How To Test A Safe Harbor Plan

Transcription

1 Profit Sharing Allocation Methods - The Better Part of Discretion A White Paper by Manning & Napier Unless otherwise noted, all figures are based in USD. 1

2 Most Profit Sharing/401(k) Plan sponsors have the basic understanding that the plan contributions must not discriminate in favor of the owners and other highly paid participants over non-owners and non-highly paid participants. Many business owners interpret this to mean I can t contribute more for myself than I do for my employees. In a general sense, this is true. But in a more specific sense, there is flexibility in the way a profit sharing contribution can be allocated to different groups or classifications of employees. Certain methods will better enable the business owner to control the cost of allocations to non-owners, while preserving desired allocations for owners and other executives. A Profit Sharing Plan is a Defined Contribution (DC) Plan that allows the plan sponsor (i.e., the employer) to choose each year whether or not to make a contribution. The choice is presumably driven by the year s profitability, and in fact years ago employers could only make contributions out of net profits. But profit sharing contributions no longer need to be made out of net profits and there are many reasons why an employer may choose to make, or not make, a profit sharing contribution. While the employer has discretion over making a profit sharing contribution, the method of allocating each plan participant s share of any contribution made must be specified in the Plan Document. There are numerous allocation methods than can be used, but the four basic methods are: 1. Salary Ratio 2. Integration (or Permitted Disparity) 3. Age-Weighted 4. New Comparability Once specified in the plan document, the allocation method can only be changed by a plan amendment or restatement. Also specified in the plan document are the requirements to share in allocations of the profit sharing contribution for the given year. Once participants accrue the right to share in allocations of the profit sharing contribution, they also accrue the right to the allocation method stated. This means that if the allocation method is changed via plan amendment after only a single participant has already accrued the right to the original allocation method, the change cannot take place until the next plan year, unless the change results in equal or greater allocations to all. Comparable Doesn t Mean Equal IRC 401(a)(4) states that A trust created or organized in the United States and forming part of a stock bonus, pension, or profit sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries shall constitute a qualified trust under this section [ ] if the contributions or benefits provided under the plan do not discriminate in favor of highly compensated employees 1 [ ]. In the case of a Defined Contribution (DC) Plan this means that either: 1. Allocation rates for Highly Compensated Employees (HCEs) must be equivalent to allocation rates for Non-Highly Compensated Employees (NHCEs), or 2. Benefits for HCEs derived from the projection of allocation rates to a stated age must be equivalent to such benefits derived for NHCEs at that same age. Later on we ll learn that comparable projected future benefits may not translate to equal present-day allocation rates. Non-Discrimination Requirements Federal Tax Regulation 1.401(a)(4) prescribes that nondiscrimination be demonstrated with either a safe harbor approach, or a rate group testing approach known as the General Test. The easiest way a profit sharing contribution can demonstrate non-discrimination is to use a safe harbor approach. A safe harbor approach can be either designbased or non-design based. A design-based safe harbor plan is designed to demonstrate non-discrimination with a uniform method of allocating contributions. Examples of uniform allocation methods are 2 : Uniform Percentage of Pay (also known as Salary Ratio) Uniform Dollar Amount Integration A non-design based safe harbor plan is eligible for an abbreviated testing approach, due to being designed in a way that is less likely to be discriminatory than a more aggressive allocation method. The only non-design based safe harbor profit sharing allocation method allowed is the Uniform Points method. 2

