EB Chapter 5: Profit Sharing Plans

Stock Bonus Plan Features vs Profit Sharing Features (contributions and deductions): When must they be established by? When are contirbutions due by? Contributions discresionary or not? Deductible contribution limit?

- As with all qualiied plans, they must be established by December 31st of the year for which teh employer will be contributing - Contributions are due by the date of the income tax return, including extensions - Contributions are discresionary, like profit sharing plans but also like profit sharing, must be substantial and recoccuring. No requirement nor prohbtion on corporation contributing for a year in which they took a loss - Like profit sharing plans, they have a deductible contribution limit of 25% of covered compensation(280,000). - When stock is contributed, FMV of the stock is deducitble. If they contribute more than the permitted 25%, in which case the employer would deduct the 25% and deduct the excess in a future year. They will pay an excise tax on portion of contribution that exceeds 25% for that year.

Advantages of ESOPs to Employer

- Can be used as estate planning vechicle for owner/princple shareholder so that they have a readily-avaliable buyer for their stock. -The corpratin can take out and loan to buy these shares and then pay it back throuogh tax deductible contirbutoins. - Owners can create a diversified portfolio without reconiton of capital gain - Helps releive cash flow by taking tax deduction on contributons - Gives employees a stake in the company

Disadvatages of ESOPs to EMployer

- Dilutes the ownership in the corpration - Put option can create cash flow problems - Substianal cost in setting up the plan - Annual appriasla create siginficant and reouccring ocst - May strain cash flows to meet payout requiremtns to departing employees at uncertain times - Personal liability concerns for officers or management who also serve as trustees for ESOPs - SS intergration not permitted

Non-recontion of gain treatment for sale to ESOP rules

- ESOP must own at least 30% of sock after sale - SH must have owned the stock for at least 3 years - SH Must have purchased qualfiied property within 3 months after trasnaction (securites of domestic companines with no more than 25% from passive investments (no mutual funds); could be as S corp

Advantages to the employees:

- ESOP provides a retirement vechicle for the employee. ESOP - Having an onwersnhip stake helps improve their morale. - Can benefit from NUA treatment

What type of entities can establish a 401K? Elidgibility for 401K plans? Vesting?

- Employers such as corporations, partnerships, LLCs, and proprietorhsip may establish one. Today tax-exempet entities can establish one. Governmental entities can no longer establish one today, but certain older govermental 401Ks prior to 1986 are grandfathered in. Self-employed individuals where only the owner runs the business may also establish one. - The standard rules are 21 one years old and worked for the emplyoer 1 year or make them wait 2 years (and/or 21years old) and fully vest them. This two year excpetion is not avaliable to 401K plans because an employee cannot be required to complete more than one year of service as a condition to participate in a 401K. Once elidgibile, they will enter on the next entrance date (usally 2 per year) - Ex. Ray Lowery, age 35, has taken a job at Extreme Soundz, which sponsors a 401K plan tht requires one year of service and has entrance dates on Jan 1st and July 1st. Dirk started work on Febuary 15th, 2019...he will be entering the plan on July 1st 2020. - Contributions to 401Ks consist of employee deferrals and possibly employer matching contirbutions. If the 401K is sponsored in conjunction with another profit sharing plan, contributions from these plans are considered separate from the 401K plan contributions. For vesting purposes, all employee defferals and earnings on them are 100% vested. Employer matching contributions, employer discresionayr profit sharing contirbutions, and the earnings on these must vest under a 2-6 graduated or 3 year cliff. - Total balance of Jared's 401K is 200,000. Of this balance, 60,000 is attributble to employer profit sharing plan and 40,000 is attributable to earnings on the employer profit sharing contributions. 39,000 consist of Jared's elective defferals and 21,000 is the earnings on these. the remainder consist of employer matching contributions and the earnings on the employer match. If the 401K plan uses a graduated vesting schedule and Wallace has completed two years of service, what is his vested balance? - Answer: 100,000 X 20%=20,000 + 60,000 + (40,000 X 20%)=8,000= 88,000 vested account balance.

Hardship Distributions: Maximum hardship distributon; under what circumstances can you take a hardship distribution?

