Funding 2020 SEP IRA to the Max
Have a client who has an LLC (PC) taxed as an S Corp. It is the husband’s business, but both he and his spouse share in the K-1 distributions. 2020 will be the first year he will be funding his SEP and he has already contributed $10,000. He only took a W-2 wage of $12,000 and nothing for his spouse. He estimates his K-1 distributions will be $400,000, $200,000 to him and $200,000 to his spouse. Here are the questions:
1. What constitutes “earnings”? Is it the wages only, the K-1 profit only, or both?
2. Since his spouse did not take a wage, is her “earnings” based solely on the K-1 or should she have taken a wage as well? Can she contribute 25% of the K-1?
3. Are they still eligible to make tax deductible IRA contributions for 2020?
4. Are there any other suggestions for the 2020 tax year if he wants to contribute a total of $50,000 on a pre-tax basis?
As I read the rules, a SEP may be a “qualified plan”. If that is the case, then based upon their incomes, they may not be eligible for tax deductible IRAs for 2020. Thought I would reach out to professionals that are more knowledgeable than I am and stop researching the IRS publications.
Thank you in advance for your help,
T. C. Martin
Permalink Submitted by William Tuttle on Sat, 2021-05-08 03:52
There are so many problems with your client’s circumstances.
Retirement contributions can only come from compensation. In the case of S-Corp 2% shareholder-employees this is W-2 wages only. K-1 distributions or any other earnings are not compensation and can not be the basis for retirement plan contributions.
Without W-2 wages, the spouse can not receive any employer contributions. With a W-2 wage of $12,000, the husband was only eligible to make a $3,000 employer contribution. If $10,000 was contributed, $7,000 in excess contributions and earnings must be returned by the S-Corp’s tax filing deadline (3/15) including extensions (9/15). If an extension was not filed by 3/15, the excess contribution must be reported by the employee on Form 5329 (6% excise tax penalty) and the employer Form 5330 (10% excise tax penalty).
See IRS Publication 590-A, page 6; “What is compensation?” If you have no other compensation Your IRA compensation will be $12,000 – $3,000 SEP IRA contribution = $9,000. SEP IRA contributions make you an active participant for the year in which the contributions are made. If the husband or spouse were active participants in 2020, they can not make deductible traditional IRA contributions. They also make too much to make Roth IRA contributions. However, between them they could make up to $9,000 in non-deductible traditional IRA contributions.
There are no other options for 2020 retirement contributions.
Finally, two points.
The spouse is not entitled to receive 50% of the S-Corp’s K-1 distributions unless they are legitimately 50% owners of the S-Corp.
The IRS requires all S-Corp 2% shareholder-employees to be paid “reasonable compensation.” The husband and spouse have been paid massive unreasonably low compensation. This is a serious tax evasion of FICA taxes.
This husband and spouse need to immediately engage a competent tax professional with the knowledge, skills and experience to clean up this mess.