The Profit Sharing Plan is usually the most flexible and cost-effective option available to a small employer. Company contributions are at the discretion of the employer, and are not required in any particular year. Allocation formulas available include basic formulas, such as “pro rata” and “Social Security integration,” as well as the age-sensitive (i.e., “cross tested”) Tiered allocation method.
Company contributions to a Profit Sharing Plan are limited to 25% of covered compensation. If an employer would prefer to make contributions in excess of 25% of covered compensation, or would prefer to make contributions for a targeted employee in excess of $54,000 (2017 DC limit, indexed), a Defined Benefit Plan should be considered rather than a Profit Sharing Plan.
General Features of a Profit Sharing Plan
Company Deduction Limit. For each type of plan, an employer may deduct contributions up to 25% of covered compensation of all participants.
Participant Allocation Limit. The maximum that a participant may be allocated in a plan year is the lesser of 100% of compensation or $54,000 (2017 limit, indexed).
Maximum Compensation. The maximum compensation that can be considered for one employee is $270,000 (2017 limit). Compensation exceeding this amount is not considered for plan purposes.
Vesting Schedule. Generally, the most restrictive vesting schedule a small plan should consider is a 6-year graded vesting schedule (beginning with 20% in the 2nd year, and increasing in 20% increments each year thereafter), or a 3-year “cliff vesting” (100% after 3 years). However, schedules more liberal than this may be used. Forfeitures resulting from the use of a vesting schedule generally reduce the employer’s cost of future contributions.
Eligibility Requirements. The employer can require up to 12 months of service to be eligible for the plan, while still retaining the plan’s vesting schedule. The employer may also require a minimum age (not greater than age 21) for plan eligibility.
Entry Dates. Once an employee has met the Eligibility Requirements, they enter the plan on the next Entry Date. Generally, the plan would be setup with Entry Dates on two or more specific dates during the year.
For example, consider a plan requiring 12 months of service for eligibility, with entry dates of January 1 and July 1. If an employee completes his first 12 months of service on August 7, he does not enter the plan until the next plan entry date which is January 1 of the next year.
Highly Compensated Employees. This is an important group for plan discrimination testing purposes: plans must not discriminate in favor of these employees. Currently, Highly Compensated Employees include the following:
- Any employee who received compensation in excess of $120,000 (limit for 2017 test year) in the prior plan year.
- Any owner with an interest greater-than-5% in either the current year or prior year.
- The spouse of a greater-than-5% owner, as well as their children, parents and grandparents.
Distributions. Normal distributions of a participant’s account may occur when the participant terminates employment with the company, retires, or becomes disabled. Generally, participants may “roll” all of the pretax distribution into an Individual Retirement Account (IRA) and continue tax-deferred earnings, or they may elect to take a lump-sum distribution and pay the tax required. Any taxable distribution before age 59 ½ (or age 55, with separation of service) may be subject to an additional 10% excise tax.
Contribution Allocation Formulas
Company contributions to a Defined Contribution Plan must not be allocated in such a way as to discriminate in favor of Highly Compensated Employees. The allocation formula describes how company contributions to the plan are allocated among the participants. There are a number of IRS-approved allocation methods a plan may use.
The standard allocation formulas are nondiscriminatory because they are uniformly applied according to certain rules. These formulas include “Pro Rata” and “Social Security Integration.”
However, there are also special formulas for allocating contributions. These methods require additional discrimination testing, but may result in a substantially higher percentage of the total company contribution allocated to targeted Highly Compensated Employees such as owners.
Benetech’s Tiered Plans use a special allocation method that is “cross tested,” in that they are Defined Contribution Plans that are tested like Defined Benefit Plans. By taking advantage of alternate means of discrimination testing, these plans can allocate up to 90% of a company’s contribution to the accounts of targeted employees.
Standard Allocation Formulas
Standard allocation formulas found in most Defined Contribution Plans follow fairly restrictive procedures. There are two common options: “pro rata” and “Social Security integration.” When one of these procedures is followed, the allocation is automatically deemed to meet nondiscrimination requirements.
Pro Rata Formula
This formula allocates the contribution on the basis of the ratio of the participant’s eligible compensation to the total covered compensation of all eligible employees. The result is that each eligible participant receives the same percentage of covered compensation.
Owners and other Highly Compensated Employees generally make more than other employees, so they are generally allocated a higher dollar amount than other employees. However, since they are allocated the same percentage of compensation as the other employees, the basic allocation meets nondiscrimination requirements.
Social Security Integration (aka “Permitted Disparity”)
This method takes into account amounts that employees and employers pay in to Social Security. The idea is that employees who make more than the Social Security Taxable Wage Base (“SSTWB,” which is $127,200 in 2017) are limited in what they will receive from Social Security after retirement.
For this reason, an “integrated” plan defines an “integration level” (usually the SSTWB), and then allocates a modest additional contribution for compensation in excess of the integration level. The result is a slightly higher allocation to employees whose compensation is in excess of the integration level when compared to the pro rata formula.
Tiered Allocation Formula
Benetech’s Tiered Plans use an alternate method of satisfying nondiscrimination requirements: it considers the benefit at retirement funded by each participant’s allocation.
The idea rests on the premise that older employees have less time to accumulate retirement benefits. Therefore, a larger current-year contribution may need to be made on behalf of each older employee to make their benefits at retirement equivalent to those of younger employees.
The targeted employees (such as owners) tend to be older than other employees. As a result, these types of plans tend to allocate a greater percentage of the total contribution to the targeted employees when compared to a plan using a standard allocation formula.
Tiered Allocation Method
The basic idea of the Tiered allocation method is to test the allocation among participants of a Profit Sharing contribution as if it were a Defined Benefit Plan (for this reason, it is often called a “cross tested” plan). A Tiered plan has a couple of important features.
First, a Tiered Plan allows allocation categories based on legitimate business distinctions, such as job classifications. For example, legitimate business categories include “Owners” and “All Others.”
Second, it applies two separate discrimination tests. The first compares the benefit at retirement that the allocation is funding for each participant; however, only a fraction of the eligible employees are included in this test.
The second test includes all participants. However, this test averages the benefit at retirement of all of the participants in each discrimination testing category.
The result is a plan design where the targeted Highly Compensated Employees only need to be older than most of the employees for the program to be effective.