SAVINGS PLANS | Profit-Sharing and Similar Plans

Almost any qualified plan can have a provision for employee contributions to supplement the plan fund or benefit. A plan that is designed particularly to exploit the possibility of employee contributions is often referred to as a savings plan or thrift plan. The term savings plan will be used here to describe a plan featuring employee after-tax contributions.

Design of Savings Plans

A savings plan is a defined-contribution plan so that employees can have separate accounts. Usually, qualified savings plans are designed as profit-sharing plans (rather than money-purchase pension plans) because only a profit-sharing plan permits account withdrawals during employment, and this is an important feature of the plan if the plan is to be described to employees as a savings medium. Thus, a savings plan can generally be described as a contributory profit-sharing plan.

The typical savings plan features employee contributions matched by the employer. Plan participation is voluntary; employees elect to contribute a chosen percentage of their compensation up to a maximum percentage specified in the plan. The employer then makes a matching contribution to the plan. The matching may be dollar for dollar, or the employer may put in some multiple or submultiple of the employee contribution rate. For example, typically a plan might permit an employee to contribute annually any whole percentage of compensation from 1 to 6 percent. The plan might then provide that the employer contributes at the rate of half the chosen employee percentage; thus, if the employee elects to contribute 4 percent of compensation, the employer would contribute an additional 2 percent.

If the plan's maximum contribution level is too high, there is a possibility of discrimination because only higher-paid employees could be in a position to contribute to the plan, and only they would receive full employer matching contributions. To prevent this type of discrimination, there is a specific numerical test applicable to after-tax employee contributions. Under this test [Code Section 401(m)], a plan is not deemed discriminatory for a plan year if, for highly compensated employees, the total of employee contributions (both matched and voluntary) plus employer matching contributions does not exceed certain numerical limits similar to those applicable to Section 401(k) plans. Administration of the Section 401(m) limits can be complex and costly.

Apart from the features relating to employee contributions, savings plans generally follow the rules for profit-sharing plans described earlier. In designing a savings plan, emphasis is usually put on features relating to the objective of providing a savings medium for employees. Thus, a savings plan usually has generous provisions for vesting, employee withdrawal of funds, plan loans, and investment flexibility.

Advantages and Disadvantages of Savings Plans

Savings plans have been very popular in the past and continue to be so, despite the advent of other types of plans, such as Section 401(k) plans, that provide greater tax leverage. Some older savings plans have been converted to add a 401(k) feature while retaining the provision for additional after-tax contributions by employees. Like all qualified plans, a savings plan provides a tax-deferred savings medium because earnings in the plan fund are not taxable until the employee's account is distributed.

A savings plan usually does not maximize the potential tax deduction available for plan contributions, because it involves after-tax contributions by the employee—contributions that are not deducted or excluded for federal income or Social Security tax purposes. A greater degree of tax deductibility can be provided with other types of plans, such as regular profit-sharing plans or Section 401(k) plans. However, some of these plans may require a greater employer outlay for the plan itself (although not necessarily for the overall compensation package). These other plans may also entail greater restrictions on the funds, which may make them a less attractive savings medium from the employee's standpoint.

Deduction of Employer Contributions

Under Code Section 404(a)(3), the maximum amount that an employer can deduct for contributions to a profit-sharing plan is 15 percent of the compensation paid or accrued during the taxable year to all employees who participate in the profit-sharing plan. This is an employer deduction limit based on compensation of all covered employees; it is not a rule stating that allocations to individual participants' accounts are limited to 15 percent of their compensation. The limitation on annual additions to individual accounts, the Section 415 limit, is discussed below.

An employer can contribute to a profit-sharing or a stock bonus plan in excess of the 15 percent limit, but the excess is not deductible and is subject to a 10 percent penalty under Section 4972. The excess amount can be carried over to a future year and deducted then, but deductions in the future year for current contributions plus carryovers are still subject to the 15 percent of payroll limit.

Combined Profit-Sharing and other Plans

If an employer has both a defined-benefit plan and a profit-sharing or other defined-contribution plan covering a common group of employees, the total contribution for both plans cannot exceed 25 percent of compensation of the common group of employees. However, if a greater contribution is necessary to satisfy the minimum funding standard for the defined-benefit plan, the employer will always be able to make and deduct this contribution.