- Harship distributions: Distributoins on account of hardship must be limited to the maximum distributable amount (total elective defferal contirbutions as of the date of distribuiton-the amount of previous distirbutions of elctive contributoins); thus, maximum distributable amount doesn't include earnings, Qualified Nonelective Contributins or Qualified Matching Contributions. - Ex. Hardu defers 5,000 of his annual compensation into the company 401K plan every year. He has been doing so for the last 10 years. Therefore, his maximum distributable amount is equal to his total elective defferals (50,000). If he had previously recieved a hardship distribution then the amount of that distribution would recuve the maximum distributable amount. - Hardship distirbuionts can only be provided if there is an immediate and heavy financial need (ex. paying funeral expenses). NOT buying a new TV or boat. Can be immediate and heavy even if it was reasonably forseeable or voluntairly incurred by the employee. Other things that constitute immediate and heavy are: medial, cost direcyly related to the purchase of a pricniple residence, tutin, room board, etc for educational expenses for the next 12 months of higher eduction for spouse, childen, or depensts; payments to prevent eviction. - Treated as immediate and necessary only to the extent that it takes care of the need, which includes an extra amount necessary to take care of any fed, state or local income taxes and/or penealty as a result of the distribution. - NOT treated as immediate and necessary if the need can be relieved from other resoruces avaliable to the employee, including resources of their spouse and minor children that are resonably avaliable. Property jointly held with wife would be include,d but property thats held by the child in an irrevokabel trust or under the Gift to Minors Act wouldnt be. - Employer can rely upon the employee's written word unless they have some other knowledge that the need can isntead be met from some other soruce - Hardship distirbutoins taxed as ordinary income and may be subject to 10% early withdrawl penealty. Those taking harship distributions are suspended from making future contirbutoins to the plan for 6 months.

Disadvantages to Employees

- Inherent lack of diversfication becuase ESOPs must invest primairly in the stock of the corporation.

ESOP transction: Leveraged ESOP

- Most ESOPs are leveraged because money must be borrowed to purchase stock from the principle shareholder. In a leveraged ESOP, the corporation makes tax deducitble contributions to the trust in the form of both princple and interest payments for the loan. Trust receives these funds and the trust, through a trustee, then repays the loan from the bank or other lender. When the trust purchases shares from the principle shareholder, these shares are normally pledged as security for the bank loan. The corporation and generally the princple shareholder (seller) garantee the loan, and the corporation's assets are pledged as collateral for the loan. - Prior to the allocation of the actual shares to the participant's account within the trust, the pledged shares are held in a seperate holding account and referred to as unallocated. As the trust repays the loan, an appropriate allocation of shares are withdrawn from the holding account and allocated to the account of the individual participant. Once withdrawn, its no longer pledged collateral for the debt.

Hardship Distributoin example: - K Mart maintains Plan Y, a profit sharing plan with a CODA tat does not permit particiaptn loans. However, it does provide elective contributions under the arrangement may be distirbuted to an elidgible employee on behalf of hardships. Amanada is an elidigble employee under Plan Y with an account balance of 50,000. Total amount of elective defferal contributions made by Amanda, who has no previously recieved a distribution from Plan T is 20,000. She request a 15,000 hardship distribution to pay 6 months of college tuitioin and room and board epxnes for her dependent child. At the time of the request, her sole asset that is reasonably avalibale if a savings account with a balance of 10,000. - Facts are the same as the previous example. Doug, another employee, has not previosuly recieved a distribution and has an account balance of 15,000. He request a 10,000 disitrbutoin from elective defferal contributoins to pay 6 mnths of college expenses for his dependent child. Doug makes a written repersenation to K Mart, and they have no knowledge to the contrary, that the need cannot be relieved otherwise.

- Paying the educational expenses within the next 12 months meets the requirement of being an immediate and heavy financial need. But since she has a savings account avalible, she may only recieve a distributon of 5,000 of her elective defferal contributoins plus an amount to pay any federal, state, or local income taxes or penealty as a result of the distrbuton. - Educatioanl epxneses within the next 12 months is still considered an immediate and heavy financial need, so since he has no other means of satisfying it, he can take a full 10,000 out of elective defferals, plus an extra amount to pay state, fedral, and local income taxes and any penealty.

