SEP IRA Convert to 401(k) - what happens to the prior year contribution?

[TaxesTech]

My new client has been a very profitable Sole Proprietorship for multiple years, and her only tax strategy was to contribute approximately $20K SEP IRA for the past two years.  

I took over this client and noticed her large schedule C profit for at least three years, and considering to use Rev. Proc 2013-30 to retrospectively elect S-Corp status.  I also noticed significant missing tax deductions due to the bookkeeping error (equipment purchases were booked into equity distribution).  For the two reasons, I think her prior year tax returns are worth amending.    

But this will push part of her prior year SEP IRA contribution into the bucket of excessive contribution, and she probably would subject to the exercise taxes.  I see the IRS allows SEP IRA to be converted to a qualified plan 401(k) and have a tax free roll-over. 

I am not familiar with how such roll-over would affect the prior year contribution limit, but do you think this conversion would be able to reduce the excessive contributions made in the prior year when the plan was a SEP IRA, in the context of amending the prior year tax return which will result in a much smaller tax liability overall?  

[sjrcpa]

"this will push part of her prior year SEP IRA contribution into the bucket of excessive contribution"

Wouldn't it push all of the prior year SEP contribution into the excess bucket? In an S Corp, SEP contributions are based on wages. I'm guessing there are no wages in the prior years bc they were a Sole Proprietor.

And what is the reason for the late S Election? "I don't like the tax result as a Sole Prop" doesn't work.

[TaxesTech]

I don't think 100% SEP IRA will be excessive contribution because the Officer Comp can be reported as Schedule C income (this is newly acquired information through a training with a tax attorney), as long as we force a zero QBI deduction.  But her amended Schedule C income (Officer Comp) will be lower.  

The reason to elect S-Corp retrospectively is because it is allowed by the IRS to save SE/payroll taxes, as long as we report a reasonable officer comp.  

[TaxGuyBill]

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@TaxesTech wrote: 

I took over this client and noticed her large schedule C profit for at least three years, and considering to use Rev. Proc 2013-30 to retrospectively elect S-Corp status.

That would only work if it was an entity (like an LLC), but even then your client does not qualify for that.

https://www.irs.gov/instructions/i2553#idm139855003360128

[TaxGuyBill]

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@TaxesTech wrote:

 because the Officer Comp can be reported as Schedule C income (this is newly acquired information through a training with a tax attorney),

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No, no, and no.  Although some people may do that once as a work-around, it is NOT legal, despite what that tax attorney told you.

[qbteachmt]

"because it is allowed by the IRS to save SE/payroll taxes"

You realize that doesn't exist? The S Corp still pays the employer amount as expense, the same as the Sched C filer has the reduction that offsets the "employer" share, so that both entity types still get an expense value for that employer share. All you did is shift the cost.

[qbteachmt]

I find it more useful to first determine, from their operation, if that is a "payroll type" of business or not. There is nothing worse than putting them into S Corp, forcing payroll, and finding out the business income flow is irregular, hit-and-miss. Are there any employees, already?

[TaxesTech]

I see the Form 2553 instruction's last update was stamped 2020.  The reasonable cause under Rev. Proc 2013-30 does not require a Form 1120S to be filed as it is a Regulatory Election for a qualified corporation.  I found the below guidance (as of January 2021) helpful (see page 15): 

https://www.irs.gov/pub/irs-irbs/irb21-01.pdf

.02 In lieu of requesting a letter ruling under this revenue procedure, a taxpayer may obtain
relief for certain late S corporation and related elections by following the procedure in Rev. Proc.
2013-30, 2013-36 I.R.B. 173. This procedure is in lieu of the letter ruling process and does not
require payment of any user fee. See section 3.01 of Rev. Proc. 2013-30, and section 15.03(3) of
this revenue procedure.

My understanding is that under this guidance, only when the requests were denied by the IRS, we can proceed to the private ruling.  But up to now, we have not experienced any denials yet under Rev. Proc 2013-30 as it is a regulatory election, I believe.

[TaxesTech]

Yes the client has been an LLC and treated that as an disregarded entity therefore reported on Schedule C.  

[sjrcpa]

" a taxpayer may obtain relief for certain late S corporation and related elections"

Did you read the criteria for certain late S Corp elections?

