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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.

© Copyright 2018 Retirement Learning Center, all rights reserved
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Complete discontinuance of profit sharing plan contributions

“I came across a prospect that froze it’s profit sharing plan several years ago, and has not made contributions since. Are there any concerns regarding the plan?”

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 plans. 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 Colorado is representative of a common inquiry related to on going contributions to a profit sharing plan.

Highlights of Discussion

While contributions to profit sharing plans are generally discretionary, meaning a plan sponsor can decide from year to year whether to make a contribution or not, the IRS expects that contributions will be “recurring and substantial” over time in order for a plan to be considered ongoing and remain viable [Treas. Reg. § 1.401-1(b)(2)].

If contributions cease, a complete “discontinuance of contributions” has occurred in the IRS’s eyes, which triggers a plan termination and complete (100%) vesting of participants’ accounts [Treas. Reg. § 1.411(d)-2(a)(1)].  Contrast this with a “suspension of contributions” under the plan, which is merely a temporary cessation of contributions by the employer. A complete discontinuance of contributions still may occur even though the employer makes contributions if such contributions are not substantial enough to reflect the intent on the part of the employer to continue to maintain the plan (e.g., only forfeitures are allocated).

The IRS makes a determination as to whether a complete discontinuance of contributions under a plan has occurred by considering all the facts and circumstances in the particular case, and without regard to any employee contributions (i.e. pre-tax deferrals, designated Roth or after-tax contributions). According to the IRS’s exam guidelines at Part 7.12.1.4, examiners are to review IRS Form 5310, line 19a, which indicates employer contributions made for the current and the five prior plan years, to determine if the plan has had a complete discontinuance of contributions. In a profit sharing plan, if the plan sponsor has failed to make substantial contributions in three out of five years, there may be a discontinuance of contributions. Other considerations include whether the employer is calling an actual discontinuance of contributions a suspension of such contributions in order to avoid the requirement of full vesting, and whether there is a reasonable probability that the lack of contributions will continue indefinitely.

Under Treas. Reg. § 1.411(d)-2(d)(2) a complete discontinuance becomes effective for a single employer plan on the last day of the employer’s tax year after the tax year for which the employer last made a substantial contribution to the profit-sharing plan. For a plan maintained by more than one employer, a complete discontinuance becomes effective the last day of the plan year after the plan year within which any employer last made a substantial contribution.

If a plan suffers a complete discontinuance and the plan sponsor has made partially vested distributions, the plan’s qualified status is at risk. The plan sponsor can fix the error by using the Employee Plans Compliance Resolution System. The correction will require restoring previously forfeited accounts to affected participants, adjusted for lost earnings, and correcting IRS Form 5500 filings for the plan.

For additional information, please refer to the IRS guidance No Contributions to your Profit Sharing/401(k) Plan for a While? Complete Discontinuance of Contributions and What You Need to Know.

Conclusion

While employer contributions to a profit sharing or stock bonus plan are discretionary in most cases (check the document language), the IRS still expects them to be recurring and substantial to a certain extent. For example, if the plan sponsor has failed to make substantial contributions in three out of five years, there may be a discontinuance of contributions, which triggers plan termination and complete vesting of benefits.

© Copyright 2018 Retirement Learning Center, all rights reserved