3 When a safe harbor approach cannot be used to demonstrate non-discrimination, then the plan must undergo the General Test. The General Test can be applied on either a contributions or benefi ts basis. Cross- Testing occurs in a DC Plan when an allocation method is tested for non-discrimination on the basis of benefi ts in the future derived from allocations in the present. Examples of profi t sharing allocation methods that must demonstrate non-discrimination by satisfying the General Test are the Age-Weighted and New Comparability methods. For purposes of this white paper, we will not consider the Uniform Dollar and Uniform Points methods because they are not commonly used in the small to mid-sized plan market. To understand how the four basic allocation methods impact an employer, a case study is appropriate. Let s use the following census of a small business. Table 1: Sample Census Title Age Date of Hire W2 Pay Owner 55 01/01/1990 $260,000 Salesman 46 01/01/2000 $125,000 Assistant 36 01/01/1995 $50,000 Clerical 61 01/01/2009 $25,000 The Salary Ratio Method The owner is approaching retirement, and has not been able to save appreciably because every penny he s earned has gone to fund his children s education and weddings, or has been invested back into his business. He would like to start a Profi t Sharing Plan and he wishes to maximize his annual allocations. In 2014, that maximum individual addition limit in a Profit Sharing Plan is $52,000. Under the Salary Ratio method, the fi rst year allocations to the plan are shown in Table 2 below. Table 2: Salary Ratio Profit Sharing Title W2 Pay PS % PS $ Owner $260,000 20% $52,000 Salesman $125,000 20% $25,000 Assistant $50,000 20% $10,000 Clerical $25,000 20% $5,000 Owner Total $52,000 Non-Owner Total $40,000 Grand Total $92,000 Percent to Owner 57% Analysis by Manning & Napier Upon review of the Salary Ratio method, the owner s allocation is maximized, but the same allocation percentage is applied to all the participants. Indeed, only 57% of the total contribution attributes to the owner. Many owners will not want to spend so much on the employees and will wonder if the employee cost can be reduced while maintaining the owner s $52,000 allocation. 3

4 The Integration Method To approach the owner s goal, one might consider using an Integration approach. Also known as Permitted Disparity, the Integration method is a way of recognizing compensation earned in excess of a percentage of the Taxable Wage Base (TWB). In 2014, the Taxable Wage Base is $117,000. Integration is considered a uniform allocation (i.e., design-based safe harbor) method because it takes into consideration that the Social Security system favors employees that earn amounts under the Taxable Wage Base. Applying the Integration method to our sample census yields the results illustrated in the Table 3 below. Table 3: Integrated Profit Sharing Title W2 Pay PS % PS $ Owner $260, % $52,000 Salesman $125, % $22,375 Assistant $50, % $8,272 Clerical $25, % $4,136 Owner Total $52,000 Non-Owners Total $34,783 Grand Total $86,783 Percent to Owner 60% Analysis by Manning & Napier Here you can see that the cost for non-owners is reduced to $34,783 (from $40,000 using Salary Ratio), while the owner s allocation remains at $52,000. Still, many business owners will note that the employee cost remains high under this method, and that the percentage of the overall contribution attributing to the owner is not ideal. For more details regarding the specifi c calculations involved with the Integration method, consult the Appendix at the end of this paper. Cross-Testing In order to reduce non-owner cost even further, while maintaining the maximum allocation for the owner, one must employ non-safe harbor methods that demonstrate non-discrimination by passing the General Test mentioned previously. The two most common nonsafe harbor allocation methods are the Age-Weighted and New Comparability methods. Among the two, New Comparability has become the most ubiquitous. Because allocations under these methods are not uniform, both methods must be cross-tested. In order to pass the General Test using cross-testing, projected future benefi ts derived from present-day allocations to NHCE participants must be comparable to projected future benefi ts derived from present-day allocations to HCE participants. On a benefi ts basis, the General Test works like this assume two participants - the owner, age 55 and his assistant, age 30. If the testing age is 65, the owner has ten years to go while the assistant has 35 years. If, using the same interest rate and mortality assumptions, both owner and assistant are to receive comparable benefi ts at age 65, the lump sum accumulations required to pay those benefi ts must also be comparable. In order to accumulate comparable lump sums at age 65, using the same interest and mortality assumptions, the annual allocations for the owner need to be much larger than those of the assistant because the owner only has ten years of accumulation (versus 35 years for the assistant). This is essentially how older participants under cross-tested plans will typically be allowed larger allocations than younger participants. 4