Contributions and deductions: Plan establishment due date? Contribution due date? Contribuitons are discresionary, but funding must be _ and _; Contribution limit for employers

- Profit sharing plans must be estbalished by the end of the caldner year (December 31st) for which employer will eb contirbuting to the plan; contributions can be made until the due date of the company income tax return, including extenions. - Ex. Weylon corp wants to establish a profit sharing plan for the current year. It must do so by December 31st of this year. However, it can fund the plan after Deceber 31st....up until the due date of the income tax extenion, if applicable. - Contributions to profit sharing plans are discresionary, but funding must be substatial and reoccuring. A plan that doesnt make contirbutions for an extended period of time risk disqualification. There is no rquirement that a company must contribute to the plan in a year in which it had profits nor is there prohibition against contribuitons for years in which they dont have profits. - Contribution limit for employers is 25% of covered compensation (considered to be compensation of all elidgible employees). Therefore, if an employer's total covered compensation paid to employees is 1,000,000, then the largest income tax deduction that can be taken for contributions to the plan is 250,000. - In some cases, an employer may contribute more than the permitted 25%. In such a case, the emplooyer will currently deduct the 25% and may carry foward the contribution amount in excess of the 25% and deduct this in a future year. However, the amount carried foward when added to the contributin made for the future year cannot exceed 25%. Additonally, the employer is required to pay a 10% tax on the portion of the contribution that exceeds 25% of coverd comepnsation.

Cash and Deffered Arrangement (CODA) Plans...aka 401Ks

A Cash or deferred arrangement is a feature that can be attatched to qualified plans that adds a contirbutory element for employees. Allows employees to defer a portion of their compensation on a pre-tax basis to a qualified plan, thereby reducing taxable income. The earnings accumulate tax-deffered until distributed. Employee are given the option to recieve all or a portion of their salary in cash or to defer a portion. These are attractive to employers because they are a means of establishing a self-reliant qualified plan without requiring employee contributions. Employers can still provide contirbutions, usally in the form of a match based on the employee's defferal, but, as with all profit-sharing plans, this is discresionary.

Combined Defined Benefit and Qualified Cash or Deffered Arrangment plans: DB(k)

A DB(k) retirement plan incorporates, under one single plan with a single trust, a defined benefit plan combined with a 401K arrangment. For plan years from 2010 and later, A DB(K) plan can be established by a sponsoring employer who employs an average of 2 to 500 workers in the preceeding calender year and employs at least 2 workers at beginning of plan year. Must meet the benefit, contirbution, vesting, and nondiscirmination requirements under IRC. - Defined Benefit componet of DB(k): The minmum benefit provided by the defined benefit plan, must provide each participant with an annual retirement that is not less than the worker's final average (average of hgihest 5 consecutive years of compenstation) pay X the lesser of (1% X years of service) or 20%. They must be fully vested in defined benefit plan after 3 years of service. - Defined Contirbutoin part of the DB(k): 401K portion of the combined plan is considered an automic contirbution arrangement if it meets notice and election requirements and if the plan provides that each worker elidgible to participate is treated as having elected to participate in a contirbutoin amount equal to 4% of their compensation (unless they elect not to or elect a lower %). Emplyoer mathcing contirbutins must be in an amount equal to 50% of the employee elective contirbutions up to 4% of compensation. Participants must be immediately fully vested in any required matching contrbuiotns. After completion of 3 years of service, a participant is fully vested in any employer nonelective contributions. A DB(K) plan is deemed to satisfy the top-heavy rules as well as the rules for ADP and ACP. A Db(k) plan can help small companines redue plan costs and paper work rather than having a 401K and defined benefit. May also help to attract talented employees.

Cash and deffered arrangemnts and Roth contirbutiokns: 3 things that make somehting a designated Roth contribution, employer requirements for Roth 401K's (3); Solo 401k

A plan may permit an employee who makes elective contributions under a qualified cash and deffered arrangement to designate some or all of those contrbutions as Roth contributions. Designated Roth contributinns are elective contributions under a qualified cash or deffered arrangment that are: 1. designated irrevocably by the employee at the time of the cash or defferal election as designated Roth contributions that are made in lieu of all or a portion of the pre-tax elective defferal contributions the employee is otherwise able to make under the plan 2. treated by the employer as includible in the employee's gross income at the time the employee would have recieved the contribution in cash if they had not deffered it 3. Maintained by plan in seperate account - Same aollar limit that applys to employee pretax defferals also applys to Roth contirbutions in total. Thereore, employee can contribute all 19,000 to a Roth 401 K or regular pre-tax 401K plan but not to both. - Employer requirments for Roth 401Ks: If it offers a Roth feature, must also offer pre-tax contribution feature, seperate accounting must be maintained for Roth contributions( as part of this feature no matching and forfeiture allocations to Roth accounts), must satisfy any other requirements for CODA plans - Solo 401K: easy to adminster 401K for only owner businesses; fewer adminsitrtive cost and requirements. May be used by somone with no employees other than a spouse. Business owner must have at least a 5% ownership share.