[TaxesTech]

No 40% S-Corp income will be pass through to Schedule E not subject to SE taxes - employer or employee portion.  That was what I meant. 

[TaxesTech]

Yes the LLC has 4 full-time non-shareholder employees

[qbteachmt]

"will be pass through to Schedule E"

Are you trying to create an S Corp for an entity that has real estate rentals as the operation/assets?

[TaxGuyBill]

As I said before, your client does not qualify.  They fail to meet SEVERAL of the requirements. 

The link to the Instructions echo the requirements set out in 2013-30.  You may need to re-read what those requirements are.

[TaxesTech]

I meant K-1 reported on schedule E.  Not rental.

[sjrcpa]

But they can qualify for 2023. They have until March 15, 2023 to make an S election for 2023.

[TaxesTech]

Say the amendment is just to incorporate the missing deductions (equipment purchases recorded as equity), that will bring down the 2020 - 2021 schedule C income, say we do not elect it as an S-Corp.  The SEP IRA contribution made would become excessive as a result of amending the tax return. 

If we convert the SEP IRA to a qualified 401(k) plan in 2022, does that change the excessive SEP IRA contribution in prior years?   

[TaxGuyBill · Accepted solution]

Changing to a 401(k) and rolling over the SEP to it does not mean it is retroactively converted (plus the employee portion needed to be decided before year-end of that tax year).

So correcting things to include the correct deductions may result in excess contributions to the SEP.

[rbynaker]

I'll ask (since I don't think anyone has yet).  Have there been SEP-IRA contributions for these 4 employees?  Do they meet the age and service requirements in the plan document?  (Surely there's a plan document for this SEP-IRA, right?)

[TaxesTech]

Yes the SEP IRA contribution was indiscriminately made for other eligible employees.  Thank you! 

[qbteachmt]

An IRA issue is not the reason to elect S Corp treatment. It should be one of the last considerations.

If this person exceeded their allowable contribution limit by putting in $20,000 then perhaps you should elect S Corp for 2023, ignore the prior IRA activity, amend the reporting info for the operations to take into account the missing info, and establish a SIMPLE IRA plan going forward.

Later, they can roll their SIMPLE IRA and their SEP IRA into their Trad IRA account, if they have all of these going, as they approach retirement planning, if that helps.

And both SIMPLE and SEP plans now accept Roth. Thank you, SECURE Act 2.

[sjrcpa]

"If we convert the SEP IRA to a qualified 401(k) plan in 2022,"

How can you do that? You posted this on 1/3/23.

[abctax55]

'......this is newly acquired information through a training with a tax attorney'

1) Get that in writing.

2) Hope that attorney is willing to sign the tax returns.

[IRonMaN]

After reading the various posts on this string, the following thought just keeps popping up in my mind:

[TaxesTech]

How can we convert SEP IRA to 401(k)?  I guess the answer is google.... 

https://www.irs.gov/pub/irs-tege/rollover_chart.pdf

[sjrcpa]

It can't be done retroactively.

And they don't have to. Client could start a 401(k) Plan for 2023 and leave the SEP as is.

[qbteachmt]

"How can we convert SEP IRA to 401(k)?"

You are confusing plan with account.

The Plan is the type of retirement and the provisions under IRS regulation, such as SEP IRA or 401(k) or SIMPLE IRA are Plans. The plan provided to the taxpayer controls the type of account(s) and provisions for the money. The contributions were made under the plan in force at that time and meeting the IRS regulations, as well.

The business establishes the plan. For instance, a SIMPLE IRA plan can provide for contributions to individual brokers and not require that every participant uses the same brokerage. "Use Form 5304-SIMPLE if you permit plan participants to select the financial institution to receive their SIMPLE IRA plan contributions. Use Form 5305-SIMPLE if you require all contributions under the SIMPLE IRA plan to be initially deposited at a financial institution you designate."

The account is what your taxpayer owns. They have an SEP IRA account, which is different than having a 401(k) account. When/if they establish a 401(k) plan, they can make sure that plan includes a provision which allows SEP and 401(k) to be rolled/transferred into the 401(k) plan, if that is what they want to do. Otherwise, let them simply keep their SEP IRA as is.

None of this changes history.