5 The Age-Weighted Method Under the Age-Weighted method, the employer s profi t sharing contribution is allocated in a manner that considers both the participant s age and compensation. Using one of the mandated mortality tables and interest rates 4, points are allocated to each participant based on age. The ratio of a participant s points to the total points of all participants determines the participant s percent of the overall profi t sharing contribution. Table 4 shows us how the Age-Weighted method works for our sample census. Table 4: Age-Weighted Profit Sharing Title W2 Pay PS % PS $ Owner $260, % $52,000 Salesman $125, % $12,000 Assistant $50, % $2,100 Clerical $25, % $7,350 Owner Total $52,000 Non-Owners Total $21,450 Grand Total $73,450 Percent to Owner 71% Analysis by Manning & Napier The reader can see that the Age-Weighted allocation method succeeds in reducing the cost for non-owners from $34,900 to $21,450. Also, the owner s allocation remains at the $52,000 level, reaching 71% of the entire contribution. However, there is one result that most employers will want to avoid. The participant labeled Clerical is a relatively new hire and has less seniority than the other participants. But because Clerical is older than the others, the allocation method gives her a dollar amount allocation that is much larger than that of the Assistant. Additionally, Clerical is receiving a higher percentage of pay allocation than anyone in the census. The owner may foresee diffi culty in explaining this to the participants should they discover the issue. For more details regarding the specific calculations involved with the Age-Weighted method, consult the Appendix at the end of this paper. The New Comparability Method This brings us to the last rung on the evolutionary ladder of allocation methods New Comparability. The New Comparability allocation method allows the employer to split its census up into groups, and to assign different allocation percentages to each group. It is less likely to pass the General Test on an allocations basis and more likely to pass on a Cross-Tested basis. Classifi cations may be defi ned in a number of ways, the most common of which is by job title. Classifi cations may also be based on the employer s different geographic locations, subsidiaries, employee types (i.e., union vs. non-union or hourly vs. salaried), and other similar bona fi de business criteria. Examples of classifications by job title are shown in Table 5. Table 5: Sample Group Titles 1. Owners 2. Non-Owners 1. Sr. Partners 2. Jr. Partners 3. All Other Employees 1. Executives 2. Managers 3. All Other Employees Similarly, classes can be defi ned for each single participant. Applying a two-group New Comparability approach to our sample census, such that the Owner is in Group 1 and Non-Owners (i.e., all other employees) are in Group 2 produces the results shown in Table 6. Table 6: New Comparability Profit Sharing Title W2 Pay PS % PS $ Owner $260,000 20% $52,000 Salesman $125,000 5% $6,250 Assistant $50,000 5% $2,500 Clerical $25,000 5% $1,250 Owner Total $52,000 Non-Owners Total $10,000 Grand Total $62,000 Percent to Owner 84% Here, we can see that the non-owner cost is reduced to only $10,000. This represents a 53% reduction over the Age-Weighted design, a 71% reduction over the Integrated design, and a 75% reduction over the Salary Ratio design. 5

6 Lastly, 84% of the plan contribution attributes to the owner. Of all the methods explored, the New Comparability method provides the most fl exibility for the employer concerned with providing a maximum allocation to the owners while minimizing the employer s cost on nonowners. There are additional considerations surrounding the use of the New Comparability method that employers should be aware of. These important details are discussed in the Appendix at the end of this paper. Conclusion A profi t sharing contribution must demonstrate nondiscrimination in either the form of allocations or benefi ts. Giving all participants the same percentage of pay as an allocation is clearly non-discriminatory. However, giving each participant the same theoretical retirement benefit is also non-discriminatory and the present-day allocations required to generate these benefi ts may not be equal. This is because older participants have less time to retirement, and thus require larger allocations to reach the same benefit level. Certain design-based safe harbor allocation methods like the Salary Ratio and Integration methods are deemed to be non-discriminatory. Non-safe harbor allocation methods like the Age-Weighted and New Comparability methods must demonstrate nondiscrimination by passing the General Test on either an allocations basis or on a benefits basis. When an allocation method passes the General Test on a benefi ts basis, this is known as Cross-Testing. In considering a Profi t Sharing Plan, including 401(k), employers will benefi t from the study of how the various allocation methods will apply to the census of its employees. Employers desiring to treat all participants equally from an allocations perspective, and only wishing to control cost by the amount of the overall contribution will benefi t most by the Salary Ratio and Integration methods. Employers seeking to make age the chief driver in the overall allocation percentage will benefi t from the Age- Weighted approach. Employers seeking the maximum fl exibility in minimizing cost on certain participant classifications while maximizing allocations to certain key owners and executives will benefi t the most by the New Comparability allocation method. For existing plans, the allocation method can only be changed by a plan amendment or restatement. The plan document will specify the requirements participants must satisfy in order to share in allocations of the profit sharing contribution for the given year. Once participants accrue the right to share in allocations, the right to the allocation method stated is also accrued and cannot be taken away. In order to change the allocation method for a given year, the plan must be amended prior to the point at which participants satisfy the allocation requirements specified in the plan document. 6

