9.2 Statutory Employee Participation Requirements (Age 21, 3-of-5 Years, Compensation)

The Three Statutory Eligibility Criteria (IRC § 408(k)(2))

To ensure that simplified employer plans provide broad retirement coverage across the workforce rather than favoring only business owners and top executives, Internal Revenue Code Section 408(k)(2) establishes strict participation rules. An employer maintaining a SEP must allocate a contribution to every employee who satisfies three statutory requirements during or on account of the calendar year:

1. Age Requirement: The employee has attained age 21 on or before the close of the calendar year.
2. Service Requirement: The employee has performed service for the employer in at least 3 of the immediately preceding 5 calendar years.
3. Compensation Threshold: The employee received at least the statutory minimum compensation from the employer for the calendar year.

The Minimum Compensation Dollar Threshold

Under IRC Section 408(k)(2)(C) and Section 408(k)(8), the minimum compensation threshold is indexed annually for cost-of-living adjustments in $50 increments:

• Tax Year 2023: $750
• Tax Year 2024: $750
• Tax Year 2025: $750
• Tax Year 2026: $800 (IRS Notice 2025-67)

If an employee meets the age and service requirements and earns at least the threshold ($800 for 2026) in compensation from the employer during the calendar year, the employer is legally obligated to fund a contribution on their behalf if any contribution is made to the plan for that year.

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The 3-of-5 Years Service Rule and Absence of the 1,000-Hour Standard

A central focus of the CISP examination—and one of the most common operational compliance pitfalls for small business employers—is the statutory definition of "service" under IRC Section 408(k)(2)(B):

Qualified Plans vs. SEPs: The 1,000-Hour Trap

Under standard qualified retirement plan rules (IRC § 410(a)(1) and ERISA § 202), a statutory "year of service" requires an employee to complete at least 1,000 hours of service during a designated 12-consecutive-month computation period. Employers frequently assume this 1,000-hour rule applies across all employer plans.

In a SEP, the 1,000-hour rule does not exist. The Form 5305-SEP instructions define service as any work performed for the employer for any period of time, however short:

• Working 500 hours counts as a year of service.
• Working 40 hours during a summer rush counts as a year of service.
• Working a single hour or a single shift in a calendar year constitutes a full year of service for that calendar year.

Mechanics of the 5-Year Lookback Window

The statutory service test examines the 5 calendar years immediately preceding the current plan year. The current calendar year itself is not one of the preceding 5 years; it is the year for which compensation is earned and the contribution is calculated.

Consider an employer determining SEP eligibility for calendar year 2025:

• The 5 immediately preceding calendar years are: 2020, 2021, 2022, 2023, and 2024.
• The employer examines the payroll records for each employee across those 5 lookback years.
• If an employee performed any service for the employer in at least 3 of those 5 specific years (e.g., worked in 2021, 2023, and 2024), the service test is 100% satisfied for 2025.

Comprehensive Service Tracking Matrix

Critical Examination Nuance: As demonstrated with Worker D, the 3 years of service do not need to be consecutive. Service in 2020, 2021, and 2022 satisfies the requirement for 2025, even if the worker took a complete leave of absence in 2023 and 2024.

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Employer Discretion: Liberalization vs. Strict Statutory Ceiling

Under IRC Section 408(k)(2), the statutory criteria (age 21, 3-of-5 years of service, and the indexed compensation threshold) represent the maximum restrictive limits an employer may impose. An employer has full legal discretion to adopt less restrictive (more liberal) eligibility rules in its written plan agreement, but is strictly prohibited from adopting more restrictive provisions:

Permissible Liberalized Provisions (More Favorable to Employees)

• Age: The employer may lower the age requirement to age 18, 19, or eliminate the age restriction entirely (e.g., all ages eligible).
• Service: The employer may reduce the service hurdle to 2 of 5 years, 1 of 5 years, or grant immediate participation upon hire (0 service requirement).
• Compensation: The employer may reduce the compensation requirement below the statutory threshold (e.g., requiring only $300, $1, or $0 in earnings).

Impermissible Restrictive Provisions (Statutory Violations)

• Imposing an age requirement of 22, 25, or 30 (exceeds age 21 ceiling);
• Requiring 4 of 5 years of service, or requiring 2 or 3 consecutive years of service;
• Requiring a minimum number of hours (such as 500 or 1,000 hours);
• Requiring compensation of $1,500, $5,000, or $10,000 (exceeds the statutory threshold, $800 for 2026);
• Imposing a "last day" rule requiring an employee to be actively employed on December 31 to receive a contribution.

If an employer specifies liberalized terms in Form 5305-SEP (such as checking the box for immediate participation upon hire), the employer is contractually and legally bound to that standard for all employees.

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Permissible Statutory Exclusions (IRC § 408(k)(2))

Internal Revenue Code Section 408(k)(2) explicitly limits the classes of employees that an employer may exclude from a SEP. There are strictly only two statutory exclusions permitted by federal law:

1. Union Employees: Employees covered by a valid collective bargaining agreement where retirement benefits were the subject of good-faith bargaining between the union and the employer pursuant to IRC Section 410(b)(3)(A).
2. Nonresident Aliens: Nonresident alien employees who receive no earned income from sources within the United States within the meaning of IRC Section 410(b)(3)(C).

