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Profit Sharing Plans

Profit Sharing Plans enable a Business to make a Contribution of a certain percentage of Compensation to each Employee.
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. These plans were born to eliminate future uncertainty regarding mortality rates and investment returns.
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Defined Benefit Pension Plan

What are Profit Sharing Plans?

The profit sharing plan is a type of compensation program that provides employees with a percentage based on their compensation. This flexibility makes it attractive for both small and large companies.
A profit-sharing plan aligns the financial welfare of employees with the success of the company.

Advantages of a Profit Sharing Plan​

Employees will work together toward the common goal of business profitability.

Boosts commitment to the organization for the long-term.

A profit-sharing plan can attract new talent to join the company.

Can help motivate the team to be productive as an encouragement to achieve the reward.

The employer is not required to contribute in those years when it is not profitable.

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Types of a Profit sharing Plan

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

In traditional profit sharing plans, all participants receive an equal profit-sharing allocation. Advantage Mandatory IRS testing may not be required. Disdvantage The plan allocation cannot be skewed in favour 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 favour this design. For example, a small consulting firm operating in a niche segment with three employees would favour such a design. Allocation in a traditional profit-sharing plan;
employee profit sharing plan of pension deductions 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 $61,000 for 2022(these limits are adjusted annually, so please check the IRS website). Disdvantage Mandatory IRS testing is required. Who favors this design Most firms would favor this design where employees can be segmented into 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;
Profit Sharing Plan of pension deductions 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;
A profit-sharing plan is a type of defined contribution retirement plan 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.
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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 into 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 401k option. A 401k option will allow employees to start deferring a small amount of their pay into the 401k plan. If you are above the age of 50, a 401k plan will allow you to defer a higher amount, called a catch-up, so it might just make sense for you as well.
The maximum 401k amount is $23,000 and the catch-up contribution limit who participate in 401(k), 403(b), most 457 plans, will remain at $7,500 in 2024.

Additional Testing requirements

Once you have decided to add the 401k feature, additional testing requirements come into 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 401k’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 into 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 $7,500 can be contributed as a catch-up. Below is how the allocations would change;
profit sharing plan provider company
Once the plan has been designed as a Safe Harbor Plan, the owner and the key employees can defer into the 401k 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 $345,000 for 2024 while keeping the allocation to the employees in the 5 – 7.5% range.

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