Age-based profit sharing plan

Age-based profit sharing plans use both age and comepnsation as the basis for allocating contributions to an employee's account. An age-based plan is chosen when the employee census is that the owner or key employee is older than most or all other empllyees and the company wants to tilt the contribution to older employees. Concept of using an age-weighing formula in the allocation of benefits is based on a theory of comparable benefits for employees at nomral retirmenet age (65). Because emplyoees are closer to retirement age, current contribuitons must be higher than those of younger employees. If two employees perofrm the same duties and make the same salary, the older employee will recieve a greater contribution - Inital step in calculating the contirbution under an age-based profit sharing plan is to determine the present value of one dollar of benefit at the normal retirement age (65). Ex. For employee A, the following calcuation is perfomred (FV=1, N=10 [differnce in current age and normal retirement age], I=8.5, PMT=0, PV= 0.44229 [contribuiotn factor for this employee]; for employee A to recieve a benefit of $1 at age 65, the plan sponsor would have to contirbute 0.4423 today. - PV decreaes for younger age participants, relfecting the longer period to retirement. Ex. If C is younger than A they might need to contirbute 0.222 today isntead of 0.44229 to have $1 at retirement. - Second Step: PV factor X employee's compensation. For A this means 250,000 X 0.4423=110,571. Once this process is complete for each employee, the resulting allocation facotrs are used to prorate the total contribuiotn to the plan to the individual employees. Ex. Employee A's allocation over the total age-weighted compensation equals 79.42% (110,571/139,229); this is a signfiicantly higher percentage than to other emplyoees because he's older. The % of total age-weighted compensation is then multiplied by the total dollar contribution to the plan (68,000).

Stock Bonus Plans Allocation Method

Allocation methods for contributions to participant's accounts in stock bonus plans are the same as those for profit sharing. Only differecne is, stock is contirbuted instead of cash - Contributions are allocated based on a % of employee's compensation. Whenever its contirbuted, its valued by a qualified appriaser. Can also use age-based allocation methods, SS intergration, and new compariablity plan that bases compensation on employee class....and like profit sharing plans this is acceptable and doesn't discriinate in favor of HC

Plan Loans: Loan requirments (6)

Although distirbutions are genrally not permitted until retirement or termination, qualified plans are permitted to make loans to plan participants. However, plan loans must be made avaliable to all participants and beneficares on an effectively equal basis, must be lmited in amount, must be paid back within a certain time period, must bear a reasonable rate of interest, must be adaquetely secured, and adminstraotr must provide proper accounitng for the loans. Although any qualified plan could estblaush a loan provision, they are genrally found in CODA plans.

Practical uses of ESOPS and Nonreconition of Gain Treatment: qualified replacement securite, nonreconition of gain treatment

An ESOP is often used to buy the stock of the retiring or departing owner of owners of a closely held corporation in order to acheive deferral of federal income taxes. Establishment of ESOPS allow onwers of closely held corproations to sell all or part of their interest in the corpration and defer reconition of the capital gain, provided a number of requirements are met. - Nonreconiton of gains treatment: If all requirements are met, the sellers (usally former principals of the corporation) may reinvest the proceeds from the sale within 12 months of the sale into qualfiied investment securites and may carry over their former adjusted basis from the corporation into these securites. As long as they retain these replacement secuirites, no taxable event. If they later sell some or all of these replacement securites, then they are entitled to a new adjusted basis equal to date of death fair market value. , thus avoiding capital gains taxation altogher. Nonrecontion of gain treatment is only avalible for C corps - Qualified replacement securites: securites in a domestic corporation, including stocks, bonds, debentures, or warrants, which recieve no more than 25% of their income from passive investments. Stock from the corproation that issued the employer securites doesn't count.

