Multiple Factors Affect the New Comparability Profit Sharing Formula
By Cal Preisinger, QKA
A profit sharing formula that more employers are electing is the “new comparability” formula. What is new comparability?
In the simplest terms, new comparability is a type of formula that projects out an employee’s current profit sharing contribution to a future annual benefit at a pre-determined retirement age. These benefits are then compared (tested) in order to confirm that they are considered nondiscriminatory between those who are highly compensated employees (HCEs) and those who are nonhighly compensated employees (non-HCEs).
Because older individuals have a shorter time to save before reaching retirement age, the current year’s profit sharing contribution will then have less time to grow, and—all else being equal—the balance at retirement would be smaller. Meanwhile the current year profit sharing contribution for younger employees has a longer time to grow and compound, resulting in a larger ending balance at retirement. By using the new comparability formula, older employees can receive the lion’s share of a profit sharing contribution in the current plan year, in theory, equalizing their retirement age benefits.
How does an employee’s compensation affect the calculation?
The projected benefit amounts are compared to an employee’s current plan year compensation, and then are used to create a ratio of that employee’s hypothetical benefit over current year compensation. This number is called the equivalent benefit accrual rate (EBAR). The EBARs are then compared to the other employee EBARs in the plan. Higher participant compensation for a given benefit will contribute to a participant having a lower EBAR. Owners/HCEs will generally want to have a lower EBAR to allow them to pass required nondiscrimination testing more easily. If their EBARs are too high compared to the other non-owner/non-HCE employees, the employer will have to give a larger profit sharing contribution to these employees.
For example, the sole owner of a medical practice and his spouse who works in the office both want to maximize their contributions for the year. If the owner receives the bulk of the compensation while the spouse is paid compensation similar to the rest of the non-HCE employees, the owner’s EBAR will be smaller than that his spouse’s (also an HCE). This may require the contributions to non-HCE employees to be much larger than what may be required if the owner had paid the spouse a higher wage, resulting in a lower EBAR.
How can the plan document affect the calculation?
As previously noted, contributions are compared among the employees to confirm that they are nondiscriminatory. For that purpose, the plan document will list groups—called allocation groups—that employees can be placed into. To have the most flexibility, a plan document can choose to have “individual allocation groups” for each employee, rather than locking them into specific groups such as “owners” and “non-owners.” This can be valuable when an owner’s much younger child starts working in the family business. If a plan document is set up with fixed allocation groups, the child (who is an HCE by family attribution of ownership) cannot have his benefit minimized directly, and will receive a profit sharing contribution amount according to the fixed group he or she falls into. When projected out to the child’s retirement age, his EBAR can become very large, making the overall allocation needed for nonHCEs in order to pass nondiscrimination testing more expensive, or even cost-prohibitive.
But if the plan has individual allocation groups—one participant to each group—the child could be placed in his own group, his benefit minimized, resulting in a lower EBAR, which then would enable the plan to pass nondiscrimination testing more easily. This allows greater flexibility in performing the allocation, as it can be tailored to meet the goals and objectives of the employer.
Can changes in the employer’s workforce affect the calculation?
Employers using the new comparability profit sharing formula should be aware that plan demographics can change from year to year. What works this year may not work next year. Employee age is one of the main factors in the new comparability equation, and the larger the variance in ages between those who are trying to maximize their contributions (generally the owners) and the other employees, the better.
If a few, or even just one, of the younger employees leaves, that can greatly affect how much the owners can receive in employer contributions or how much it will cost to maximize their contributions for the year. Likewise, if the workforce generally is close in age to the owner, the contribution may more closely resemble a pro-rata allocation, in which everyone needs to receive the same percentage to satisfy nondiscrimination testing.
These are just a few issues that employers may encounter when calculating year-end profit sharing contributions using new comparability allocations, revealing why it is so important to work with a competent tax advisor or financial professional.