Profit Sharing Plans

Profit Sharing Plans

  • How they work

Contribution allocation formula:

Bauman, Noonan and AssociatesProfit sharing plans are defined contributions plans where the employer decides whether or not to make a contribution in a given year. Contributions cannot exceed 25% of eligible payroll and are subject to the annual additions limit. Eligible payroll is the total compensation of all employees eligible to participate in the plan. The annual additions limit is the maximum contribution a participant can receive in a single year. For 2018, it is $55,000 increasing to $61,000 for those eligible for the 401k catch-up provision.

Contributions are allocated among plan participants according to the formula contained in the plan document. There are many contribution allocation formulas; some more favorable to company owners than others. The following are four of the most common:

Salary Proportionate Formula:

Under this formula, the compensation of all participants is added up and the relationship that each participant’s compensation bears to the total compensation is determined. Contributions are then allocated according to this ratio. The following example assumes a $30,000 employer contribution:

  • Participant
  • A
  • B
  • C
  • D
  • E
  •  
  • Status
  • Owner
  • Non-Owner
  • Non-Owner
  • Non-Owner
  • Non-Owner
  •  
  • Compensation
  • $200,000
  • $70,000
  • $50,000
  • $40,000
  • $30,000
  • Total
  • Contribution
  • $15,384.62
  • $5,384.62
  • $3,846.15
  • $3,076.92
  • $2,307.69
  • $30,000.00

Here the company owner receives a little more than half of all employer contributions.

Integrated Formulas:

There are several variations of this formula. The most popular of which involves a 5.7% employer contribution on all compensation earned and an additional employer contribution of 5.7% on income in excess of the taxable wage base up to the maximum amount of compensation that can be taken into consideration for plan purposes. The taxable wage base for 2017, $127,200, is income subject to the retirement income portion of social security tax. The maximum compensation can be taken into account for plan purposes for 2015 is $265,000.

Example:

  •  
    Participant
  • A
  • B
  • C
  • D
  • E
  •  
  •  
    Status
  • Owner
  • Non-Owner
  • Non-Owner
  • Non-Owner
  • Non-Owner
  •  
  •  
    Compensation
  • $200,000
  • $70,000
  • $50,000
  • $40,000
  • $30,000
  •  
  • Base
    Contribution
  • $11,400
  • $3,990
  • $2,850
  • $2,280
  • $1,710
  •  
  • Excess
    Contribution
  • $4645.50
  • 0
  • 0
  • 0
  • 0
  • Total
  • Total
    Contribution
  • $16,045.50
  • $3,990.00
  • $2,850.00
  • $2,280.00
  • $1,710.00
  • $26,875.50

The company owner did better under this formula, receiving about 60% of the employer contribution.

Age Weighted Plans:

Under this formula, contributions are allocated based on future benefits. Older, highly-paid participants, who are often company owners, receive larger contributions. They receive large contributions because there is less time to fund the future benefit and there is more of a benefit to fund.

Example:

  • Participant
  • A
  • B
  • C
  • D
  • E
  •  
  • Status
  • Owner
  • Non-Owner
  • Non-Owner
  • Non-Owner
  • Non-Owner
  •  
  • Compensation
  • $200,000
  • $70,000
  • $50,000
  • $40,000
  • $30,000
  •  
  • Age
  • 58
  • 47
  • 42
  • 39
  • 28
  • Total
  • Contribution
  • $53,000.00
  • $6,969.26
  • $3,310.63
  • $2,073.53
  • $900.00
  • $66,253.42

The company owner did better still under this formula receiving almost 80% of employer contributions.

Comparability of Benefit Formulas:

These are similar to age-weighted plans in that contributions are allocated based on future benefits. However, unlike age-weighted plans, participants don’t automatically receive a larger contribution as they grow older or as their compensation increases.

The most frequently used comparability of benefits formula is based on rate groups. Participants in a rate group share common characteristics, such as ownership interest, compensation or job category. Each rate group receives a different level of employer contributions. The formula is tested before contributions are made to insure that the allocation is not discriminatory. Discrimination here refers to contributions received by company owners and other highly compensated employees and those received by non-highly compensated employees.

Example:

  • Participant
  • A
  • B
  • C
  • D
  • E
  •  
  • Status
  • Owner
  • Non-Owner
  • Non-Owner
  • Non-Owner
  • Non-Owner
  •  
  • Rate Group
  • 1
  • 2
  • 2
  • 2
  • 2
  •  
  • Compensation
  • $200,000
  • $70,000
  • $50,000
  • $40,000
  • $30,000
  •  
  • Age
  • 58
  • 47
  • 42
  • 39
  • 28
  • Total
  • Contribution
  • $40,000
  • $3,500
  • $2,500
  • $2,000
  • $1,500
  • $49,500

The owner did best here, receiving almost 82% of all contributions.

Advantages and Disadvantages:

The main advantage of profit sharing plans is that, unlike pension plans, employer contributions are discretionary. The employer has the ability to maximize contributions in a good year and to make smaller or even no, contribution in a bad year. Another advantage is that the contribution allocation formulas can be easily modified to reflect changing employer requirements. This is not the case with other types of plans, particularly defined benefit plans.

The disadvantage of profit sharing plans is that all contributions come from the employer. For plans with more than a few participants, this can get expensive. Few employers have the resources to fully fund their employee’s retirement. A way around this is to add a 401k provision so that employees can save for their own retirement.