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Comparing profit sharing allocation formulas

“What are the most common contribution formulas for profit sharing plans and how do they compare?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Virginia is representative of a common inquiry related to profit sharing plan contributions.

Highlights of the Discussion

Profit-sharing plan contributions are discretionary in most cases, and they must be made according to a nondiscriminatory allocation formula. The most common formula used is a formula that allocates contributions based on a percentage of each participant’s compensation, but there are several others, including flat dollar, integrated and cross-tested as described in the following paragraphs. The actual formula that a sponsor must apply will be detailed in the plan document that governs the plan.

Flat Dollar

A plan sponsor who uses a flat dollar contribution formula in its profit sharing plan must contribute the same dollar amount to each eligible employee, regardless of the participants’ level of pay.

Pro Rata

An allocation formula that provides eligible participants with a contribution based on the same percentage of compensation is known as a pro rata formula.

Integrated

An integrated allocation formula allows a plan sponsor to provide higher contributions for eligible participants who earn amounts over a set threshold, as long as the “permitted disparity rules” of IRC Sec. 401(l) are satisfied. Integrated plans are also known as “Social Security-based” or “permitted disparity” plans. The permitted disparity rules allow plan sponsors to give eligible participants who earn compensation above the “integration level,” which is typically the Social Security Taxable Wage Base (TWB), an additional contribution. This additional contribution is equal to the lesser of

  • Two times the base contribution percentage, or
  • The base contribution percentage plus the “permitted disparity factor.”

If the plan sponsor sets the integration level at the TWB, then the permitted disparity factor equals 5.7 percent. Note that the plan sponsor may set the integration level at an amount lower than the TWB. If this is done, however, the plan sponsor must then reduce the permitted disparity factor according to the following table.

 

Integration Level Applicable Permitted Disparity Factor
The Taxable Wage Base (TWB) 5.7%
81-99% of the TWB 5.4%
21-80% of the TWB 4.3%
0-20% of the TWB 5.7%

 

Cross-Tested

Profit sharing plans typically satisfy general nondiscrimination rules by comparing the amount of contributions given to participants. The IRS allows plan sponsors to prove their plans are nondiscriminatory under a testing alternative known as the “cross-testing method.” Under the cross-testing method, contributions are converted to equivalent benefits payable at normal retirement age, and then compared to determine whether or not the benefits unduly favor highly compensated employees over nonhighly compensated employees. This is similar to defined benefit plan testing. The most common types of cross-tested plans are age-weighted and new comparability plans.

  1. Age-weighted

In an age-weighted profit sharing plan, the employer’s contribution to the plan is allocated among employees based on factors that combine compensation with deferred annuity factors based on age. The higher the age, the larger the factor, and the larger the allocation to the participant will be.

2.  New comparability plans permit plan sponsors to favor select groups of participants. Under the new comparability rules, plan sponsors are allowed to define and assign employees to different contribution “rate groups” within the plan. The contribution level for each rate group may vary, as long as the plan proves nondiscriminatory under the cross-testing method.

  Comparing Profit Sharing Plan Contribution Allocation Formulas for 2018
Employee Age Compensation Flat Dollar Pro Rata Integrated Age Weighted New Comparability
Owner A 48 $275,000.00 $7,500 $55,000.00 $55,000.00 $55,000.00 $55,000.00
Owner B 60 $275,000.00 $7,500 $55,000.00 $55,000.00 $55,000.00 $55,000.00
Participant C 43 $60,000.00 $7,500 $12,000.00 $10,180.56 $8,389.03 $3,987.12
Participant D 50 $60,000.00 $7,500 $12,000.00 $10,180.56 $13,917.81 $3,987.12
Participant E 32 $30,000.00 $7,500 $6,000.00 $5,090.28 $1,893.16 $1,993.56
    $700,000.00 $37,500 $140,000.00 $135,451.40 $134,200.00 $119,967.80
               
 Assumptions       % of Compensation Integration Level (TWB) Factor Rate Groups
         20% $128,700  7.50% 1. owners
              2. non-owners

The above represents a hypothetical scenario for illustrative purposes only to maximize contributions for the business owners. It cannot be used for tax or legal advice.

Conclusion

When made, profit-sharing plan contributions must be allocated according to a nondiscriminatory formula as specified in the plan document. But as the table above illustrates, some formulas (depending on the make up of employees) can allow a greater share of the overall contribution to be given to owners or other more highly paid participants.

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