Category: Individuals; Compensation & Employee Benefits
Subject: SEP
Title: SEP Contributions: Eligible Earnings
IRC Sections: 414(c), 408
Filename: 1298.html
Date Produced: 01/94

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Taxpayer (TP) is a sole proprietor of a profitable business. A SEP has been established, and TP has made maximum contributions in the past. In 1993, TP established another business in a different state. The new business is also conducted as a sole proprietorship; however, TP does not personally manage the new business. The new business operated at a loss for 1993.

Issues
1. Is it necessary for TP to cover the employees of the new business under the SEP? If so, would it help to place the new business in the name of TP's wife?

2. For purposes of computing TP's earnings eligible for SEP contributions, must the loss of the new business be counted?

Answers
1. It is necessary for TP to cover the employees of the new business, and this result would not change if the business were transferred to TP's wife.

2. It appears that the loss from the new business does not have to be considered in determining earnings eligible for SEP contributions; however, this conclusion is not free from doubt.

Discussion: Issue 1
Internal Revenue Code (IRC) Section 414(c) provides the following guidance.

(c) Employees of partnerships, proprietorships, etc., which are under common control.

For purposes of sections 401, 408(k), 410, 411, 415, and 416 under regulations prescribed by the Secretary, all employees of trades or businesses (whether or not incorporated) which are under common control shall be treated as employed by a single employer. The regulations prescribed under this subsection shall be based on principles similar to the principles which apply in the case of subsection (b).

Since IRC Section 408(k) is the statutory authority for dealing with SEP's, the provision set forth above is made specifically applicable to SEP determinations.

Two proprietorships are considered to be under common control if the same five or fewer individuals own a controlling interest in both. Regulation Section 1.414(c)-2. Since TP will have 100% ownership and control of both businesses, it seems clear that both the old and new businesses will be considered a single employer for SEP purposes. Under 408(k), all employees meeting certain age and service requirements must be covered by the SEP. Since both the new and the old businesses would be treated as a single employer, §408(k) would require that all eligible employees of both businesses be covered.

With respect to the issue of transferring ownership of the new business to TP's wife, the regulations provide clear guidance. Regulation Section 1.414(c)-4(b)(5) provides that an individual shall be deemed to own an interest owned by his spouse. Accordingly, transfer of the new business to TP's spouse would have no effect since the wife's ownership of the new business would be attributed back to TP. This result assumes that TP and his spouse are not legally separated.

Discussion: Issue 2
SEP contributions are determined based on compensation of the employee. Under IRC §401(c)(1), self-employed individuals are treated as employees for purposes of the rules related to qualified retirement plans. IRC §408(k)(7)(B) provides that for SEP purposes, the term compensation has the same meaning as in §414(s). §414(s) cross references to §415(c)(3) which provides that compensation means earned income as defined by §401(c)(2). §401(c)(2) provides that earned income means income from self employment as defined by §1402; however, §401(c)(2) also provides several important modifications the relevant one being that earned income must derive from a trade or business in which the taxpayer's services are a material income producing factor.

The law is clear in this instance. If TP's services are a material income producing factor with respect to the new business, then the loss of the new business must be considered as part of TP's total compensation eligible for SEP contributions. On the other hand, if TP's services are a not a material income producing factor with respect to the new business, then the loss need not be considered. In other words, the answer in this instance is entirely fact driven.

The element of uncertainty expressed above lies in one's interpretation of TP's facts. Surprisingly, I cannot locate any meaningful cases or rulings interpreting whether personal services are deemed to be a material income producing factor. Accordingly, the interpretation is in the eye of the beholder, so to speak. The fact that TP does not live in the same state as the new business and the fact that TP employs a manager to run the new business would seem to indicate fairly strongly that TP's income or loss from the new business is produced not by TP's personal services, but rather by TP's capital. On the other hand, one might argue that TP is performing significant services through his oversight of the business notwithstanding the fact that the oversight is done from another state. Based solely on the facts set forth above, I would argue that TP's services are not a material income producing factor. This argument could be challenged with reasoning along the lines stated above. Clearly, the above statement of facts is extremely superficial. As TP's tax advisor, you should explore whether there are additional facts which might bear on the outcome of this question. Further, you should take into consideration TP's needs with respect to contributions for the new business should that business become profitable in the future. Clearly, it would be unwise to construct an argument for 1993 that would be a hinderance in the future if the new business turns a profit.