Profit Sharing Allocation Methods The Better Part of Discretion
A White Paper by Manning & Napier
www.manning-napier.com
Unless otherwise noted, all figures are based in USD.
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Profit Sharing Allocation Methods-The Better Part of Discretion | A White Paper by Manning & Napier
Comparable Doesn’t Mean Equal
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.
2.
3.
4.
Salary Ratio
Integration (or Permitted Disparity)
Age-Weighted
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.
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 employees1[…].”
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 are2:
• 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.
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Profit Sharing Allocation Methods-The Better Part of Discretion | A White Paper by Manning & Napier
The Salary Ratio Method
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 benefits basis. CrossTesting occurs in a DC Plan when an allocation method is
tested for non-discrimination on the basis of benefits in the
future derived from allocations in the present. Examples of
profit sharing allocation methods that must demonstrate
non-discrimination by satisfying the General Test are the
Age-Weighted and New Comparability methods.
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 Profit 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 first year allocations to the plan
are shown in Table 2 below.
Table 2: Salary Ratio Profit Sharing
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.
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
Table 1: Sample Census
Owner Total
$52,000
Non-Owner Total
$40,000
Grand Total
$92,000
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
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.
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Profit Sharing Allocation Methods-The Better Part of Discretion | A White Paper by Manning & Napier
The Integration Method
Cross-Testing
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.
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 benefits
derived from present-day allocations to NHCE participants
must be comparable to projected future benefits derived
from present-day allocations to HCE participants.
Table 3: Integrated Profit Sharing
Title
W2 Pay
PS %
PS $
Owner
$260,000
20.000% $52,000
Salesman
$125,000
17.900% $22,375
Assistant
$50,000
16.544%
$8,272
Clerical
$25,000
16.544%
$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 specific calculations involved with the
Integration method, consult the Appendix at the end of this
paper.
On a benefits 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 benefits at
age 65, the lump sum accumulations required to pay those
benefits 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.
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Profit Sharing Allocation Methods-The Better Part of Discretion | A White Paper by Manning & Napier
The Age-Weighted Method
Under the Age-Weighted method, the employer’s
profit 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
rates4, 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 profit 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
$260,000
20.0%
$52,000
Salesman
$125,000
9.6%
$12,000
Assistant
$50,000
4.2%
$2,100
Clerical
$25,000
29.4%
$7,350
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. Classifications
may be defined in a number of ways, the most common of
which is by job title. Classifications 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 fide business criteria.
Examples of classifications by job title are shown in
Table 5.
Table 5: Sample Group Titles
Owner Total
$52,000
1. Owners
Non-Owners Total
$21,450
1. Sr. Partners 2. Jr. Partners
3. All Other Employees
Grand Total
$73,450
1. Executives
3. All Other Employees
Percent to Owner
2. Non-Owners
2. Managers
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 difficulty 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.
Similarly, classes can be defined 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.
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Profit Sharing Allocation Methods-The Better Part of Discretion | A White Paper by Manning & Napier
Lastly, 84% of the plan contribution attributes to the owner.
Of all the methods explored, the New Comparability
method provides the most flexibility 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 profit sharing contribution must demonstrate nondiscrimination in either the form of allocations or benefits.
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 benefits 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 benefits
basis, this is known as Cross-Testing.
In considering a Profit Sharing Plan, including 401(k),
employers will benefit 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
benefit most by the Salary Ratio and Integration methods.
Employers seeking to make age the chief driver in the
overall allocation percentage will benefit from the AgeWeighted approach. Employers seeking the maximum
flexibility in minimizing cost on certain participant
classifications while maximizing allocations to certain key
owners and executives will benefit 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.
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Profit Sharing Allocation Methods-The Better Part of Discretion | A White Paper by Manning & Napier
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 specified
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 defined
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 table3.
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
TWB
4.3%
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 specific 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 16.544%. 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 first receives an allocation of
16.544% 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 profit sharing
allocation, actuarial factors specific to the interest rate
and mortality table specified 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 five 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
Actuarial
Points
Factor
Name
Pay
Owner
$260,000 .038144
9,917.44
Percent of
Total Points
70.7847%
Salesman $125,000 .018304
2,288
16.3304%
Assistant
$50,000 .008096
404.8
2.8892%
Clerical
$25,000 .056019
1400.475 9.9957%
Analysis by Manning & Napier
These percentages can then be applied to a plan level
profit sharing dollar amount if known. Or, as is typical,
we can back into a minimum total profit sharing amount
necessary to reach the $52,000 maximum (2014) for the
Owner. To find this amount we simply divide $52,000 by
the Owner’s point percentage of 70.7847%. Doing this
yields a total profit sharing dollar amount of approximately
$73,500. Applying each participant’s point percentage
to this total profit sharing amount yields the allocations
shown in Table 4.
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Profit Sharing Allocation Methods-The Better Part of Discretion | A White Paper by Manning & Napier
Age-Weighted plans usually satisfy the General Test on
a benefits basis with little difficulty. The reason is that
allocating the contribution using normalization factors as
done above will generally produce the same equivalent
benefit rate for all participants.
Gateway Test, apply. To satisfy the Gateway Test the
Minimum Allocation Gateway (i.e., lowest allowable
allocation rate) for any benefitting NHCE is one-third of the
highest allocation rate for any benefitting HCE (also known
as the One-Third Test).6
Important Details about the New
Comparability Method
However, if every benefitting NHCE receives an allocation
of at least 5%, the Minimum Allocation Gateway is deemed
satisfied, and the allocation rates for HCEs are not limited,
except by the individual addition limit under IRC §415(c)
($52,000 in 2014).7
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
1
3–8
2
9 – 11
3
12 – 19
4
20 – 29
5
30 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 benefit 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
classifications 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
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 benefitting under a separate plan, could satisfy certain
non-discriminatory classification 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 benefits rates (when cross-testing) are adjusted
within allowable limits to reflect employer provided Social
Security benefits. 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 Profit 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.
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Profit Sharing Allocation Methods-The Better Part of Discretion | A White Paper by Manning & Napier
Sources: 2014 ERISA Outline Book; Internal Revenue Code; Treasury Regulations; IRS LRM 94
1
The code defines 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 satisfied. 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 2005-16. 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