Regardless of their nature or topic matter, off beat questions are one of the spices of life. When it comes to the realm of taxation generally speaking the answers frequently distill down to - it depends.
These two questions were asked of me on my last trip to New York City and I couldn't restrain a spontaneous sarcastic guffaw as we were in the middle of the Museum of Modern Art attempting to comprehend the Matisse Cut-Out Exhibit and I was day dreaming that my 10 year old daughter may perhaps be an artistic genius.
But the taxpayer turns out was serious, very serious indeed and pressed me for an adequate response. The best starting point in addressing questions of this ilk lies in understanding that spices aside life on this planet is short and time is precious. From there things sort of fall into place if you follow the Internal Revenue Code and recognizing that reprobate behavior generally leads to ill gotten gains. Nevertheless here is my answer, interpret it as you see fit.
The establishment of a Simplified Employee Pension (SEP) does not require IRS approval, but there must be a formal written plan document and the Sole Proprietor also must treat him or her self as an employee of the sole proprietorship that is paid a wage and receives IRS Form W-2 at the end of the year.
This also means of course that you must prepare, sign and file IRS Form 941 - Federal Employment Tax Return quarterly; IRS Form 940 Federal Unemployment Tax Return annually as well as pay yourself and withhold federal and state income tax regularly and consistently and turn that money over to the IRS and the state department of Revenue or Taxation in which business is conducted.
In addition you must be compliant with your state's labor laws regarding unemployment tax and worker's compensation insurance as well. Remember you are treating yourself as an employee and employee labor laws vary state by state, some of which are absolutely archaic if not inane. Colorado has a few interesting examples of this.
For federal purposes the stipulation is that the business has EARNED business income, INCURRED business expenses, and has at least one employee. Yes, that employee can be the owner. Completing IRS Form 5305-A SEP - Salary Reduction and Other Elective Simplified Employee Pension: Individual Retirement Accounts Contribution Agreement - in part satisfies this requirement but it gets nuanced and somewhat complicated, so buckle up.
Compensation for plan allocations is basically the pay a participant employee received from the employer for personal services for a year. You can generally define compensation as including: wages and salaries, fees for professional services, other net earnings received (cash or non-cash) for personal services actually rendered by an employee, including commissions, tips, fringe benefits, and bonuses.
For SEP and qualified plans, net earnings from self employment is your gross income from your trade or business provided your personal services are a material income producing factor, minus (of course) allowable business deductions. Allowable deductions include contributions to SEP and qualified plans for common law employees and the deduction allowed for the deductible part of your self employment tax.
When considering net earnings generally they tend to include a partner's distributive share of the partnership income or loss (other than separately stated items, such as capital gains and losses). For SEP contribution purposes however this is not the case. For example do NOT include income passed through to a partner when considering income for SEP contribution purposes.
Guaranteed payments to limited partners are net earnings from self employment if they are paid for services to or for the partnership. Distributions of other income shareholders of S-Corporations are ALSO not considered net earnings for these purposes either and do not qualify for SEP contribution purposes.
For a self employed individual, compensation means all earned income and generally includes amounts deferred in the following employee benefit plans as elective deferrals: Qualified cash or deferred arrangement (section 401(k) plan); Salary reduction agreement to contribute; to a tax sheltered annuity (section 403(b) plan), a SIMPLE IRA plan, or a SAR SEP; Section 457 non-qualified deferred compensation plan or Section 125 cafeteria plan.
Net earnings from self employment does not include items excluded from gross income (or their related deductions) other than foreign earned income and foreign housing cost amounts. For the deduction limits, earned income is net earnings for personal services actually rendered to the business. You take into account the income tax deduction for the deductible part of self employment tax and the deduction for contributions to the plan made on your behalf when figuring net earnings.
As point of clarification earned income is net earnings from self employment from a business in which your services materially helped to produce the income. You can also have earned income from property your personal efforts helped create, such as royalties from your books or inventions. Earned income includes net earnings from selling or otherwise disposing of the property, but it does not include capital gains. It includes income from licensing the use of property other than goodwill.
Net of it all if you made it this far the take away from this post is that if you are a sole proprietor with passive income you really should not waste your precious time on this planet with such an inane tax 'strategy' of attempting to use passive income from a sole proprietorship to fund a SEP. Unless you want to pay me a LOT of $$ to defend your position you just should NOT claim pass through income as earnings for SEP contribution purposes in any regard either.