How to Set Up a Profit-Sharing Plan that Works for Your Organization

A profit sharing plan is a type of defined contribution plan that is sometimes used as a supplement to a primary retirement program. Today, John Rubino of Rubino Consulting Services explains the key elements of an effective profit-sharing plan.

Your Compensation Program Objectives

Any good compensation program, Rubino says, should be:

• Internally equitable
• Externally competitive
• Affordable
• Understandable
• Legal /defensible
• Efficient to administer
• Capable of being reshaped for the future
• Appropriate for the organization
• Designed to attract, retain, and motivate employees
• Creating an alignment between employee efforts and business objectives

How do profit-sharing plans fit into the picture? They are structured so that employees share in their companies’ profits and potentially gain a greater interest in their organizations’ success.

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Two Types of Profit-Sharing Plans

1. Cash plan: At the time profits are determined (annual corporate financial benchmarks are attained or exceeded), contributions are paid directly to employees as a percentage of base salary or as a flat monetary amount. The payout is taxed as ordinary income when distributed.

   Cash plans are straightforward short-term variable compensation programs, paid in lump sum to employees typically on an annual basis. Organizationwide financial profitability targets are established. If these are reached or exceeded, a pot of money is immediately freed up and distributed to employees. However, it can be argued that these aren’t true “incentive” programs in that they don’t do a lot to truly motivate a change in employee behavior.

2. Deferred plan: Profit-sharing contributions are not paid immediately but rather deferred to individual accounts set up for each employee. Payouts and any investment earnings accrued are typically distributed at retirement.

   Deferred plans, like other retirement programs, must meet a variety of requirements to qualify for preferential tax treatment under ERISA requirements. There are rules that govern certain requirements for reporting and disclosure of plan information, fiduciary responsibilities, employee eligibility for participation, vesting of benefits, and funding. Qualified plans must satisfy IRS nondiscrimination rules.

Establishing a Deferred Plan: 3 Steps to Success

1. Adopt a written plan document: Plans begin with a written document that serves as the foundation for day-to-day operations. A deferred profit-sharing plan allows the company to decide from year to year whether to contribute on behalf of employees. You’ll need a set formula on how the contributions are made, a vesting schedule, and annual testing for nondiscrimination purposes.
2. Develop a recordkeeping system: An accurate recordkeeping system will track and properly attribute contributions, earnings and loses, plan investments, expenses, and benefit distributions. This will help when filing required forms for the federal government.
3. Provide plan information to employees: You must notify employees who are eligible to participate in the plan about certain benefits, rights, and features. Also, a summary plan description (SPD) must be provided to all participants.

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Operating a Deferred Plan: The Key Elements

Elements of operating deferred profit-sharing plans include:

1. Participation: Typically, a plan includes a mix of average employees and managers/executives. However, a plan may exclude some employees from a profit-sharing plan if they have not attained age 21, have not completed 1 or 2 years of service, or are covered by a collective bargaining agreement that does not provide for participation in the plan.
2. Contributions: Each company decides on the business’s contribution to participants’ accounts in the plan. Contribution amounts can vary each year based on business conditions.

   You need a set formula for determining how the contributions are allocated to participants’ accounts. The simplest and most common allocation formula specifies that the company contribution is calculated so that each participant receives an amount that is the same percentage of his or her base salary.

   Company contributions and forfeitures (nonvested company contributions of terminated participants) are subject to a per-employee overall annual limitation. This limit is the lesser of 100 percent of the employee’s compensation or $53,000 for 2015.

   Companies can deduct amounts not exceeding 25 percent of aggregated compensation for all participants and the per-employee limits noted above.

3. Vesting: The plan can be designed so that the company contributions become vested (nonforfeitable) over time, according to a specified vesting schedule.
4. Nondiscrimination: To preserve the tax benefits of the plan, it must provide substantial benefits to the average employees—not just owners, managers, and executives. Annual nondiscrimination testing needs to be performed. However, if the company allocates a uniform percentage of compensation to each participant, then no testing is required because the plan automatically satisfies the nondiscrimination requirement.

Tomorrow, we’ll look at Rubino’s remaining 5 steps to operating a deferred plan, plus an introduction to the new interactive webinar, Assembling a Pay Grade System: The Step-by-Step Process for Getting It Right.