Employee contributions to 401K: 6 total forms of cotnrbutions to 401K, employee elective defferal limit, Payroll taxes on elective defferals?; Employer deposits of elective deffrals....when are they due?; Employee after tax contributions (thrift plans)

Call forms of contributions to a 401K include: employee elective defferals, employee after-tax contributions, employer matching contirbutions, employer profit-sharing contirbutions, or employer contributions used to solve an ADP/ACP problem. - Employee elective deferral limit for 2019: 19,000 (25,000 if 50 or older) - Although elective defferals defer state and federal income tax, they still face payroll tax, of which employees and employers must pay they half of the payroll tax on elective defferals. - Employee elective defferals must be deposited and segregated from employer's assets by the earliest date that is reasonably possible. However, the segregation of the assets must be completed by the 15th day of the month following the month of the defferal from employee's compensation - Some 401K's permit employees to make after-tax contirbutions to the plan. These have been called thrift plan contirbutions and were utilized by those who wanted to save more than the amount allowed under the ADP test. Any earnings on these grow tax free until distirbuiton.

contributoins to ESOPs

Contributoins made by the corporation to the trust, contributing stock or cash so that they can buy new or exsisting shares. Trust also has the option to borrow funds to buy shares while the corpration makes cash contributoins to the plan so that the loan can be repaid. - Corpration can deduct contirbutoins made - Contributions still subject to the 25% limit of covered compensation. However, if employer's stock is obtained by virtue of a loan (leveraged ESOP), then the permissible deductions for the employer are increased for the interest on the loan....aka employer is allowed to deduct all interest paid on the loan over and above the 25% deduction of total elidgible payroll of plan participants - Corpations allowed further tax deductions for diviends paid on stock held by an ESOP under various circumstances

Employee Stock Ownership plans

ESOPs. a special form of stock bonus plan that reward employees with both ownership in the corporation and provide owners with substianital tax advantages. An ESOP is controlled through a trust. The sponsor company recieves tax deductions for contributons of stock from the corporation. ESOP then allocates the stock to seperate acocunts for benefit of individaul employee-participants

Participation in 401K: salary reduciton agreement,

Employee enrollment meetings are typiclly held after the establishment of a 401K to inform employees of the plan details and to encourage participation in the plan. These meetings are held in order to comply with ERISA requirements. The most popular form of election under a CODA is a salary reduction agreement in which employee agrees to reduce compensation in exchange for the elective deferral contribution to the plan. Salary reduciton agreement pay apply to current salary, to a salary increase, to a bonus comission, or other form of compensation for services. - Employee's election to defer is genrally made as a % of income or a dollar amount that will be contirbuted to the plan for the current year and usally directs the funds to be invested in a specific manner - Sam elects to reduce her 50,000 salary by 20% (10,000) if the funds are depositied in the 401K. She recieves a W-2 showing taxable compensation of 40,000 with the remaining 10 contributed to her 401K. Typically she will choose how funds are invested: stocks, bonds, cash, or other investments.

Employer contirbutions: mathcing contributions, stock bonus contirbutoins (nonelective employer contirbution); INCOMPLETE

Employers and plan sponsors often provide a matchign contribution based on the employee elective deferral contributions to the 401K plan. These matching contributions act as an incentive for employees to contribute more than they might have otherwiese contirbuted. - Ex. Rita elected to defer 8% of her 40,000 slary to a 401K plan. Her employer matches 50% of her deferral up to a maximum of 6% of compensation. For the year, Rita contributes 8% of her salary (3,200) and her employer contirbutes 3% (1,200) for a total contirbution of 4,400. - Ex. Joyce is 50 and is attempting to maximize her employee defferal contirbutoins. She has a 50,0000 salary and her employer matches dollar for dollar up to 4% of salary. Joyce defers 19,000 as well as the 6,000 catch up contirbution for a total of 25,000. Emplyoer match is 2,000 for a total of 27,000. Only 25,000 of her salary is subject to income tax, although payroll taxes are paid on the full 50,000. - Stock bonus contributions: Because 401Ks consist of a CODA attached to a profit sharing plan or stock bonus plan, employers may also make a contribution to the profit sharing (stock bonus plan). These contirbutoins are often referred to as the nonelective employer contirbution. Employee elective defferal contributions do not count against the plan contirbution limit of 25%, so large contirbutions can be made as nonelective profit sharing contirbution. Total contirbutions to qualfiied plans for the year is still limited to 56,000 per person for 2019. - See example 5.14

Contribitons to qualfied plans: Contributory or noncontirbutory? Mandantory funding requirements? Requirment if contirbutoins are made and plans that are an expcetion to this?