7 APPENDIX Calculation Detail Integration Method To use the Integration method, an Integration Level must be chosen. The Integration Level is a percentage or portion of the Taxable Wage Base (TWB), and is specifi ed in the plan document. Under the Integration method, a Base Percentage is applied to total compensation, and an Excess Percentage is applied to compensation over the Integration Level. The disparity is the difference between these two percentages. As you might expect, regulations limit the Maximum Disparity Allowance, which is defi ned to be the lesser of a Maximum Disparity Percentage, or the Base Percentage. The Maximum Disparity Percentage depends on the Integration Level (i.e., the percentage of the TWB) in effect at the beginning of the plan year. The Maximum Disparity Percentage is determined under the following table 3. Table 7: Maximum Disparity by Integration Level Integration Level Maximum Disparity Percentage Taxable Wage Base 5.7% More than 80% but less than 100% of TWB 5.4% The greater of $10,000 or 20% of TWB, but less than 80% of 4.3% TWB Less than the greater of $10,000 or 20% of TWB 5.7% The cumulative effect of applying these percentages to compensation below and above the TWB generally results in higher overall allocations to HCEs. The Integration Level chosen in the example is 80% of TWB plus $1 (or $93,601 in 2014). For individuals with compensation that is well above the TWB, this specifi c Integration Level is often chosen to maximize the effect. The reason is that the Maximum Disparity Percentage of 5.4% is applied to a larger piece of excess compensation. The calculation of allocations under the Integration method works as follows. Beginning with the Owner, we note that his total compensation is $260,000 and the Integration Level is $93,601. This means his compensation in excess of the Integration Level is $166,399. Based on Table 7, and our chosen Integration Level, the Maximum Disparity Percentage is 5.4%. Thus this amount can become our Excess Percentage and 5.4% of the excess compensation ($166,399) is $8,986. Since we are seeking a maximum allocation of $52,000 for the owner, we need a Base Percentage that yields a base allocation equal to $43,014 ($52,000 - $8,986). This Base Percentage is the result of dividing $43,014 by $260,000, and is %. Now that we have a Base Percentage (16.544%) and an Excess Percentage (5.4%), we can see how the allocations in the table are determined, rounded to the nearest dollar. Essentially, each participant fi rst receives an allocation of % of total compensation. Then, any participant with compensation in excess of the Integration Level ($93,601) receives an additional allocation of 5.4% on that excess compensation. Calculation Detail Age-Weighted Method To properly conduct an Age-Weighted profi t sharing allocation, actuarial factors specifi c to the interest rate and mortality table specifi ed in the Plan Document are required. In our example, we have chosen an interest rate of 8.5% and the Unisex Pensioners 1984 mortality table. The actuarial factor is based on the number of years from the end of the plan year to the retirement age stated in the Plan Document, which is assumed to be the greater of age 65 or fi ve years of participation. The actuarial factor for each participant is multiplied by that participant s compensation, to arrive at a number of points. After each participant s points are calculated, they are added together for a total number of points. Then, each participant s points are divided by the total number of points to arrive at the percentages shown in Table 8. Table 8: Age-Weighted Points Name Pay Actuarial Factor Points Percent of Total Points Owner $260, , % Salesman $125, , % Assistant $50, % Clerical $25, % Analysis by Manning & Napier These percentages can then be applied to a plan level profi t sharing dollar amount if known. Or, as is typical, we can back into a minimum total profi t sharing amount necessary to reach the $52,000 maximum (2014) for the Owner. To fi nd this amount we simply divide $52,000 by the Owner s point percentage of %. Doing this yields a total profit sharing dollar amount of approximately $73,500. Applying each participant s point percentage to this total profi t sharing amount yields the allocations shown in Table 4. 7