Section 415 Limits

The Section 415 limits that apply to profit-sharing plans are those applicable to all defined-contribution plans. The annual addition to any participant's account cannot exceed the lesser of 25 percent of the participant's compensation or $30,000 (as indexed for inflation). For a profit-sharing plan, the annual addition includes the participant's share of any forfeitures as well as employer and employee contributions. This means that when forfeitures are allocated to a participant's account, the amount of employer contributions that can be allocated may be reduced. The Section 415 limits usually affect only highly compensated employees covered under the plan.

Investment Earnings and Account Balances

As a defined-contribution plan, a profit-sharing plan must provide separate accounts for each participant. However, unless the plan contains a provision permitting participants to direct investments (discussed below), the plan trustee or other funding agents will generally pool all participants' accounts for investment purposes. The plan must then provide a mechanism for allocating investment gains or losses to each participant. Most methods for doing this effectively allocate such gains and losses in proportion to the participant's account balance.

IRS revenue rulings require accounts of all participants to be valued in a uniform and consistent manner at least once each year, unless all plan assets are immediately invested in individual annuity or retirement contracts meeting certain requirements. The plan usually will specify a valuation date or dates on which valuation occurs. Investment earnings, gains, and losses are allocated to participants' accounts as of this date.

Participant-Directed Investments

Under ERISA Section 404c, any "individual account" plan (such as a profit-sharing, stock bonus, or money-purchase pension plan) can include a provision allowing the participant to direct the trustee or other funding agent as to the investment of the participant's account.

If the plan administrator provides a broad range of investment choices—so that the participant's choice has real meaning—then the trustee and other plan fiduciaries are not subject to fiduciary responsibility for the investment decision.^[1] A plan can technically allow unlimited choice of investments, but this increases the plan's administrative burdens. Often, a family of mutual funds is offered as an investment option to increase the administrative feasibility of participant direction. At least three investment alternatives must be included.

Investment direction gives the participant a considerable degree of control over the funds in his or her account. It is frequently used in profit-sharing plans, particularly those for closely held businesses where the controlling employees have by far the largest accounts. On the other hand, to the extent that participant direction of investments removes the security provided by the fiduciary rules, such a provision is at odds with a plan objective of providing retirement security, and it would not be appropriate if this were a major objective of the plan for a particular employee group.

To prevent certain abuses associated with participant-directed investments, the Code provides that an investment by a participant-directed qualified plan account in a collectible will be treated as if the amount invested were distributed to the participant as taxable income to the participant. A collectible is defined in Code Section 408(m) as a work of art, rug or antique, metal or gem, stamp or coin (excluding certain federal and state-issued coins), alcoholic beverage, or any other tangible personal property designated as a collectible by the IRS.

Withdrawals during Employment and Loan Provisions

The incentive (rather than retirement security) focus of profit-sharing plans tends to dictate that participants be given the opportunity to control or benefit from their accounts even before retirement or termination of employment. There are various ways to do this. One such provision is a participant-directed account, as discussed above. Another is a special feature permitted in profit-sharing plans but not in pension plans—a provision for account withdrawals from the plan during employment.

The regulations require that employer contributions under a profit-sharing plan must be accumulated for at least two years before they can be withdrawn by participants.^[2] However, in some revenue rulings, the IRS has permitted a plan provision allowing employees with at least 60 months of participation to withdraw employer contributions, including those made within the previous two years. Also, revenue rulings have permitted a plan provision for withdrawal in the case of "hardship," including contributions made within the previous two years. Hardship must be sufficiently defined in the plan and the definitions must be consistently applied. All these limitations apply only to amounts attributable to employer contributions to the plan. If the plan permits employee contributions, the employee contributions can be withdrawn at any time without restriction.

In considering the design of withdrawal provisions, it is important to keep in mind that the taxation and early-withdrawal penalty rules act as disincentives for participants to withdraw plan funds. These rules indirectly reduce the advantages of using a qualified plan as a medium for preretirement savings.