Employers are, of course, allowed to make contirbuitons. A pure profit-sharing plan is noncontributory (employees do not contirbute). Earnings are not subject to income tax until distirbuted. - No mandantory funding requirements. Contribuitons are made on a discreisonary basis each year. - If contribitons are made, they cant discirminate in favor of officers and highly compensated employees. This does not mean that contribitons to rank and file employees and the highly compensated have to be equal. - Some profit sharing plans, though nondiscimitory, that provide for larger allocations to shareholders, officers, and highly compensated employees. These include: age-based profit sharing plans, intergrated plans, and new comparaibility plans. These plans are still within the anti-discirmnation limits of the IRS.

Vaulation of emplyoer securites in ESOPs: pruposes for valuation

For tax deduction purposes, employee needs to know for NUA purposes, lender needs to know for if and how much to lend, if put or repurhcase option excercised, for financial statemnts and reports - Valuations should be guided by current appriasls by outside, indepdent valuation experts. - Publically traded stock easily indentifable for market price, where its tricker for closely held stock. - corpation can be penealized for any overstatement of valuation, inlcuding losing tax deduction for contirbutoin

SS Intergration examples: - Guyton Taxidermy sponors an intergrated profit sharing plan that provides for a 10% base contribution % and an excess contribution % of 15.7%. Two employees, Mike who has coverd compensation of 200,000 and Dave who earns 50,000. Intergration level is 132,900. How much of a contribution does each recieve?

If Dave earns 50,000 he would recieve a contirbution of 5,000 (10% X 50,000). Mike would have a total contirbution of 13,290 (10% X 132,900) + (200,000-132900=147,100 X 15.7%= 10,534.7)= 23,825

Stock Bous Plans and ESOPS

If a company doesnt have a whole lot of cash to distribute, a sotck bonus plan or ESOP might be a better option than a regular profit sharing plan. - Stock Bonus Plan may be established and maintained by an employer to provide benefits similar to theose of a profit sharing plan. While contirbutions are similar in terms of deductibility for the employer, a stock bonus plan is NOT depdent on profits. Contirbuotins to and distributoins from are usally in the form of stock. - ESOP: a qualfiied plan that invests primairly in "qualying employee securities," typially shares of stock in the corporation creating the plan.

Stock Bonus Plans and Voting Rights (how do they compare to the voting rights of stock in profit sharing plans?)

If a profit sharing plan consists of employer stock, the plan particiaptn genrally does not have voting rights in the stock held by the plan. However, participants in a stock bonus plan must have pass through voting rights on employer stock that is held by the plan on their behalf. "Pass Through" voting rights mean that voting rights of the stock pass through from the plan all the way down to the participant.....so the participant could vote the shares of stock allocated to their stock bonus plan account.

Forfeitures

If employee is terinated and they have funds in profit sharing plan that are less than 100% vested, employee forfeits the amount not vested. Forfeitures of profit-sharing plan may be used to reduce future plan contirbutions or be reallocated to remaining accounts. Such forgeitures allocations cannot discirminate in favor of HC employees. - Forfeitures can be allocated to remaining employees account balances or they could be allocated on current year compensation (same as normal contirbuionts to the plan) They cannot be allocated to participant's accounts that have aleady reached their annual additions limit for the year; therefore, an owner who has managed to have current contributions of 56,000 for 2019 made to his account will likely consider having forfeitures reduce future compensation to the plan since they cant personally benefit. Altenrativelu, forfeitue policy can be cobined with intergration or an age-based approach to assist the onwer in recieving the maximum contirbuiotn allowed. - Ex. Geroge has a 30,000 account balance and is 80% vested in his profit sharing plan when he terminates employment. His vested balance is 24,000 and he forfeits the remaining 6. It could be used to reduce future plan contirbutions, ex. 68,000 contribuiton in age-based profit sharing plan could be reduced to 62,000 or the 6 could be disributed to the remainig participatns with teh largest allocation probably made to owner.

