SEP and SIMPLE errors could spell disaster

July 11, 2017|James Derzon

If you’re an employer that sponsors either a Simplified Employee Pension (SEP) or Savings Incentive Match Plan for Employees (SIMPLE) plan, make sure that you understand and follow the terms of your plan document.

Failure to do so could put a big dent in your pocketbook.

SEPs and SIMPLEs suffer from lack of oversight

The heart of the problem with SEPs and SIMPLEs is that although they are not subject to all the rules and reporting requirements that apply to qualified retirement plans (like 401(k) plans), they don’t have enough eyes looking at them.

SEPs and SIMPLEs typically have no third-party administrators running the plans, and financial audits of these plans are not required, which sometimes discover operational errors.

So if an employer doesn’t understand a plan at all or misunderstands key components of a plan, errors could go undetected for years, and fixing them might not be so easy.

Types of errors that might occur

Errors might occur in complying with eligibility and participation requirements, plan contribution rules, employee salary reduction election rules for SIMPLEs, and employee notification rules.

Additionally, salary reduction SEPs have special non-discrimination and participation rules to deal with.

Options for dealing with plan errors

There are basically two ways to deal with plan errors if you discover them before the IRS does.

  • Fix them prospectively and go on with life…but be prepared for the consequences in the event of an IRS audit.
  • Correct past errors under IRS guidelines, if possible.

What’s the problem with correcting past errors?

Under the IRS retirement plan correction program, SEP and SIMPLE errors may be self-corrected only if they are “insignificant.” If SEP or SIMPLE errors are “significant,” they may only be corrected under a formal filing with the IRS under its Voluntary Correction Program With IRS Approval (VCP).

The problem is that many SEP and SIMPLE errors are significant and have existed for a long time. Under VCP, errors have to be corrected for all the years that they existed even if these years are “closed” by a statute of limitations.

This means that in order to correct plan errors, employers may have to dig into old records going back 10 or 20 years (or more) to figure out what was done and what should have been done. Then they will need to put a submission together (or pay someone to do it for them), file it with the IRS (along with a filing fee) and pay for the error (the cost of correction and the filing).

It is possible to file on an anonymous basis, and withdraw a filing if you don’t like the results.

Consequences of an IRS audit

If the IRS audits and discovers errors with your SEP or SIMPLE, its first course of action would most likely be to offer you what is known as Correction on Audit or “Audit CAP.”

Under Audit CAP, you have to correct the errors and pay a negotiated penalty. The IRS states that the penalties will not be excessive and will generally depend on the type and extent of the failures.

If you can’t reach an agreement with the IRS under Audit CAP as to the correction of the failures or the amount of the penalty, then your SEP or SIMPLE will be disqualified.

Effects of SEP or SIMPLE disqualification are uncertain

Although the IRS explains the consequences of qualified retirement plan disqualification on its website, it has never specifically explained the consequences of SEP or SIMPLE disqualification.

However, here are a few issues that could result, assuming that the SEPs and SIMPLEs would still be considered IRAs—but just not subject to the special rules that apply to SEPs and SIMPLEs.

  • Employer contributions that were made to SEPs and SIMPLEs could retroactively be treated as wages subject to income tax withholding and FICA taxation.
  • Salary deferrals that were made under a SIMPLE IRA could retroactively be treated as wages subject to income tax withholding (they already would have been treated as FICA wages).
  • Instead of going after all the employees and having them amend their tax returns to report the employer contributions and salary deferrals as wages, it is possible that the IRS might only go after the employer for income tax withholding, FICA taxation if applicable (both the employer and employee portions) and related late payment and interest penalties.
  • Some employees might have received contributions to their SEP or SIMPLE IRA accounts that are in excess of the limitations that apply to traditional IRAs (currently $5,500 per year for individuals under age 50).

Individuals with these excess contributions are subject to a 6% penalty each year the excess stays in their accounts. These individuals may have to take taxable distributions to escape future excess contribution penalties. These taxable distributions would be subject to 10% early distribution penalties if the individuals are under age 59 ½.

Conclusion

If you’re not sure about any aspect of your plan, ask questions and feel free to contact us. If mistakes occurred in the past, consider correcting them. In any event, operate your plan correctly going forward, and make sure that your plan document is up-to-date.

The current versions of applicable IRS forms that may be used as plan documents are as follows:

  • Form 5305–SEP (Rev. December 2004)
  • Form 5305A–SEP (Rev. June 2006) (not required to be used if you used the March 2002 version of Form 5305A–SEP)
  • Form 5304–SIMPLE (Rev. March 2012) (not required to be used if you used the March 2002, August 2005 or September 2008 version of Form 5304–SIMPLE to establish the plan)
  • Form 5305–SIMPLE (Rev. March 2012) (not required to be used if you used the March 2002, August 2005 or September 2008 version of Form 5305–SIMPLE to establish the plan)

Prototype SEP and SIMPLE plans of financial institutions may also be used as plan documents.

Please contact Jim Derzon at 800-236-2246 if you have any questions.


Jim Derzon, CPA, is an employee benefits specialist for our firm on technical matters pertaining to retirement plans and employee benefits. Jim works in these areas with our clients, large and small. He has extensive experience in both industry and public accounting.