8 Age-Weighted plans usually satisfy the General Test on a benefits basis with little diffi culty. The reason is that allocating the contribution using normalization factors as done above will generally produce the same equivalent benefit rate for all participants. Important Details about the New Comparability Method Care must be taken when using the New Comparability method in an IRS approved Prototype Plan Document versus a Volume Submitter Plan Document. In a Prototype document, the number of allocation rates is limited. 5 Firstly, the number of allocation rates for HCEs cannot exceed the number of eligible HCEs, and in no case can exceed 25. Secondly, the maximum number of allocation rates for NHCEs is 25. But the actual limit for NHCEs is based on the number of eligible NHCEs and may be lower as described below. Table 9: Prototype Plan Allowable Allocation Rates Eligible NHCEs Maximum Allocation Rates 2 or less or more 6 25 When there are more than 30 NHCEs, the number of allocation rates allowed is calculated by dividing the number of eligible NHCEs by 5 and then rounding-up to the nearest whole number. So in order to be allowed 25 allocation rates, a Prototype plan must benefi t at least 125 eligible NHCEs. These limits on the number of allocation rates do not apply to Volume Submitter documents. However, IRS standards of reasonableness always apply, particularly with issues such as deemed CODA arrangements for self-employed persons, and classifi cations that limit participation to shortest-service and lowest-paid employees while excluding other NHCEs. As mentioned above, the New Comparability method will not normally pass the General Test on an allocations basis. But in order to gain entrance to the General Test on a benefits basis, certain preconditions, known as the Gateway Test, apply. To satisfy the Gateway Test the Minimum Allocation Gateway (i.e., lowest allowable allocation rate) for any benefi tting NHCE is one-third of the highest allocation rate for any benefi tting HCE (also known as the One-Third Test). 6 However, if every benefi tting NHCE receives an allocation of at least 5%, the Minimum Allocation Gateway is deemed satisfi ed, and the allocation rates for HCEs are not limited, except by the individual addition limit under IRC 415(c) ($52,000 in 2014). 7 The Minimum Gateway Allocation requirement can be avoided if each allocation rate provided can meet the Broadly Available Test. 8 This test is met if each allocation rate is available to a group of participants who, if treated as benefi tting under a separate plan, could satisfy certain non-discriminatory classifi cation requirements under Treasury Regulation 1.410(b)-4. Since most plans will opt for the Minimum Allocation Gateway, these additional requirements won t be addressed herein. Imputing Permitted Disparity Similar to the disparity permitted under a design-based safe harbor allocation method (i.e., Integration), Permitted Disparity may also be imputed for a non-safe harbor plan that relies on the General Test to demonstrate nondiscrimination. A detailed explanation of this imputation is beyond the scope of this paper. Simply though, allocation rates or benefi ts rates (when cross-testing) are adjusted within allowable limits to refl ect employer provided Social Security benefi ts. Oftentimes, a cross-tested allocation may be very close to passing the General Test, but not close enough. Imputing Permitted Disparity is a technique that can be employed to push the allocation into passing. It s important to recognize that regulations prevent the employer from double-dipping, by limiting the multiple use of Permitted Disparity in the same year for the same employees, in different plans. 9 For example, if the employer uses the Integration method in a sponsored Profi t Sharing Plan, then the employer is limited in the amount of imputed disparity used in any other plan (i.e., a DB Plan) on the same employees to pass the General Test. Similarly, if an employer imputes Permitted Disparity in the General Test of one plan, then that employer is limited in the level of Integration used in another sponsored plan s allocation method. 8

9 Sources: 2014 ERISA Outline Book; Internal Revenue Code; Treasury Regulations; IRS LRM 94 1 The code defi nes precisely what is meant by the phrase Highly Compensated Employee (HCE). Under IRC 414(q)(1), an employee is an HCE for a plan year if: 1) The employee owns more than 5% of the employer (or a related employer) at any time during the current or prior plan year. If the employee s highest ownership percentage during this period is more than 5%, the test is satisfi ed. Family attribution rules apply (IRC 318); or 2) The employee s compensation for the prior plan year is more than a prescribed dollar amount subject to annual cost-of-living increases. 2 IRC 401(l), Treasury Regulation 1.401(a)(4)-2(b). 3 Treasury Regulation 1.401(l)-2(d) 4 The interest rate used must be between 7.5% and 8.5% 5 IRS Revenue Procedure IRS LRM 94 6 Treasury Regulation 1.401(a)(4)-8(b)(1)(vi)(A) 7 Treasury Regulation 1.401(a)(4)-8(b)(1)(vi)(B) 8 Treasury Regulation 1.401(a)(4)-8(b)(iii) 9 Treasury Regulation 1.401(l)-5(b) Approved CAG-PUB044 (5/14) 9