SEP Fallout on Amended Returns

Q: Tax Playa, I have to amend some old returns to claim depreciation on a home office for my sole proprietorship.  As a result, my net income from self-employment will decline.  I contributed the max to my SEP-IRA given that higher level of net income, so this will result in my having contributed too much.  What do I do?  Is there any penalty involved?
D.B., Somewhere USA

A: This is an excellent question, and an example of the nitty gritty of tax prep that I love.  The basic answer is that you will have to pay an excise tax of 10% for the extra contribution.  However, you will be able to roll the extra contribution into a future year's SEP-IRA limit...

First, a little background:

1. A tax return can be amended for up to three years after the original due date, plus extensions.  In the case of amending a return to increase or decrease business income, this can have an effect on items dependent on the amount of that income, like SEP-IRA contributions.
2. A SEP-IRA contribution can be made based on 20% of net income from self-employment, not counting the deduction for one-half of the self-employment tax.  The universal limit on defined contribution pension savings applies ($45,000 in 2007).  The amount contributed can be taken as an adjustment to income, making it deductible.
3. One reason to amend a return would be to claim a deduction for depreciation erroneously not claimed.  For a self-employed taxpayer with a home office deduction, this will have the effect of lowering net income from self-employment, and therefore the amount able to be contributed to a SEP-IRA for the affected tax year.

DB is in this situation.  What to do?

First, DB, you should know that any excess SEP-IRA contribution can be applied to the amount you put into SEP-IRAs for future years.  For instance, suppose you found that lowering your net income from self-employment in the affected year reduced your allowable SEP-IRA contribution by $1000.  You would simply put in $1000 less than you are allowed for the latest SEP-IRA contribution year.

However, you don't get off that easy.  If SEP-IRA excess contributions are not withdrawn by the due date of the return (plus extension), you must pay a 10% penalty excise tax on the extra amount.  This is filed on Form 5330, and should be filed with your amended return.

Suppose you no longer have income in the current tax year to qualify for SEP-IRA contributions?  In that case, you will have to withdraw the excess amount.  When that happens, you will probably have 20% withheld for taxes, and will receive a 1099-R at the end of the year.  In order to avoid paying a 10% early withdrawal penalty on your taxes, you will have to mark the withdrawal as a return of an excess contribution on Form 5329 the year you receive the 1099-R.

Needless to say, all of the above is a bit complicated.  However, that's what makes taxes so fun.

Comments

[Jeff Day EA]

Why wasn't advice given to not amend the returns for the extra depreciation but instead to file a 3115 (as long as he went over two years) and take the deduction on the current year and then not have to be concerned about the prior SEP contributions?

Jeff Day

[Ryan Ellis]

In this taxpayer's case, all of the unclaimed depreciation was in the three-year amended filing window. As such, my understanding is that the proper move is to do amended returns in this situation. For clients that have older unclaimed depreciation, I've done as you suggest.

Nevertheless, this doesn't come up often. What's been your experience?