Also known as qualified retirement plans, profit-sharing plans are established by employers to provide employees with opportunities to save for retirement.
“Keeping good employees can increase company profits,” says Glenn Gelman, managing director at Santa Ana-based Glenn M. Gelman & Associates CPAs, “while also reducing the high cost of recruiting and replacing valued employees.”
Smart Business spoke with Gelman about how companies can fold profit-sharing plans into their overall business plans and use them to retain good workers while maximizing profits.
Why should companies be thinking about profit-sharing plans right now?
Profit-sharing plans serve as great employee retirement planning tools and as golden handcuffs in that they can have vesting restrictions that force employees to stay a certain period of time before they can obtain all their benefits. They also allow for retirement of key executives and open up spots for younger executives.
Right now, the majority of profitable companies have either a profit-sharing plan or a pension plan in place.
How can these plans serve as tax tools?
Qualified plans ‘qualify’ for favorable tax treatment under the Internal Revenue Service Code. As long as they meet the requirements for maintaining such plans, employers and self-employed individuals can deduct contributions made to the plan. Employees aren’t immediately taxed on the contributions made on their behalf, but at retirement when distributions are made. Employers may make additional contributions on a pre-tax basis, to certain types of plans such as 401(k) plans and earnings on retirement plan funds accrue on a tax-deferred basis as well.
At the time that the contributions are made, the income grows tax free within the pension plan.
How do these plans work?
In a profit-sharing plan, up to 15 percent of each employee’s eligible compensation can be contributed to a trust held for the benefit of the employees, including those shareholders who are owners. The amount contributed to a profit-sharing plan cannot be discriminatory, meaning it cannot favor highly compensated employees. However, if properly structured based on age or classification of employee, these plans frequently yield a significant benefit to highly compensated employees despite the discrimination rules.
What benefits can companies expect from using profit-sharing plans?
These plans improve employee morale and provide security for older employees. They also add nontaxable compensation for each employee, or at a minimum the tax is deferred and can be used within a 401(k) plan or as an addendum to a 401(k) plan to further increase employee benefits.
What challenges come with using these plans?
When complicated pension plans (such as defined benefit plans) are used, they often yield a higher percentage of benefit to the highly compensated. However, they are also less flexible and often require mandatory annual contributions.
How can a company get started with a profit-sharing plan?
The first step is to find a third-party administrator also known as a TPA who will not benefit directly from the investment side of the equation. These are professionals who prepare tax returns, design the plans, administer the plans and send out the participant statements, but they do not invest the money. They are the best people to design a plan because they don’t have a conflict of interest, whereby many large institutions will gladly manage your plan for free because they are going to earn commissions on plan investments.
What advice would you give a firm looking to start a profit-sharing plan right now?
In designing a plan, a company should look not only at how much is allocated to the highly compensated employee, but also how flexible the plan is in terms of mandatory contributions. There are also esoteric plans, such as the 412(i) defined benefit pension plan, which invests in annuities and life insurance. These plans take seven to 10 years to recover the tax surrender charges or the penalties for cashing in early on the insurance. I would also consider an Employee Stock Ownership Plan, which is a form of a qualified plan, if succession planning is a major concern.
GLENN M. GELMAN, CPA, MSD, is managing director at Glenn M. Gelman & Associates CPAs in Santa Ana, Calif. Reach him at (714) 667-2600 or firstname.lastname@example.org.