Profit Sharing Plans

PROFIT SHARING ILLUSTRATION 2009

Employee	Age	Salary	New Comparability	Integrated	Salary Ratio
Owner*	54	245,000	49,000	49,000	46,570
Owner*	54	245,000	49,000	49,000	46,570
Employee1	29	30,000	1,500	5,048	5,702
Employee2	39	40,000	2,000	6,731	7,603
Employee3	24	45,000	2,250	7,573	8,554

All Employees		605,000	103,750	117,352	115,000
Preferred Employees*		490,000	98,000	98,000	93,140
Other Employees		115,000	5,750	19,352	21,860
% of Total			94.46%	83.51%	80.99%

A profit sharing plan is the most flexible retirement plan available. Discretionary company contributions are determined each year by the board of directors or other governing body. If the company makes little or no profit, no contribution is required that year, but low profits don't mean a contribution can’t be made. A profit sharing plan can include an option allowing the company to make a contribution even if the company has no profit.

Plan sponsors are generally required to file an IRS Form 5500, and are subject to non-discrimination and top-heavy testing requirements. Thus, profit sharing plans incur plan administration costs that are deductible to the plan sponsor as a business expense. Profit sharing plans are subject to minimum participation requirements. Therefore, all eligible employees must be covered under the plan. Additionally, while eligibility may be less restrictive, it may be limited to employees who have attained age 21, and have completed (1) one year of service (if a vesting schedule is desired, generally requires dual entry dates); or, (2) two years of service (requires 100% vesting).

Profit sharing contributions are generally allocated to eligible employees based on compensation.

Permitted disparity, commonly referred to as “Social Security Integrated” takes into account the inequity of benefit accruals under the Social Security (SS) system. SS benefits, as a percentage of pay, are larger for employees with earnings below the SS (FICA) wage base, $87,900 for 2004. Under an integrated allocation formula, additional contributions of 5.7% (the maximum integration percentage permitted) can be made to employees earning in excess of the SS wage base. The sponsor may select a dollar figure lower than the SS wage base. However, the integration percentage will be reduced accordingly. A good rule of thumb is that the pro-rata % of compensation should be at least 5.7%; otherwise the permitted disparity % must be reduced, thus minimizing the impact of using this formula.

An age-weighted profit sharing plan works like a defined benefit plan with discretionary contributions. Since the participant’s age, or length of time until retirement, is factored into the allocation formula, older participants receive a larger proportionate share of the contribution. This can be advantageous in a situation where the key employees are significantly older than the other employees.

Although this type of plan is available to any size company, age-weighted plans are especially well suited for small businesses and professional practices. The owners of these firms tend to be older than their employees, so the allocation formula allows a larger share of the plan contribution to flow into their accounts.

Treasury Regulations Section 401(a)(4) allows testing of defined contribution plans based on projected benefits. The basic concept is that the same contribution does not produce the same benefit for everyone. For example, 1% of pay allocated to a 55 year old will, at an investment return of 8.5% compounded annually, grow to 2.26% of pay by the time he reaches age 65. The same 1% allocated to a 35-year-old, under similar circumstances, will grow to 11.56% of pay by age 65, more than five times the benefit for the 55 year old. A much larger contribution would be required for the 55-year-old to even out the level of projected benefit. The age-weighted allocation levels the benefit by increasing the contribution amounts for older employees. If there is a disparity in compensation levels toward the older person, the allocation favors the older person even more. The result is the contribution dollars being skewed toward older, key employees in a manner that is not ruled as discriminatory.

Although in certain situations the age-weighted plan design works extremely well, one drawback is that employees with the same salary may receive a different allocation. Another issue is that an older non-principal employee may receive a disproportionate share in relation to a younger principal.

The Comparability plans, also known as cross-tested or rate-group plans, are similar to age-weighted plans in that the testing for discrimination is based on projected benefits as opposed to contribution percentages. The difference from the age-weighted design is that separate allocation levels can be created. An example would be a law firm’s plan with two benefit levels, one for the staff (5%) and one for the principals (15%). This would be appropriate in a situation where there is a significant difference in age between two principals with similar compensation. An age-weighted plan would be unfavorable to the younger principal.

This formula is allowed by permitting an "averaging" of projected benefits, allocated to multiple classifications of employees. The basis of the testing is: (1) converting the contribution amounts into projected benefits as of a specific testing date (age 65); (2) defining the rate groups of each Highly Compensated Employee; (3) testing each rate group pursuant to coverage regulations under Section 410(b).

This plan design works well in a situation where a business wants to favor a certain group of participants. It is also an option that could allow an executive to reach the maximum annual addition level. In recent years, a popular design strategy for small companies and professional groups is to combine a cross-tested plan with a Safe-Harbor 401(k) plan. The change in top-heavy rules will make this even more popular.