QUALIFIED PROFIT-SHARING PLANS

The basic profit-sharing plan is a defined-contribution plan in which employer contributions are typically based in some manner on the employer's profits, although there is no actual requirement for the employer to have profits in order to contribute to the plan. Even a nonprofit organization may have a "profit-sharing" plan. The general characteristics are as follows:

• The employer contribution may be specified as a percentage of annual profits each year or, for even more flexibility, the plan may provide that the employer determines the amount to be contributed on an annual basis, with the option of contributing nothing even in years in which there are profits or, conversely, making contributions in unprofitable years.

• The plan must have a nondiscriminatory formula for allocating the employer contribution to the accounts of employees.

• Because the plan is a defined-contribution plan, the benefit from it consists of the amount in each employee's account, usually distributed as a lump sum at retirement or termination of employment.

• The plan may permit employee withdrawals or loans during employment.

• Eligibility and vesting are usually liberal because of the incentive nature of the plan.

• Forfeitures from employees who terminate employment are usually reallocated to the accounts of remaining participants, thus making the plan particularly attractive to long-service employees.

• The main price for the advantages of the design is that the employer's annual deduction for contributions to the plan is limited to 15 percent of the payroll of employees covered under the plan.

Eligibility and Vesting

Profit-sharing plans are typically designed with relatively liberal eligibility and vesting provisions, compared with pension plans. This is because the employer generally wishes the incentive objective of the plans to operate for short-term as well as long-term employees, and also because the simplicity of administering a profit-sharing plan makes it less necessary to exclude short-term employees to reduce plan administrative costs. Thus, many profit-sharing plans permit employees to enter the plan immediately upon becoming employed, or after a short waiting period—for example, until the next date on which the plan assets are valued. A great variety of vesting provisions are used, and they are typically tailored to the employer's specific needs.

As a qualified plan, a profit-sharing plan is subject to the restrictions on eligibility and vesting provisions. In summary, a minimum age requirement greater than 21 is not permitted, nor can a waiting period for entry be longer than one year, or up to 1½ years if entry is based on plan entry dates. Under the age discrimination law, no maximum age for entry can be prescribed (and contributions must continue for as long as the employee continues to work).

A profit-sharing plan is more likely to discriminate in favor of highly compensated employees as a result of high employee turnover and the use of forfeitures, as discussed below. Therefore, the IRS may require the more stringent three- to seven-year vesting schedule in new profit-sharing plans. Most profit-sharing plans use a vesting schedule that is at least as generous as this schedule. Even more stringent vesting is required if the plan is top-heavy.

Employer Contribution Provision

There is great flexibility in designing an employer contribution provision for a profit-sharing plan. The contribution provision can be either discretionary or of the formula type.

With the discretionary provision, the company's board of directors determines each year what amount will be contributed. It is not necessary for the company actually to have current or accumulated profits. Many employers will wish to contribute the maximum deductible amount each year, but a lesser amount can be contributed.

Although employers are permitted to omit contributions under a discretionary provision, the IRS requires that contributions be "substantial and recurring." If too many years go by without contributions, the IRS is likely to find that the plan has been terminated, with the consequences (basically 100 percent vesting for all plan participants and distribution under a specified payment schedule). No specific guidelines are given by the IRS as to how many years of omitted contributions are permitted, so the decision to skip a profit-sharing contribution must always be made with some caution.

With a formula contribution provision, a specified amount must be contributed to the plan whenever there are profits. Typically, the amount is expressed as a percentage of profits determined under generally accepted accounting principles. There are no specific IRS restrictions on the type of formula, so flexibility is possible. For example, the plan might provide for a contribution of 7 percent of all current profits in excess of $50,000, possibly with a limitation on the amount deductible for the year. There is also considerable freedom in defining the term profit in the plan. For example, profit before taxes or after taxes can be used, with before-tax profits being the most common. Profit as defined in the plan can also include capital gains and losses or accumulated profits from prior years. Even an employer that is organized under state law as a "nonprofit" corporation can have a profit-sharing plan funded from a suitably defined surplus account.