Failing the ADP test: 4 alternatives to bring plan into complienace: corrective distirbutions, recharazterization, qualified nonelective contirbutions, qualfiied mathcing contirbuitons

If the ADP test is not met, that means there was an excess elective defferal contribution by the HC. This means either the HC deferred too much or the NHC deffered too little. The negative election (the latter) is often used to entice NHC to contirbute more. They have 2.5 months after the plan year for which the contributoinks were made or else a 10% penealty on excess deferral contribution amount. Four altenratives to bring plan into compliance: 1. Corrective distribtuions: this invovles distributing funds back to the HC. The leveling method uses the elective defferal of teh HC employee with the highest defferal, Emplyoee C is reducd by the amount necessary to reduce the deferral to the highest defferal to the next highest dollar defferal (see page 237). This process continues to reduce to the next highest deferral. If the total excess conributoins is not fully allocated, the process continues until the amount is distributed. Any earnings on these amounts are also returned. If distirbuted within the 2.5 months following plan year, returns are taxed that year; if after the 2.5 months, taxed the following year. 2. Recharacterizaiton: Can choose to rechaacterize excess deferrals as after-tax contributions. This must be completed within 2.5 months after the end of the plan year to avoid teh 10% tax. This could cause problems as far as failing the ACP test. 3. Qualfiied Nonelective Contirbutoins: Employer can make a qualflfied nonelective contribution to increase the ADP of the NHC comployees for purposes of passing the ADP test. This contribution is treated as if deferred by the employee and therefore is included in the calculation of ADP. Ex. ADP of HC is 6% and the ADP of NHC is 3.75%. To pass the ADP test, the NHC employees must have an ADP at least equal to 4%. Plan sponsor can choose to make a Qualfiied Nonelective contribution to all eldigible employees that will increase the ADP of the NHC to 4%. 4. Qualfiied mathcing contribuions: Like Qualified nonelective contribubtion, but isntead of being made to all elidgible employees, its made only to those elidgible employees who elected to defer during teh plan year. Eseentially, its an addtional match from the employer to increase the defferal % of the NHC. Because the contribtions are treated as being made by the employee, the QMC is 100% vested. Ex. ADP of NHC is 6% for the plan year and the ADP for the HC is 8.2% for the year. To pass nondiscimination test, plan sponsor needs to increase the ADP of the nonhighly compenstaed to 6.2%. Those who did no defer during the year would not recieve any QMC. -

ADP Test: its purpose and its two test; its calculation

Limits employee elective defferals for the HC employees based on the elective defferals of NHC employees. A qualified plan with a CODA does not fail the ADP test simply because all elidgible employees are highly compensated. - The ADP for elidgible highly compensated employees for the plan year is limited by the ADP for all elidgible employees for the proceeding plan year and must meet either of the following test: 1. Test one: ADP for the group of eligible highly compensated employees is not more than the ADP of all eldigble NHC X 1.25. 2. 200%/2% ADP tesT: The excess of the actual defferal % for the group of elidgible highly compensated employees over all the elidgible NHC is not more than 2 percentage points and the ADP for the group of elidgible HC employees is not more than the ADP of all other elidgible employees multipled by 2 - Generally, the current plan year ADP for the HC is tested against the ADP of the NHC for the prior plan year. The logic is, knowing the ADP for the NHc for the prior year will allow the HC to comply for the current year. Plans can, however, use the current year or the prior year; using the current year could give HC more a slighly higher deferral ceiling and provide more fleixibility in the event that the plan fails. In the first year of a 401K or the year that such a plan is established, there is obviously no prior year on which to base the ADP for HC. In the first year, therefore, the they will use 3% or the current year's defferals for the NHC. - Calculating ADP: Consider all elidigble employees, even those who chose not to defer anyhting. Next, calculate ADR for each of the elidgible employees by dividing the elective defferal contribtion by the employee's compensation. Once the ADR is determined for each employee, the amount of the ADP is calculated by averaging the ADRs for the employees within each group (NHC and HC). Once deterined for each group, the ADPs are comapred using the 1,25 test or the 200%/2% test. SEE EXAMPLE on PAGE 235. hb

Distribtions: Ways in which distirbutions can be made

May pay distributions in a lump-sum or in installments. By using lump-sum distirbutions, a company accelerates its rephurcase option, allows current employees who participate to share in potential growth of teh company, and protects former employees from absorving future losses in company value. - By Using installment distirbutoins, permitted to pay distribbutions in substianlly equal payments over a period not longer than 5 years. - Subject to minimum distirbution requriements

