Non-discrimination Rules for Qualified Profit-Sharing Plans

We’re thrilled to have you back for another installment in our series on profit-sharing. In our last piece, you understood the basics of integrating profit-sharing plans with 401(k) programs. However, even before combining these arrangements, you must adhere to non-discrimination standards, which prevent these plans from favoring highly compensated employees (HCEs) disproportionately. Today, we will delve deeper into these non-discrimination regulations for qualified profit-sharing plans. Continue reading for more insights.

Understanding Non-Discrimination Rules for Qualified Profit-Sharing Plans

The nondiscrimination rules outlined in the Employee Retirement Income Security Act (ERISA) of 1974 are there to ensure equity and fairness in the workplace. While profit-sharing plans are an excellent tool to incentivize employees and boost productivity, the stimulus plan is an exercise in futility if it only favors highly compensated employees (HCEs), leaving out other workers.

That’s why these laws exist—they encourage fairness and inclusivity when sharing the company’s collective profits.

With this in mind, the IRS tests companies’ profit-sharing plans using various methods annually to ensure they are compliant with the non-discrimination standards outlined in ERISA.

Coverage Test (IRC Section 410(b))

This is one of the most common tests in use today. It ensures profit-sharing plans are inclusive, covering both HCEs (Highly Compensated Employees) and NHCEs (Non-Highly Compensated Employees). That being said, there are two key ways to satisfy the coverage test:

The Ratio Percentage Test

This approach ensures companies distribute profit-sharing plans fairly between HCEs and NHCEs. It dictates that the percentage of covered NHCEs be at least 70% of the benefiting HCEs.

Let’s look at a practical example. Suppose you set up a profit-sharing plan for your workforce that covers 50% of your HCEs. The Ratio Percentage Test then dictates that the plan should cover at least 35% of your NHCEs as well (35% is 70% of 50%).

Average Benefits Test

In case your profit-sharing plan fails to meet the Ratio Percentage Test requirements, the IRS may resort to using the Average Benefits Test. It examines the benefits provided to HCEs and compares them to those provided to NHCEs. Specifically, it is satisfied if the average benefits provided to NHCEs are at least 70% of those provided to HCEs.

Let us also examine a practical scenario. Imagine your company provides a profit-sharing plan to 50 HCEs and 150 NHCEs. The total benefits provided to HCEs amount to $1.5 million and $2.7 million for NHCEs.

Under the Average Benefits Test, the average benefits per employee are calculated as follows:

• HCEs: $1,500,000 / 50 = $30,000 per HCE
• NHCEs: $2,700,000 / 150 = $18,000 per NHCE

Consequently, computing the ratio of average benefits of NHCEs to HCEs comes to:

• $18,000 / $30,000 = 0.60 or 60%

As you can see, this ratio fails to meet the minimum requirement of 70% as outlined in the Average Benefits Test. As such, your firm would have to adjust its benefits to meet these requirements.

Top Heavy Test (IRC Section 416)

The top-heavy plan uses terminology distinct from the coverage test we analyzed above. It is designed to ensure that profit-sharing plans are not disproportionately concentrated in the hands of key employees.

Key employees, as defined by the top-heavy test, earn over a specified amount and own a significant portion of the business. Notably, the IRS adjusts these figures annually to account for inflation.

For the fiscal year 2023, key employees earn more than $215,000, owners of more than 1% of the business who also earn more than $215,000, and business owners holding more than 5% of the stock capital.

With this in mind, a profit-sharing plan is considered top-heavy if the total value of the plan for key employees exceeds 60% of the total value of all plan accounts.

Let's consider a practical scenario: Suppose you design a profit-sharing plan totaling $10 million. Key employees receive $7 million, while non-key employees get $3 million.

To determine whether the plan is top-heavy, the percentage of plan value for key employees is calculated as follows:

• Percentage of Plan Value for Key Employees = ($7 million / $10 million) * 100 = 70%

In this case, 70% exceeds the 60% threshold, indicating that the plan is top-heavy, and the company would need to make necessary adjustments.

Next Steps

The non-discrimination tests mentioned are the most commonly used today. However, there are other approaches the IRS may use to evaluate your company’s profit-sharing plans, including the Contributions and Benefits Test.

Whatever the case, it is crucial to consult professionals such as attorneys, tax advisors, and financial consultants when designing profit-sharing plans for several reasons.

To begin with, they can help ensure that your plan complies with the non-discrimination rules outlined under ERISA, saving your company from penalties and fines due to non-compliance. They will also analyze the nature of your business and help you design a plan that ensures maximum tax efficiency.

Conclusion

The IRS conducts annual tests on qualified profit-sharing plans utilized by business owners like yourself to ensure they are not disproportionately concentrated in the hands of key employees. These tests include the Top-Heavy and Coverage Tests. To ensure your plan complies with these rules and regulations, it is essential to engage financial consultants and attorneys specialized in profit-sharing plans.

Next week, join us to learn about the tax implications of issuing a profit-sharing plan under IRS rules.

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

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