Profit sharing plans are a type of defined contribution plans where the employer makes an allocation to the employees and bears no future risk and liability. The allocations are typically a percentage of compensation. There plans were born to eliminate future uncertainty regarding mortality rates and investment returns.
There are different types of profit sharing plans and the one feature that separates them is the method in which the monies are allocated. Based on this, profit sharing plans can be classified into two types:
- Traditional Profit Sharing Plans
- New Comparability Profit Sharing Plans
Traditional Profit Sharing Plans: In traditional profit sharing plans, all participants receive an equal profit sharing allocation.
Advantage: Mandatory IRS testing may not be required.
Disadvantage: The plan allocation cannot be skewed in favor of the owners or key employees. This is a major disadvantage if you are looking to put aside more money for yourself as the owner of the business.
Who favors this design: A business where every employee contributes the same amount of expertise in the running of the business would favor this design. For example, a small consulting firm operating in a niche segment with three employees would favor such a design.
Allocation in a traditional profit sharing plan:
Allocation to Owner: $26,500
Allocation to Employees: $9,900
New Comparability Profit Sharing Plans: The new comparability design was born out of the need to allocate higher benefits to key employees and owners of the business.
Advantage: The business owners can contribute up to the maximum permitted amounts each year. This amount is limited by the IRS and is $54,000 for 2016.
Disadvantage: Mandatory IRS testing is required.
Who favors this design: Most firms would favor this design where employees can be segmented in to different classes with each subset contributing different levels of expertise in the operations of the business.
If the above example were to be redesigned as a new comparability profit sharing plan below is how the allocations would be made:
Allocation to Owner: $54,000
Allocation to Employees: $4,950
New comparability plans are dependent on the age and compensation of the employees. As such, employees with higher compensations would receive a larger amount as a contribution. Similarly, an older group of employees would end up skewing the contributions on the higher end. Below is how the allocation would look if two of the employees were older:
Allocation to Owner: $54,000
Allocation to Employees: $7,425
How is the allocation to employees determined?
The allocation to employees is determined by performing cross testing of the contributions/benefits allocated to the owner and key employees against those allocated to the rank and file employees.
This is better explained with an example. Let’s start with the earlier case where the owner wishes to contribute the maximum amount towards his retirement plan. The plan administrator will then allocate 5% of W-2 compensation to all employees and will check if the all the tests required by the IRS pass. The allocation percentage will be increased or decreased till one of the tests fail, and the allocation percentage just before the failure of the test is the minimum required allocation to the employees.
So what exactly are these tests?
Testing includes different types of tests, namely, minimum allocation gateway test, minimum coverage test, and a discrimination test. Trust us, the details are not fun or easy, so leave it to the plan administrator.
Further enhancements to the profit sharing plan
Once you get in to the game of retirement plans, it hardly ever remains simple. If you decide to establish a profit sharing plan, you might have your employees requesting to add the 401(k) option. A 401(k) option will allow employees to start deferring a small amount of their pay into the 401(k) plan. If you are above the age of 50, a 401(k) plan will allow you to defer higher amount, called as a catch up, so it might just make sense for you as well. The maximum 401(k) amount is $18,000 and the catch up is limited to $6,000 for 2016.
Additional Testing requirements
Once you have decided to add the 401(k) feature, additional testing requirements come in to play. This is because the IRS requires testing to be carried out for different money types and between different groups. For example, the deferrals by the owners have to be tested against the deferrals by the employees and similarly for the profit sharing allocations.
A frequent problem arises when the owners and the key employees defer to their 401(k)’s but the employees do not. This results in a failed test. In order to avoid this, the profit sharing plan will have to evolve in to a safe harbor plan. This is achieved by segmenting the total profit sharing allocation into a safe harbor allocation (3% of W-2) and the rest will be deemed as a profit sharing allocation. The safe harbor allocation is 100% vested immediately. This can be explained better with an example. Let’s take the case study above where the business owner wanted to contribute the maximum amount to his own retirement. Since this owner was above the age of 50, an additional $6,000 can be contributed as a catch up. Below is how the allocations would change:
Once the plan has been designed as a safe harbor plan, the owner and the key employees can defer in the 401(k) plan even if the employees do not defer any money.
This was all about profit sharing plans. If you feel you have even more cash flow and want to put more money aside for yourself, you might want to consider evolving this design into a floor offset design. A floor offset includes a defined benefit plan which can allow contributions as high as $200,000 while keeping the allocation to the employees in the 5-7.5% range. Read more about it here.