What is a Profit Sharing Plan?

Profit Sharing Plans

A “Profit Sharing” plan is a defined contribution plan in which employers have the discretion to determine when and how much the company pays into the plan. The contribution does not necessarily need to be linked to business profitability and may be as little as zero in a given year. The method by which employer contributions are made can vary based on plan design.

Did you know that all 401(k) plans are actually profit sharing plans? That’s right, a 401(k) provision simply allows for deferrals into a profit-sharing plan.

The amount allocated to each individual account is usually based on the salary level of the participant.

Profit sharing plans can be a compelling tool in encouraging financial security in retirement. These plans are a valuable option for businesses that are considering a retirement plan, providing benefits to employers and their employees.

Why starting a profit sharing plan?

A profit-sharing plan allows the employer to choose how much to contribute to the plan each year, including making no contribution for a year.  It is a type of plan that gives employers flexibility in choosing the key features. Employers start a profit sharing plan for additional reasons:

  • A well-designed profit sharing plan can help attract and keep employees.
  • The money contributed to a profit sharing plan may grow through investments in savings accounts, stocks, mutual funds, bonds, money market funds, and other types of investments.
  • Contributions and profits generally are not taxed by the Federal Government or by most state governments until they are apportioned.
  • A profit-sharing plan may allow employees to take their benefits with them when they leave the company, easing administrative duty.

Many of the actions needed to operate a profit sharing plan involve fiduciary choices. This is true whether someone has been hired to manage the plan or do some or all of the plan management. Using discretion in hiring someone to administer and manage the plan makes them a plan fiduciary to the extent of that discretion or control. Hiring someone to perform fiduciary functions is itself a fiduciary act. Thus, fiduciary status is based on the functions performed for the plan, not a title.

Decisions to establish a plan

Some decisions with respect to a plan are business decisions, rather than fiduciary decisions. For instance, the decisions to establish a plan, to include certain features in a plan, to amend a plan, and to terminate a plan are business decisions. When making these decisions, one is acting on behalf of their business, not the plan, and therefore, would not be a fiduciary. However, when steps are taken to implement these decisions, these administrators are acting on behalf of the plan and thus, in making decisions,  and maybe acting as fiduciaries.

Therefore,  the persons or entities that are fiduciaries are in a position of trust with respect to the participants and beneficiaries in the plan. The fiduciary’s responsibilities may include acting solely in the interest of the participants and their beneficiaries or acting for the exclusive purpose of providing benefits to workers participating in the plan and their beneficiaries and defraying reasonable expenses of the plan.  Additionally, they may be responsible for carrying out duties with the care, skill, discretion, and conscientiousness of a prudent person familiar with such matters.  Having a prudent plan administrator who will following the plan documents, diversify plan investments is hugely important.

The responsibility to be prudent covers a wide range of functions needed to operate a plan. Since all these functions must be carried out in the same manner as a prudent administrator would, it is imperative that one consults various experts in many fields, such as investments and accounting.

The plan must designate a fiduciary, typically the trustee, to make sure that contributions due to the plan are collected. If the plan and other documents are silent or indeterminate, the trustee generally has this responsibility. As part of following the plan documents in operating the plan, the plan document will need to be updated from time to time for changes in the law.

Who is a Plan Sponsor?

  • Goal: Businesses looking for flexible ways to allocate employer contributions in order to increase retirement readiness and achieve tax benefits.
  • Demographic: Companies of any size can take advantage of this structure.
  • Generosity: Contributions to eligible employees can vary based upon the profit sharing structure and employee demographic. Profit sharing plans are subject to age-based discrimination testing and include design options such as the following:
    1. Traditional: A pro-rata percentage of annual income or fixed dollar amount.
    2. Integrated: Also known as Permitted Disparity, this method accounts for Social Security compensation limits.
    3. Age Weighted: A greater percentage of profit sharing contributions are allocated to older employees.
    4. New Comparability: Creates categories of employees that can have differing allocations.

Let us provide you with assistance and our insight on how to appropriately set up, manage and update plan information. Contact Us today!