Profit Sharing Plans
Profit sharing plans offer employers both design flexibility and discretion with regard to contributions. Employer contributions are self-determined and can be allocated in a number of ways. If an employer makes little or no profit during a year, no contribution is required, although low profits don’t restrict the contribution level and an employer is permitted to make contributions even if the company is not profitable.
There are three basic types of profit sharing plans: traditional, age-weighted and new comparability. The difference between the plans is the contribution allocation formulas used for each one. The following sections discuss the three types of plans.
Traditional profit sharing plan
A traditional profit sharing plan follows the salary ratio method, which is designed to allocate employer contributions to all participants on a uniform basis. For example, if one employee receives a 10%-of-pay contribution, all eligible employees would be allocated 10% of compensation as their share of the contribution. A profit sharing plan with a salary ratio formula is similar to a simplified employee pension (SEP) plan, but may be more attractive than an SEP plan in situations where an employer (a) does not wish to cover certain part-time employees, (b) wants to make employer contributions subject to a vesting schedule or (c) wants more control over the assets.
The age-weighted method allocates contributions based on both the age and compensation of eligible employees. It is similar to a defined benefit pension plan, but gives employers the option of making discretionary contributions. Since a participant’s age or length of time until retirement is factored into the allocation formula, older participants receive a proportionately larger share of the contribution. This can be advantageous in situations where a company’s key employees are significantly older than its other employees.
The new comparability, or cross-tested, allocation method allows an employer to divide its employees into different classifications for purposes of allocating contributions. If non-discrimination requirements are met, a larger share of a company’s contribution may be made on behalf of those employees to whom the employer wishes to provide more significant benefits.