Definition of net earnings: Net earnings must be from self-employment where your personal services are a material income-producing factor. "Net earnings" equals your business gross income, minus allowable deductions from that business (including contributions to the plan for your employees), reduced by the tax deduction for your self-employment tax. Net earnings are also reduced by the deduction for contributions you make for yourself. This adjustment is made indirectly by reducing the contribution rate called for in the plan when you figure the maximum contribution for yourself. Thus, for example, the 15% contribution becomes a contribution of 13.0435% of net earnings before the contribution, and the 25% rate becomes 20%.

For more information see Publication 560 Retirement Plans for Small Business (SEP, Keogh, and SIMPLE Plans).

A simplified employee pension (SEP) is a written plan that allows you to make deductible contributions toward your own and your employees' retirement without getting involved in more complex retirement plans. A corporation also can have a SEP and make deductible contributions toward its employees' retirement. But some advantages available to Keogh and other qualified plans, such as the special tax treatment that may apply to lump-sum distributions, do not apply to SEPs.

Under a SEP, you make the contributions to an individual retirement arrangement (called a SEP-IRA in this chapter), which is owned by you or your common-law employee.

SEP-IRAs are set up for, at a minimum, each qualifying employee. A SEP-IRA may have to be set up for a leased employee, but need not be set up for an excludable employee. You may be able to use Form 5305-SEP in setting up your SEP. For more information, get Publication 560.

Contribution limits. Contributions you make for a year to a common-law employee's SEP-IRA cannot exceed the smaller of 15% of the employee's compensation or $30,000. Compensation, for this purpose, generally does not include employer contributions to the SEP.

Annual compensation limit. You generally cannot consider the part of compensation of an employee that is over $160,000 when you figure your contributions limit for that employee.

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For employees in a collective bargaining unit for which the $160,000 limit does not apply, the compensation limit is $250,000

More than one plan. If you also contribute to a defined contribution retirement plan, annual additions to an account are limited to the lesser of (1) $30,000 or (2) 25% of the participant's compensation. When you figure these limits, your contributions to all of the plans must be added. Since a SEP is considered a defined contribution plan for purposes of these limits, your contributions to a SEP must be added to your contributions to defined contribution plans.

Reporting on Form W-2. Do not include SEP contributions on Form W-2, Wage and Tax Statement, unless there are contributions over the limit that applies or there are contributions under a salary reduction arrangement.

Contributions for yourself. The annual limits on your contributions to a common-law employee's SEP-IRA also apply to contributions you make to your own SEP-IRA. However, special rules apply when you figure your maximum deductible contribution. See Deduction of contributions for yourself, later.

Deduction limits. The most you can deduct for employer contributions for common-law employees is 15% of the compensation paid to them during the year from the business that has the plan.

Deduction of contributions for yourself. When figuring the deduction for employer contributions made to your own SEP-IRA, compensation is your net earnings from self-employment, which takes into account:

1.The deduction allowed to you for one-half of the self-employment tax, and 2.The deduction for contributions on behalf of yourself to the plan.

The deduction amount for (2), above, and your compensation (net earnings) are each dependent on the other. For this reason, the deduction amount for (2) is figured indirectly by reducing the contribution rate called for in your plan. This is done by using the Rate Worksheet for Self-Employed, shown earlier in the chapter.

SEP and profit-sharing plans. If you also contributed to a qualified profit-sharing plan, you must reduce the 15% deduction limit for that plan by the allowable deduction for contributions to the SEP-IRAs of those participating in both the SEP and the profit-sharing plan.

SEP and other qualified plans. If you also contributed to any other type of qualified plan, treat the SEP as a separate profit-sharing plan for purposes of applying the overall 25% deduction limit described in section 404(h)(3) of the Internal Revenue Code.

Employee contributions. Participants can also make contributions of up to $2,000 to their SEP-IRAs independent of employer's SEP contributions. The portion of the IRA contributions that is deductible may be reduced or eliminated because the participant is covered by an employer retirement plan (the SEP plan). See Publication 590 for details.

Salary Reduction Arrangement

A SEP can include a salary reduction (elective deferral) arrangement. Under the arrangement, employees can elect to have you contribute part of their pay to their SEP-IRAs. The income tax on the part contributed is deferred. This choice is called an elective deferral, which remains tax free until distributed (withdrawn).

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Beginning in January 1997, an employer is no longer allowed to establish a SARSEP. However, participants in a SARSEP that was established before 1997 (including employees hired after 1996) can continue to elect to have their employer contribute part of their pay to the plan.

This election is available only if:

1.At least 50% of your employees eligible to participate choose the salary reduction arrangement, 2.You had 25 or fewer employees who were eligible to participate in the SEP (or would have been eligible to participate if you had maintained a SEP) at any time during the preceding year, and 3.The deferral each year by each eligible highly compensated employee (as defined in Publication 560) as a percentage of pay (deferral percentage) is no more than 125% of the average deferral percentage (ADP) of all nonhighly compensated employees eligible to participate (the ADP test). You generally cannot consider compensation of an employee in excess of $160,000 in figuring an employee's deferral percentage.

Limits on elective deferrals. In general, the total income an employee can defer under a salary reduction arrangement included in a SEP and certain other elective deferral arrangements for 1997 is limited to the lesser of 15% of the participant's compensation (as defined in Publication 560) or $9,500. This limit applies only to the amounts that represent a reduction from the employee's pay, not to any contributions from employer funds.

Employment taxes. Elective deferrals, not exceeding the ADP test, are not subject to income tax in the year of deferral, but are included in wages for social security, Medicare, and unemployment (FUTA) tax purposes.

Reporting SEP Contributions on Form W-2

Your SEP contributions are excluded from your employees' income. Unless there are contributions above the limit that applies, or unless there are contributions under a salary reduction arrangement, do not include these contributions in your employees' wages on Form W-2, for income, social security, or Medicare tax purposes. Your SEP contributions under a salary reduction arrangement are included in your employees' Form W-2 wages for social security and Medicare tax purposes only.

Example. Jim's salary reduction arrangement calls for a deferral contribution rate of 10% of his salary to be contributed by his employer as an elective deferral to Jim's SEP-IRA. Jim's salary for the year is $30,000 (before reduction for the deferral). The employer did not elect to treat deferrals as compensation under the arrangement. To figure the deferral amount, the employer multiplies Jim's salary of $30,000 by 9.0909%, the reduced rate equivalent of 10% to get the deferral amount of $2,727.27. (This method is the same one that you, as a self-employed person, use to figure the contributions you make on your own behalf.) See Rate Worksheet for Self Employed, earlier in the chapter.

On Jim's Form W-2, the employer shows total wages of $27,272.73 ($30,000 minus $2,727.27), social security wages of $30,000, and Medicare wages of $30,000. Jim reports $27,272.73 as wages on his individual income tax return.

If the employer elects to treat deferrals as compensation under the salary reduction arrangement, Jim's deferral amount would be $3,000 ($30,000 x 10%) because, in this case, the employer uses the rate called for under the arrangement (not the reduced rate) to figure the deferral and the ADP test. On Jim's Form W-2, the employer shows total wages of $27,000 ($30,000 minus $3,000), social security wages of $30,000, and Medicare wages of $30,000. Jim reports $27,000 as wages on his return.

In either case, the maximum deductible contribution would be ($30,000 x 13.0435%) $3,913.05.

For more information on employer withholding requirements, see Publication 15.

For more information on SEPs, see Publication 560.