Revisiting the Standard Profit-sharing Plan

Volume 4 Issue 2007

Employers looking to sponsor a tax-advantaged retirement plan have several choices. The profit-sharing plan is one popular choice, especially when used in combination with a 401(k) salary deferral plan.

On the Plus Side

A profit-sharing plan is very flexible. The employer isn’t locked into making a certain size contribution to the plan each year. Instead, the employer decides how much to contribute (within tax law limits). If need be, the employer can skip making a contribution.

A Downside

Like other tax-qualified plans, a profit-sharing plan can’t discriminate in favor of highly compensated employees. To meet this requirement, a standard profit-sharing plan generally allocates the employer’s plan contribution among eligible employees based on a uniform percentage of compensation. Here’s an example of how it might work:

	Salary	10% Profit-sharing Allocation
Employee 1 (Owner)	$200,000	$20,000
Employee 2	50,000	5,000
Employee 3	35,000	3,500
Total	$285,000	$28,500

This approach is straightforward, but it does have a potential drawback. The contributions the business can afford to make might not be large enough to provide an adequate retirement benefit to owners and other key employees.

A Potential Solution

In that case, a “new comparability” plan design can be a solution. With this design, the profit-sharing plan is tested for nondiscrimination based on the projected future value of the benefits the plan will provide at normal retirement age. In many cases, highly paid employees can receive greater allocations of the profit-sharing contribution (as a percentage of their compensation) than employees who don’t earn as much.

Keeping expenses at manageable levels is always a challenge for small businesses and professional practices, even for firms that are very profitable. A profit-sharing plan — with a new comparability design — can be an option worth exploring.