Spring/Summer Series Part 2: Profit Sharing Plans

So, what is a profit sharing plan? The answer is obvious...it’s a plan to share profits, right? WRONG!

(OK, I promise not to do that again.)

Despite its name, making a contribution to a profit sharing plan is not contingent upon the employer’s profit. The reason for the misnomer is that such plans were originally designed to share profits, but that changed over time. Now we’re stuck with the straightforward-seeming name whether we like it or not.

So to answer my own question, a profit sharing plan is a means to provide employees with deferred compensation. In its simplest form, an employer makes a contribution to the plan, and each eligible employee (or participant) shares in that contribution based on the ratio of that participant’s pay to all participants’ pay. For example, 50 year old Jane Owner has a plan with two participants, herself and 30 year old John Employee. Jane’s compensation is $200,000 per year. John’s is $50,000 per year. Any contribution made to the plan will be allocated 80% to Jane and 20% to John. For 2019, the company contributes $40,000, with $32,000 going to Jane’s account and $8,000 going to John’s.

“But wait!” complains Jane. “I already contribute toward my employees’ retirement security in the form of Social Security, at least up to the Taxable Wage Base. Isn’t there some way I can contribute more for those (like myself, for instance) who earn more than the SSTWB?”

Why, yes, Jane, there is. It’s called Permitted Disparity. (In the old days, it used to be called “integrated with Social Security.” Some people still refer to it as such.) With Permitted Disparity, there is an allocation based on all pay, plus another allocation based on pay in excess of the SSTWB. In our example above, Jane would get 5.7% of $67,100 ($200,000 - $132,900), and then the rest would be allocated 80% to Jane and 20% to John. The resulting allocation is $32,765 for Jane and $7,235 for John.

As with all defined contribution plans, what the employee gets out of the plan depends on what goes in on his behalf plus investment growth. Longer term employees, in general, will have more contributions, more investment growth, and higher vesting, resulting in greater retirement security.

Some advantages of a (regular or permitted disparity) profit sharing plan:

• Easy for employer and employee to understand
  
  
• Lower administration costs than other types of plans
• Contribution is completely discretionary. The employer can contribute the maximum allowed one year and $0 the next.
• Contributions can be used as an incentive for employees, sort of like a bonus for later
• Neither the employee nor the employer pay FICA on the contribution
  
  
  

Some disadvantages:

• Cannot pick how much to give to individual participants, as the employer can with a bonus
• In order for the owner to get a high percentage of pay, the employees must get a high percentage of pay as well
  
  
  

For those employers who feel the disadvantages outweigh the advantages, there are other types of profit sharing plans we can look at.

Next up: age based and new comparability profit sharing plans.