Profit Sharing Allocation Formulas Explained

It’s a pleasure to have you join us for the third article in our Profit Sharing series. In our previous discussion, we explored qualified profit-sharing plans, focusing on the different ERISA criteria these plans must meet to secure unique tax benefits for eligible employees. We identified that qualified profit-sharing plans fall into cash-based and equity-based plans.

Today, we'll explore the various allocation formulas for cash-based qualified profit-sharing plans. You will learn how to calculate profit-sharing contributions and understand the benefits and drawbacks of each formula. Join us below for more detailed insights.

Types of Profit-Sharing Allocation Formulas

An allocation formula is a framework that determines how contributions made to a profit-sharing plan are distributed among staff. Companies choose from various allocation formulas depending on their profit-sharing goals and available resources. They are highlighted below:

Comp to Comp Method

Also known as the pro rata method, this technique distributes employer contributions based on each employee's compensation relative to the total. Say a company has made a profit-sharing contribution worth $100,000, and the total compensation for all employees is $1 million. If an employee's annual compensation is $50,000, they would receive $5000.

Pros

Here are the potential advantages of the comp to comp profit sharing allocation method:

• It's simple to calculate and understand.
• Money allocated to employees is directly tied to their earnings, which can motivate them.

Cons

The pro rata method does come with its fair share of downsides:

• Highly compensated employees receive a disproportionate share of the profit-sharing contributions.

That being said, this profit-sharing plan is ideal for companies whose worker's compensation is relatively homogenous.

New Comparability

The new comparability allocation formula, while being more complex than the pro rata method, allows employers to reward staff based on their roles, tenure, and other classifications.

To distribute company profits based on this formula, you must divide your staff according to classes, including executives, management, and general staff. You'll then assign different contribution rates for each classification. For instance, executives may receive 10% compensation, management 5%, and staff 3%. Finally, you'll calculate the contributions based on these rates and compensation for employees in each class.

It's important to note that employer contributions disbursed under the new comparability formula must pass cross-testing to ensure they do not disproportionately favor highly compensated employees.

Pros

• Can be customized according to employee groups.
• Employers can tailor this strategy to meet specific goals and retention strategies.

Cons

• Profit-sharing contributions under this formula are complex to administer and require regular compliance testing.
• Lower-paid employees may view this profit-sharing plan as unfair.

Integrated (Permitted Disparity Method)

The integrated method is ideal for employers that want to attract and retain high-earning and highly skilled employees because it favors workers earning above the Social Security taxable wage base.

This profit-sharing plan takes into account that Social Security benefits provide proportionally more income to lower-paid employees. Consequently, it allows for a disparity in contributions, which is permitted by the IRS. Although more complex to administer, this approach can encourage employees to remain with the company longer, thereby reducing turnover.

Pros

• Acknowledges that lower paid workers receive a higher replacement rate from social security.
• This profit-sharing allocation method can attract and retain key talent.
• It's more flexible, allowing companies to distribute contributions according to set strategic goals.

Cons

• It's complex to administer and must comply with intricate IRS rules.
• May be perceived as unfair by lower-paid workers.

Flat Dollar

Under this plan, eligible employees receive the same dollar regardless of their position or seniority. Here are some of the advantages:

Pros

• Easy to administer.
• Promotes a sense of fairness among employees as everyone receives the same dollar amount.
• Demonstrates that the employer values all staff equally, which can boost morale.

Cons

• Lack of incentive for highly compensated employees.
• The one-size-fits-all approach does not account for differences in compensation, seniority, and job responsibility.

Age Weighted

This profit-sharing contribution technique takes into account an employee's age and compensation. Older workers with a few years to save for retirement get higher compensation than younger staff. It uses actuarial calculations to calculate the contribution limits for each participant.

Pros

• Demonstrates fairness based on retirement need.
• Offers higher contribution limit for older employees.

Cons

• Demands actuarial knowledge to determine contribution rates.
• Younger employees may perceive the plan as unfair.

As you can see, the profit-sharing allocation formula that a company chooses largely hinges on the nature of its workforce and its strategic goals. Some plans may be better suited for older workers, others will work for younger employees, and others will be equal.

Conclusion

This article marks the end of our analysis of cash-based qualified profit-sharing plans. In our next piece, we will be delving into the world of equity-based profit-sharing plans. Don't miss out!

Are you wondering about any of the issues mentioned above? Please email us at info@wilkinsonlawllc.com or call (732) 410-7595 for assistance.

At Wilkinson Law, we give business owners the documents and advice they desperately need to fund, grow, protect and sell their businesses. We are trustworthy business advisors keeping your business on TRACK: Trustworthy. Reliable. Available. Caring. Knowledgeable.®