SEP Eligibility Rules

[DatapointFP]

Hi All,

I have a client who has a multi-member LLC tree service business.  He and his partner are each 50% owners.  They have no direct employees but have seven "leased employees."  And in this case, I'm not technically referring to the IRS definition of a leased employee but will get to that in a moment.  They are simply employed by a payroll company and referred to by that company as "leased employees."

As for the IRS definition of a leased employee, all seven do meet the three criteria spelled out in chapter 1 of IRS Publication 560.  Furthermore, the employees do not qualify for any of the three exceptions.  Therefore, according to chapter 1 of IRS Publication 560, they "…must generally be treated as your employee for retirement plan purposes…"

SEPs are referenced in chapter 2 of pub 560, but it is not clear in that publication or in other documents on irs.gov whether this particular rule on leased employees being treated as your employees applies to a SEP.  It is crystal clear that the rule applies to "qualified plans" but not as clear on SEPs.  In chapter 4 (Qualified Plans), this section appears:

"Leased employee. A leased employee, defined in chapter 1, who performs services for you (recipient of the services) is treated as your employee for certain plan qualification rules."

So, here's my question:

Does this rule on a leased employee being treated as your employee for retirement plan purposes apply to SEPs?

The rest of the story is this:

Only one of the employees will meet the "three of the last five years" rule on SEP eligibility by year-end, and it happens to be the employee the owners want to reward (and who makes the most money).  However, they are contributing the full amount for themselves and would have to do 25% for him if this "leased employee rule" applies to SEPs.  In that case, it appears they would save money AND benefit themselves by doing a New Comparability 401k plan with safe-harbor and giving all the employees a non-elective 3% contribution.  This would allow the owners to get up to the full $61k, which they are not quite hitting with the SEP.

Thanks in advance for your time and expertise!

[SweetieJean]

Client?  TT is not licensed for use by paid tax preparers.

[DatapointFP]

Sorry, this is not related to tax prep.  I'm not a tax preparer.  I'm a financial advisor.  I have a new financial planning client who owns a business, and his CPA is telling him that the leased employees do not have to be considered for he and his partners' SEP IRAs.  The language is vague in Pub 560 and other docs on SEPs, but I think the owners have to count them as employees and include them once they've worked for three years.  I do not use TT to prepare their taxes...only my own.  Just thought someone in this forum might know the answer.

[Mike9241 · Accepted solution]

it would seem the appropriate code section is 414(n)

(n)Employee leasing
(1)In general
For purposes of the requirements listed in paragraph (3), with respect to any person (hereinafter in this subsection referred to as the “recipient”) for whom a leased employee performs services—
(A)the leased employee shall be treated as an employee of the recipient, but
(B)contributions or benefits provided by the leasing organization which are attributable to services performed for the recipient shall be treated as provided by the recipient.
(2)Leased employee
For purposes of paragraph (1), the term “leased employee” means any person who is not an employee of the recipient and who provides services to the recipient if—
(A)such services are provided pursuant to an agreement between the recipient and any other person (in this subsection referred to as the “leasing organization”),
(B)such person has performed such services for the recipient (or for the recipient and related persons) on a substantially full-time basis for a period of at least 1 year, and
(C)such services are performed under primary direction or control by the recipient.
(3)Requirements
For purposes of this subsection, the requirements listed in this paragraph are—
(A)paragraphs (3), (4), (7), (16), (17), and (26) of section 401(a),
(B)sections 408(k), 408(p), 410, 411, 415, and 416, and
(C)sections 79, 106, 117(d), 125, 127, 129, 132, 137, 274(j), 505, and 4980B.
(4)Time when first considered as employee
(A)In general
In the case of any leased employee, paragraph (1) shall apply only for purposes of determining whether the requirements listed in paragraph (3) are met for periods after the close of the period referred to in paragraph (2)(B).

(B)Years of service
In the case of a person who is an employee of the recipient (whether by reason of this subsection or otherwise), for purposes of the requirements listed in paragraph (3), years of service for the recipient shall be determined by taking into account any period for which such employee would have been a leased employee but for the requirements of paragraph (2)(B).

(5)Safe harbor
(A)In general
In the case of requirements described in subparagraphs (A) and (B) of paragraph (3), this subsection shall not apply to any leased employee with respect to services performed for a recipient if—
(i)such employee is covered by a plan which is maintained by the leasing organization and meets the requirements of subparagraph (B), and
(ii)leased employees (determined without regard to this paragraph) do not constitute more than 20 percent of the recipient’s nonhighly compensated work force.
(B)Plan requirements
A plan meets the requirements of this subparagraph if—
(i)such plan is a money purchase pension plan with a nonintegrated employer contribution rate for each participant of at least 10 percent of compensation,
(ii)such plan provides for full and immediate vesting, and
(iii)each employee of the leasing organization (other than employees who perform substantially all of their services for the leasing organization) immediately participates in such plan.
Clause (iii) shall not apply to any individual whose compensation from the leasing organization in each plan year during the 4-year period ending with the plan year is less than $1,000.
(C)Definitions
For purposes of this paragraph—
(i)Highly compensated employee
The term “highly compensated employee” has the meaning given such term by section 414(q).

(ii)Nonhighly compensated work force
The term “nonhighly compensated work force” means the aggregate number of individuals (other than highly compensated employees)—
(I)who are employees of the recipient (without regard to this subsection) and have performed services for the recipient (or for the recipient and related persons) on a substantially full-time basis for a period of at least 1 year, or
(II)who are leased employees with respect to the recipient (determined without regard to this paragraph).
(iii)Compensation
The term “compensation” has the same meaning as when used in section 415; except that such term shall include—
(I)any employer contribution under a qualified cash or deferred arrangement to the extent not included in gross income under section 402(e)(3) or 402(h)(1)(B),
(II)any amount which the employee would have received in cash but for an election under a cafeteria plan (within the meaning of section 125), and
(III)any amount contributed to an annuity contract described in section 403(b) pursuant to a salary reduction agreement (within the meaning of section 3121(a)(5)(D)).
(6)Other rules
For purposes of this subsection—
(A)Related persons
The term “related persons” has the same meaning as when used in section 144(a)(3).

(B)Employees of entities under common control
The rules of subsections (b), (c), (m), and (o) shall apply.

so lease employees would be covered once they meet the requirement of 408(k)(2)

(2)Participation requirements

This paragraph is satisfied with respect to a simplified employee pension for a year only if for such year the employer contributes to the simplified employee pension of each employee who—
(A)has attained age 21,
(B)has performed service for the employer during at least 3 of the immediately preceding 5 years, and
(C)received at least $650 in compensation (for 2021) (within the meaning of section 414(q)(4)) from the employer for the year

for a partnership, it establishes and contributes to the SEP, if a sep contribution is made for the partners, then it must be made for eligible employees which would include leased employees that can not be excluded.

.

[DatapointFP]

Thanks for this information, Mike.  Yes, I've read this section over and over.  What is not clear to me is whether 414(n) applies to SEP IRAs.  I can't find any place that definitely states that.  This is the best I've found so far and does seem to concur with your conclusion:

4.72.17 Simplified Employee Pensions (SEPs) and Salary Reduction Simplified Employee Pensions (SARSE...

4.72.17.5.2 (08-28-2017)

Leased Employees

1. The person or firm for whom services are performed may have to include in a SEP any leased employee who is treated as an employee of the recipient.

2. In general, a leased employee is any person who is not an employee of the recipient but who is hired by a leasing organization and performs services for the recipient. See IRC 414(n).

Thank you very much for the second set of eyes on this.  Much appreciated.

David