Many plan designers prefer to have a prohibition or at least restrictions on withdrawals from the employer-contributed portion of the account. This is because favorable investment results sometimes depend on having a pool of investment money that is relatively large and not subject to the additional liquidity requirements imposed by the possibility of participant withdrawals. Some typical restrictions found in profit-sharing plans include a requirement that the participant demonstrate a need for the money coming within a list of authorized needs either set out in the plan or promulgated by the plan administrator and applied consistently. Such needs might include educational expenses for children, home purchase or remodeling, sickness or disability, and so forth. Another method of restricting plan withdrawals is to provide a penalty on a participant who withdraws amounts from the plan (in addition to the 10 percent federal penalty tax, which also applies). A plan penalty might include suspension of participation for a period of time, such as six months after the withdrawal. The plan penalty cannot, however, deprive a participant of any previously vested benefit.

Loan provisions are appropriate for profit-sharing plans. Again, however, a generous loan provision in a plan may have the effect of reducing the amount of funds available for other plan investments.

Incidental Benefits

The regulations permit profit-sharing plans to provide as an incidental benefit life, accident, or health insurance for the participant and the participant's family. Incidental life insurance is the only one that is commonly provided. If employer contributions are used to provide insurance, the incidental benefit limitations must be met.

If the plan provides incidental whole life insurance, the usual test is that aggregate premiums for each participant must be less than 50 percent of the aggregate of employer contributions allocated to the participant's account. If the plan purchases term insurance or accident and health insurance, the aggregate premiums must be less than 25 percent of the employer contributions allocated to the participant's account. The current IRS position is that universal life premiums also must meet the 25 percent limit. Note that these tests apply to the aggregate—that is, the total contributions made for all years at any given time. If either of these limits is exceeded, the plan could be disqualified. However, insurance premiums paid with employer-contributed funds that have accumulated for at least two years are not subject to these limitations.

If the employee dies before normal retirement age, the plan can provide that the face amount of the policies plus the balance credited to the participant's account in the profit-sharing plan can be distributed to the survivors without the life insurance violating the incidental benefit requirement. This can be done even though the amount of life insurance might be more than 100 times the account balance expressed as an expected monthly pension.

If life insurance is provided by the plan, the term insurance cost is currently taxable to the employee or the insurer's term insurance rates. Accident and health insurance provided by an employer under the plan might not be taxable because of the exclusion provided for employer-provided health insurance. However, there usually is no particular benefit in providing accident and health insurance under a profit-sharing plan. It is usually provided in a separate plan not connected with the profit-sharing plan.

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.

CURRENT QUALIFIED PLAN TRENDS | Profit-Sharing and Similar Plans

Although only the traditional types of pension plans involve an employer commitment to adequate retirement income for employees, trends in management, the economy, and the workforce have produced a gradual erosion in qualified pension plan coverage and a movement toward "nonretirement" plans—that is, defined-contribution plans that provide a form of savings and incentive benefits for employees without a specific funding commitment by the employer. The reasons for this trend include the following:

Figure 1: Pension Coverage

• Competition and cost pressures to minimize wage and benefit costs

• Increasing acquisition, dissolution, and reorganization of business enterprises discourage employer long-term commitment to employees

• Decline in collective bargaining; labor unions have traditionally favored the defined-benefit plan

• Increased mobility in the workforce; the 40-year career with one employer has become a rarity

• Employers are using more part-time employees, leased employees, and independent contractors who would generally receive little benefit from a traditional pension plan

• Increase in families with two wage earners; traditional pension plans tend to duplicate benefits in such cases

We will discuss the following:

• Qualified profit-sharing plans

• Savings or thrift plans

• Employer stock plans (stock bonus plans and ESOPs)

Increasingly, the trend in qualified planning is toward salary savings plans such as 401(k) plans, which are primarily funded through employee salary reductions that are contributed to the plan. These plans are typically combined with the traditional employer-funded profit-sharing plans, or with those in which employer contributions match the employee salary reductions. First, to fully understand how salary savings plans work, the basic profit-sharing plan and its variants