Level 5

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

Forum|Forum|3 years ago
January 3, 2023
5 replies
26 views

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?

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sjrcpa

Level 15

"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.

The more I know the more I don’t know.

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TaxesTechAuthor

Level 5

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.

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TaxGuyBill

Level 15

@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),

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.

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TaxGuyBill

Level 15

@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

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TaxesTechAuthor

Level 5

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.

sjrcpa

Level 15

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

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

The more I know the more I don’t know.

qbteachmt

Level 15

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?

Don't yell at us; we're volunteers

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TaxesTechAuthor

Level 5

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

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TaxGuyBill

Level 15

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

Level 13

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?)