More to Consider When Using the New Comparability Profit Sharing Formula
By Cal Preisinger, QKA
In a previous installment of Ask an Expert, you discussed the factors to be aware of when designing a plan using the new comparability profit sharing formula. Are there ways to make the formula more flexible to work better for our clients?
The new comparability formula has become one of the more popular profit sharing formulas commonly used. But there are some nuances to be aware of—and solutions for making the formula work better for your clients’ plans.
Use Flat Dollar Amounts
Younger employees with lower compensation typically will have higher equivalent benefit accrual rates (EBARs), which makes them an attractive nonhighly compensated employee (nonHCE) group to give increased profit sharing to when needing to pass required testing. But what may make numerical sense on paper may cause other unintended consequences. If employees happen to discover that they received different profit sharing percentages than other associates, the resulting conversation can be awkward for the employer. This can be especially difficult if the associate who received the larger percentage does not have as many years of service with the employer as the other associate(s) who received less. Giving flat dollar amounts rather than percentages of profit sharing can help this conversation. This can be done by “backing into” the required contribution amount needed to pass testing, resulting in all non-HCEs receiving the same flat dollar amount. This may be a more expensive alternative but—though there are no guarantees—might make for an easier conversation with employees down the road.
Limit Safe Harbor Nonelective Contributions to NonHCEs
Many plans that adopt a new comparability formula require nonHCEs to receive a minimum contribution. This contribution is referred to as the “gateway minimum” and the percentage required is directly derived from contribution percentages that the highly compensated employees (HCEs) are receiving. In addition to the benefit of exempting the plan from actual deferral percentage (ADP) and actual contribution percentage (ACP) testing, the safe harbor nonelective contribution can be used to offset this gateway minimum. This is why the gateway minimum contribution is commonly designed in conjunction with new comparability. But, as mentioned earlier, when giving a contribution to a younger employee, the typical result will be a high EBAR. If this younger employee happens to be an HCE—perhaps the child of an owner—who is looking to maximize her own contributions, the profit-sharing testing can be doomed right from the start.
Designing the plan to only require nonHCEs to be eligible for safe harbor contributions can help limit contributions, potentially minimizing these high EBARs of unintended HCEs. Although this may seem like it would limit the contributions that HCEs could receive, because safe harbor and profit sharing are included in the same nonelective source, whatever the owner does not receive in safe harbor contributions she could potentially make up in profit sharing.
Review Plan Demographics and Possibly Remove Allocation Conditions
It’s common for employers to require employees to have a certain number of hours and/or be employed on the last day of the plan year in order to receive part of the employer’s profit sharing allocation. These allocation conditions are meant to reward only those employees who have contributed the most to the company’s success and not those who may have been hired for a short time or moved on. An unintended consequence of this approach may be an increase in the cost of the profit sharing component because it lessens the pool of nonHCE employees who can be included in the calculation and who, many times, will have higher EBARs. By including these employees, the cost of profit sharing to the rank and file employees may be more reasonable and allow HCEs to receive the more meaningful benefits they may be looking for.
It should be noted that every employer’s situation is different, which is why working with a competent tax advisor or financial professional can be instrumental in navigating these complex situations.
