A Simplified Employee Pension (SEP) is an employee's individual retirement account or annuity (IRA) which may receive an increased rate of contributions from the IRA holder's employer.  To operate properly, each eligible employee must have an IRA to accept the employer's contributions.  Any employer, whether it is a corporation, partnership, or even a one-person sole-proprietorship with no other employees, may establish a SEP.  SEPs are particularly useful for persons regularly employed by a company but who "moonlight" for themselves as independent contractors. That is why SEPs are sometimes referred to as a "moonlighter's retirement plan".  While originally designed for small business employers, there is no limit on the size of employer that may set up a SEP.

Generally, an employer who establishes a SEP must cover each and every employee who has:

reached age 21,
worked for the employer during the year in which the contribution is made
worked for the employer for at least three of the previous five years, and
received at least $300 in compensation (adjusted for inflation -- $550 for 2011 ) for the year in which the contribution is made.

 A SEP plan must be in writing and must include a formula for the allocation of contributions and provisions governing participation, vesting and nondiscrimination.  The plan must be established no later than the business' income tax filing date for the year that it is contributing.  A SEP is the only type of employer-sponsored retirement plan that can be established after the employer's tax year has ended. This makes SEPs extremely attractive for businesses that do not know their financial condition until tax time. However, the plan must exist at the time the contributions are made and the contributions must be made within the applicable time limits (discussed below).

An employer is not required to make contributions to a SEP. However, if an employer makes contributions, they must be made under a written formula that indicates how the employer will calculate each employee's share. Annual contributions by the employer are limited to the lesser of 25% of the employee's compensation or $40,000 (adjusted for inflation, $49,000 in 2011). SEP contributions need not be made every year. The decision to contribute or not is left solely to the employer.   
For tax and legal purposes, the SEP plan is officially adopted when:

traditional IRAs have been established for all eligible employees;
the agreement form has been completed without modification;
employees receive disclosure statements indicating the existence of the plan, that IRAs involve a degree of investment risk, and that the plan administrator will notify employees of any contributions to the SEP no later than January 31st of the following year.  

The final two steps are usually accomplished by simply signing and distributing IRS Form 5305-SEP to all eligible employees.

Since the employer will claim a tax deduction for contributions under a SEP, the IRAs established under a SEP arrangement must be traditional IRAs, not Roth IRAs. All eventual distributions from the account will be fully taxable to the employee, and are subject to the same restrictions as traditional IRAs.

 Model SEPs

The IRS has developed a one-page tax form, 5305-SEP, that meets all the requirements of a Simplified Employee Pension plan and does not require any special document preparation.  Form 5305-SEP is the simplest, most efficient, and least expensive way for a small business to establish a retirement plan for its employees.  By using the IRS model, the employer need not develop an individual plan.  ( click here to view IRS Form 5305 - SEP in PDF format)

An employer may set up a Model SEP using Form 5305-SEP under the following conditions:

the employer does not currently maintain any other retirement plan and has not maintained a defined benefit plan at any time in the past,
an IRA has been established for each eligible employee,
the employer does not use the services of leased employees, and
all eligible employees of all members an affiliated service group, a controlled group of corporations, or a trade or business under common control, of which the employer is a member, participate in the SEP.

Since Form 5305-SEP is a "pre-approved" plan, no favorable ruling from the IRS is required when establishing a Model SEP, nor is it filed with the IRS. The employer simply retains a signed, dated copy of the completed form with its business records.
Employers who establish a model SEP, and have furnished each eligible employee with a copy of the completed form and other required information set forth in the instructions, need not file annual reports with the IRS. However, this exception from the annual reporting obligations is not available if the employer selects, recommends, or influences employees to choose IRAs into which contributions will be made under the SEP, and those IRAs are subject to special provisions that limit a participant's ability to withdraw funds (other than restrictions applicable to IRAs in general).

Employers using a Model SEP may not integrate the SEP contributions with, or offset them by, FICA (Social Security) contributions (see Integration).

 Non-Model SEPs

The IRS allows employers to create unique SEP plans for their employees.  Many financial institutions have also received approval from the IRS for the use of their own prototype SEPs, allowing them to  combine plan administration and investment services. This "one-stop" shopping for retirement plan and investment services is attractive to busy employers.

 Unlike the Model SEP plans, these unique non-model SEP's must be approved by the IRS.  A copy of the proposed SEP must be filed with the IRS with a request for a "favorable ruling". Likewise, any proposed amendments to the plan must also be filed with the IRS even if those amendments are required due to changes in the tax code.

Employers with fewer than 100 employees may claim a tax credit equal to 50% of the cost to establish a SEP, SIMPLE or other qualified plan. The credit is limited to $500 per year for each of the first three years of the plan's existence.  (click here to view IRS Form 8881 "Credit for Small Employer Pension Plan Startup Costs" in PDF format)