The advantage of the formula approach is that it is more attractive to employees than the discretionary approach and more definitely serves the incentive purpose of the plan. However, if a formula approach is adopted, the employer must remember that the formula amount must always be contributed to the plan; the formula constitutes a continuing legal and financial obligation for the business as long as the plan remains in effect. It is possible to draft formulas that take into account possible adverse financial contingencies. Without such provisions, the formula may have to be amended in the future in the event of financial difficulty.

Allocations to Employee Accounts

The plan's contribution provision determines the total amount contributed to the plan for all employees. The plan must also have a formula under which appropriate portions of this total contribution are allocated to the individual accounts of employees. Here there is less flexibility because the allocation provision must meet nondiscrimination requirements. The law provides that contributions must be allocated under a definite formula that does not discriminate in favor of highly compensated employees. Any formula that meets these requirements can be acceptable, but most formulas allocate to participants on the basis of their compensation, compared with the compensation of all participants. That is, after the total employer contribution is determined, the amount allocatable to a given participant is

If compensation is used in the allocation formula, the plan must define compensation in a way that does not discriminate. Compensation might include only base pay or might be total compensation including bonuses or overtime. Only the first $150,000 (as indexed for inflation) of each employee's compensation can be taken into account in the plan formula.

Service is another factor often used in the formula for allocating employer contributions. However, since highly compensated employees are likely to have long service, the IRS will probably require a showing that any service-based formula will not produce discrimination.

Age-Based Allocation Formula and Cross-Testing

Under IRS regulations, it is possible for a profit-sharing plan's allocation formula to take the participant's age at plan entry into account. That is, the plan can provide a greater allocation percentage of compensation to a participant who entered the plan at, say, age 55 than to a participant who entered at age 25. The purpose of this allocation method is to provide the late entrant with a more adequate benefit at retirement, given the fact that the late entrant has fewer years to accumulate plan contributions. Compared with a target plan, the age-based profit-sharing plan has the additional advantage that the employer is not "locked-in" to an annual contribution obligation, which may make this approach attractive to smaller or less stable businesses.

Age-based profit-sharing allocation formulas and target plans are examples of a method of discrimination testing known as cross-testing. A cross-tested defined-contribution plan is tested for discrimination in favor of the highly compensated as if it were a defined-benefit plan. That is, projected benefits at retirement age are determined for all participants in the defined-contribution plan (by assuming that the current level of contributions to each participant's account continues each year until that participant's retirement age). These projected benefits, as a percentage of each participant's compensation, are then tested for discrimination. If lower-paid employees are generally younger than highly compensated employees, cross-testing may allow relatively low contribution levels (percentages of compensation) for the lower-paid employees because the contributions for the younger employees are projected over a longer period of time than those for the older employees. Cross-tested plans are often used by smaller businesses to provide substantial contributions for highly compensated employees, with relatively low costs for coverage of other employees.

Forfeitures

A forfeiture is an unvested amount remaining in a participant's account when the participant terminates employment without being fully vested under the plan's vesting schedule. Thus, forfeitures can occur in any defined-contribution plan that does not have 100 percent immediate vesting. Forfeitures can be reallocated to accounts of other participants or used to reduce future employer contributions. In a profit-sharing plan, forfeitures are usually reallocated to participants to provide an additional incentive for continuing service.

Forfeitures must be allocated in a nondiscriminatory manner. In most plans, forfeiture allocations are made in the same manner as allocations of employer contributions—on the basis of compensation or a combination of compensation and service. The IRS usually will not accept a forfeiture allocation provision based on account balances of remaining participants because such a provision may provide substantial discrimination.

Analysis of profit-sharing plans of smaller employers that have existed for a number of years generally shows that by far the largest account balances are those for highly compensated participants. This is because the combination of higher compensation, longer service (and therefore more years in the plan), and low turnover among the highly compensated group eventually produces a great disparity in account balances. This phenomenon is, in fact, one of the reasons why closely held businesses adopt profit-sharing plans. As such, they are not deemed to be discriminatory. However, if a plan contains any features designed to multiply this inherent discrimination (such as forfeiture allocation based on account balance), the IRS generally will not approve it.