP must not discriminate in favor of highly compensated employees (HCEs), contributions must be made under a written allocation formula, and contributions must be fully vested when made.
Although a SEP must be written, there is no complicated plan document or procedures involved in setting up a SEP. Moreover, third-party administration is not required for ongoing record keeping and there is no IRS filing required such as a Form 5500. The IRS provides a prototype form to establish a SEP, it is Form 5305. A SEP can be adopted simply by completing this form and giving a copy to the employees.
Although SEPs are subject to the top-heavy rules applying to qualified plans, these rules generally have no effect on a SEP (even if it is top-heavy) unless the plan is integrated with social security. This is because the minimum vesting and contributions required of top-heavy plans are automatically met by SEPs (except plans integrated with social security).
Employers may make tax-deductible contributions up to 25 percent of compensation (not to exceed $46,000) on behalf of each eligible participant in the plan. All earnings (i.e., interest, dividends, and capital gains) in a SEP accumulate on a tax-deferred basis until withdrawn. SEP contributions are not “locked in;” in other words, after the initial contribution is made, no further contributions must be made. Once the employer makes the contribution to each eligible employee’s SEP account, the employee controls the investment direction of his/her account. This potentially reduces the employer’s fiduciary liability.
SEPs are excellent vehicles for closely-held businesses with few employees or high employee turnover. Because a SEP must cover all eligible employees and cannot discriminate in favor of highly compensated employees, they must be used with care otherwise significant amounts may need to be paid to nonowning employees to enable payments to be made on behalf of the owner. Consequently, SEPs are even better suited for self-employed individuals because no payments need to be made to other employees (because there are no other employees).
One of my favorite SEP arrangements involves establishing a SEP for director’s fees. As long as the company for whom the director’s fees are paid is not related, the director can establish a SEP for just the directors fees. When calculating a self-employed individual’s own SEP contribution deduction, compensation is defined as net self-employment earnings less the deduction for half of the self-employment (SE) tax and after a reduction for the individual’s own SEP contribution. This latter reduction requires using a simultaneous equation that effectively reduces the self-employed participant’s maximum contribution percentage to 20%. Thus, if an individual has $20,000 of director’s fees, the maximum SEP contribution is $3,942, computed as follows:
| Director’s Fees | $20,000 |
50% self-employment tax (assumes subject only to the 2.9%
Medicare tax) | (290) |
| | 19,710 |
| 20% (maximum rate factoring in simultaneous equation) | .20 |
| | |
| Maximum SEP contribution | $ 3,942 |
Assuming the individual in this situation is subject to the maximum tax rates, the tax savings for establishing the SEP would equal $1,577.
Although the benefits of establishing a SEP for directors fees are fairly significant, even larger benefits can be secured if a 401(k) plan is used instead. In my next post, I will discuss these benefits and recommend that a SEP be used in 2008 followed by a single person 401(k) in 2009.