Absolute Prohibition on Category Exclusions

Every other class of worker who satisfies the plan's age, service, and compensation rules must be covered. An employer cannot exclude:

• Part-time or seasonal employees;
• Temporary or per diem workers;
• Remote or work-from-home personnel;
• Salaried vs. hourly workers;
• Family members or relatives of the business owner;
• Corporate officers or non-shareholder employees.

Terminated and Deceased Employees

A common compliance error involves employees who separate from service or pass away during the calendar year. Because the SEP must cover every eligible employee, if an employee satisfied the age and service criteria and earned at least the compensation threshold during the calendar year, the employer must fund a SEP contribution on their behalf, even if the employee resigned, was terminated for cause, or died prior to the date the employer deposits the contribution. For a deceased employee, the contribution must be deposited into an IRA established for the decedent's estate or designated beneficiary.

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Severe Consequences of Omitting an Eligible Employee & EPCRS Correction

Excluding an eligible employee from a SEP contribution is an operational defect that strikes at the heart of plan qualification. Under IRC Section 408(k), if an employer fails to fund an eligible employee's account, the entire plan loses its status as a SEP for all participants for that tax year. As a result:

• The employer forfeits its corporate tax deduction for all SEP contributions;
• Contributions deposited into owners' and other employees' IRAs are reclassified as regular annual IRA contributions, creating massive excess contributions subject to the 6% annual excise tax under IRC Section 4973;
• All affected employees face potential tax penalties and unexpected taxable income.

Correction under the IRS Employee Plans Compliance Resolution System (EPCRS)

To avoid disastrous plan disqualification, an employer discovering an omitted employee must utilize the IRS Employee Plans Compliance Resolution System (EPCRS), currently codified under Revenue Procedure 2021-30 and updated under SECURE 2.0:

1. Corrective Contribution Mandate: The employer must make a full retroactive corrective contribution to a SEP IRA on behalf of the excluded employee. The contribution amount must equal the exact percentage of compensation that was contributed for other participants during that plan year.
2. Lost Earnings Calculation: The employer cannot merely deposit the nominal principal contribution. The employer must calculate and deposit lost investment earnings from the date the original contribution was due (the employer's tax filing due date) through the actual date of the corrective deposit. Earnings are calculated using either the actual rate of return of the employee's IRA or the plan's benchmark rate.
3. Employer-Funded Relief: The employer must fund the corrective contribution entirely out of business operating assets. The employer is legally prohibited from reducing future contributions for other employees or requesting refunds from existing participants to pay for the correction.
4. Self-Correction Program (SCP): Under expanded EPCRS rules, most operational eligibility omissions can be corrected under SCP without submitting a formal filing or paying a user fee to the IRS, provided the employer adopts updated administrative compliance procedures to prevent recurrence.

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Realistic Bank Administrative Scenario: The Part-Time Exclusion Error

At First Commercial Trust Bank, CISP administrator Jason conducts an annual compliance audit for client Pinnacle Logistics LLC, which established a SEP using model Form 5305-SEP in 2022. Pinnacle funded a 15% contribution for calendar year 2024 on March 14, 2025.

Client Circumstances & Audit Findings

During payroll reconciliation, Jason discovers that Pinnacle's payroll officer omitted employee Marcus from the 2024 SEP contribution. The payroll officer explained that Marcus was a "part-time seasonal college worker who never worked 1,000 hours in any single year," and therefore assumed he was ineligible under federal retirement law.

Jason reviews Marcus's complete employment and payroll history:

• Date of Birth: April 10, 2002 (attained age 22 in April 2024);
• Service Record (Hours Worked):
  • 2020: 0 hours
  • 2021: 140 hours during summer freight handling
  • 2022: 95 hours during peak holiday shipping
  • 2023: 0 hours
  • 2024: 180 hours during spring and summer operations
• 2024 W-2 Compensation: $4,800.

CISP Regulatory Analysis and Corrective Protocol

1. Debunking the 1,000-Hour Rule: Jason informs Pinnacle's management that under IRC Section 408(k)(2)(B), the qualified plan 1,000-hour standard has no legal application to SEPs. A year of service is defined as any calendar year in which an employee performs any service.
2. Statutory 3-of-5 Verification: For plan year 2024, the 5 immediately preceding calendar years are 2019 through 2023. Marcus worked in only two of them (2021 and 2022), so he would fail the statutory 3-of-5 test. However, the executed Form 5305-SEP on file shows that Pinnacle chose a more liberal service requirement: service in at least 1 of the immediately preceding 5 years.
3. Operational Failure: Because Pinnacle adopted a 1-year service rule in its plan document, Marcus was legally eligible for the 2024 plan year (having worked in 2021 and 2022, exceeding 1 year, and earning $4,800 in 2024 at age 22). Omitting Marcus violated the written terms of the plan.
4. EPCRS Correction Execution:
   • Principal Contribution: 15% × $4,800 = $720.00.
   • Lost Earnings: The contribution was due on March 15, 2025. By July 15, 2025 (4 months delinquent), the plan's benchmark portfolio returned 4.0%. Lost earnings equal $720.00 × 4% = $28.80.
   • Total Deposit: Pinnacle deposits $748.80 into Marcus's newly opened SEP IRA at First Commercial Trust Bank.
   • Jason documents the correction under the EPCRS Self-Correction Program (SCP), preserving the tax-qualified status of the entire plan.