Are SEP-IRA Contributions Subject To Self-Employment Tax?

A Simplified Employee Pension (SEP) is a traditional individual retirement account that may accept expanded employer contributions, including contributions from self-employed individuals. SEPs are treated as defined contribution plans and are subject to the overall limits on employer contributions. Deductible contributions for self-employed individuals are effectively limited to the lesser of $41,000 or 25% of net self-employment income.

For self-employed individuals, the question arises as to whether contributions to an individual’s own SEP are subject to self-employment tax. It is generally well understood that SEP contributions are not subject to Social Security or federal unemployment taxes for employees. In addition, the contributions to employee SEPs are clearly deductible from the self-employed individuals’ own income as an ordinary business expense. In fact, in Publication 560, the Internal Revenue Service advises sole proprietors to deduct contributions to employee SEPs on Schedule C, before determining net income subject to self-employment tax.

Until recently, IRS publications were not consistent, however, on how to treat self-employed individuals’ contributions to their own SEPs. The IRS, however, recently has removed the inconsistent instructions, and in Publication 560, the Service advises self-employed individuals to deduct contributions to their own SEPs on line 30 of Form 1040.

Following these instructions would leave their own SEP contributions subject to self-employment tax. Is this the correct result?

IRC Section 1402(a) defines net earnings from self-employment that are subject to the self-employment tax. It provides at least 15 different special deductions and exclusions from gross income, none of which explicitly includes a deduction for one’s own SEP contributions. IRC Section 1402(a) does, however, provide for all the normal business deductions allowed by the IRC. This is, in fact, how contributions to an ordinary employee’s SEP are deducted.

So, is a self-employed individual an employee for purposes of deducting his own SEP contributions from self-employment income? Yes. Under IRC Sections 408(k)(7)(A) and 401(c), if the “personal services of the tax-payer are a material income-producing factor” in the business, then the self-employed individual will be treated as an employee with net income who is eligible for SEP contributions. There is no basis for distinguishing between SEP contributions on behalf of other employees and contributions on behalf of the self-employed owner who is actually working in the business.

So, it appears that the IRS has cleared up the inconsistency in its publications by choosing the wrong interpretation. All self-employed individuals with SEPs should consult with their tax advisors to see how this issue should be handled.

John Fenton, J.D., M.S.B.A., is a staff writer for Tax Facts, a National Underwriter Company publication. He can be reached via e-mail at jfenton@nuco.com.


Reproduced from National Underwriter Edition, June 11, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.