Each year, the employer decides how much to contribute into a profit sharing plan. The amount may vary between 0% and 25% of eligible compensation. It is not necessary to have current or accumulated profits to make a contribution. The Profit Sharing contribution is allocated to eligible employees using the formula stated in the plan document, which is designed. The most common allocation formulas are as follows:
Pro Rata Formula:
This is the traditional plan that allocates a contribution percent, for example 15%, equally to each participant, based on compensation. Each participant receives the same percent of compensation.
Tiered/ Cross-Tested Allocation:
IRS regulations now allow Plan Sponsors to divide plan participants into groups, tiers, or classes. The groups can be based on different factors such as job title, length of service, etc. Each group may receive a different contribution allocation, subject to non-discrimination testing. In order to qualify for favored status, a plan must not discriminate in favor of highly compensated employees (HCE) with respect to eligibility, contributions or benefits. This allocation method provides the most flexibility and works best with companies who have older highly compensated employees and younger non-highly compensated employees.
Highlights of Profit Sharing Plans:
- Total flexibility: An employer has the ability to make a tax-deductible contribution or not to make one, whether there are profits or not.
- Advantageous to businesses that do not wish to commit to a contribution each year.
- Maximum total contribution is $53,000 (2016) per participant. Maximum compensation used for plan purposes is $265,000 in 2016.
- Share of the contribution is based on each participant’s compensation.
- Shares can be designed to benefit selected employees by various allocation methods. Such shares can favor a select group of employees based on age, compensation or specific classes of employees.
- Earnings accumulate tax deferred.
- A vesting schedule is usually attached to profit sharing accounts.
- Forfeitures can be used to reduce future contributions or can be reallocated to participants.