Distributions of Defeined Contirbiton plans: Different scenarios for which distirbutions may occur (4); Hardship distributions (ASK BUTLER ABOUT)

Participants of 401K's can generally take distirbutions from the plan following the same rules provided to other qualified plans. However, all CODA type plans, including 401Ks, provide that in addition to the normal distirbution options, plan participants may take dsitributions for hardships. All and all, dsitirbutions may occur after: - Retirment, death, or seperation of service - Termination of the plan without the estbalishment of another - Certain acquistions of the company or company assets - Certainn harships Distributions on account of any of these items are taxable as ordinary income to the extent the participant does not have an adjusted basis in the 401K plan and may also be subject to a 10% penealty.

Voting rights and ESOPs

Participats have full voting rights with public corporations, and those of private copanines may be liited to just voting on major issues, with the trustee voting the shares on their behalf for other stuff.

What is a profit sharing plan: What is it? What type of formula does it use? What CANT its fomrula do?

Plan established by employers to provide for the sharing in profits with employees. - Must provide a "defenite" forumla for allocating contributions among participants and for distribitng the funds in the plan after a fixed number of years, the attaintment of stated age, or upon the occurenace of some event like layoff disability, death, severance of employment, etc. - An example of a definete formula is if it provides an allocation in proportin to the basic compensation of each employee - A profit sharing plan does NOT qualify if contributions are made at such times and in such amounts that the plan discirminates in favor of officers, shareholders, or other supervisors.

New Comparability Plans

Profit sharing plan where contributions are made to an employee's account based on their respective classification in the compnay as defined by the sponsor. The contribution for the "owner" classificatio n will always be higher than that of the other classifications. The higher contribuitons are based on the concept of cross-testing, where contribuions to a defined contribuiton plan are determined to be nondiscriminatory in terms of benefits rather than contirbutions (since lanauge in IRS code is "qualfied plan contributions or benefits must not discirminate in favor of highly compensated employees"). Either contirbutions or benefits must be nondiscirmnatory..not both, - New comparability plan is qualfied if it conforms to one of teh two "minimum allocation gateways" in order to be considerd non-discriminatory 1. If each NHC has an allocation rate that is at least 1/3rd of the allocation rate of HC with highest allocatioin rate. 2. Each NHC recieves an allocation of at least 5% of the NHC compensation. - Additionally, if it doesnt meet any of the minimum allocation gateway requirments it can still meet non-discrimination requirements if it has "broadly avaliable" allocation rates or age-based allocation rates that are based on either gradual age or service schedule. - New comparability plans genrally more expensive to adminsiter, but they do allow for higher contirbutoins to owners.

Ellidgibility for profit-sharing plans; vesting; Distributions

Profit sharing plans are subject to standard elidgibility rules of other qualifie plans....greater of 21 and 1 year of service or 2 years (and/or 21) and 100% vested after 2 years. - follows 3 year cliff or 2-6 year graudated (20% after two years, 40% after 3, etc) - Genrally, no distribuions unless termination, hardhsip, disability, or retirement. Does permit in-service withdrawls after fufilled 2 years with the plan.

Portfolio Diversification: What can employees do to combat the lack of diversification?

Profit sharing plans are usally designed to invest in diversified investment portfolios. So, most of these plans are NOT exlusively invested in employer stock. For stock bonus plans, they usally are funded in 100% of employer's stock. This makes them "cash free" for the employer as they are predominately funded with the employer's stock in order to provide benefits without the need of cash. This results in an undiversified portfolio for participants. - To the extent that a stock bonus plan is sponsored by a publically traded company, Pension Protection Act of 06 requires the plan to allow participants to diversify their pre-tax deferrals, after-tax contributions, and employer contirbutions that have been invested in employer's securites. Must be offered a choice of at least 3 investment options, each of which must be diversified and have materially different risk and return characterisitics (usally means one type of stock, cash, and bond investment option) - All plan participants must be allowed to diversift the investment of their elective deferrals and after-tax contributions, and plan participants with 3 or more years of service must be allowed to diversify other types of contributoins made on their behalf.

Nondiscrimination Testing for CODA plans: ADP and ACP; employer's 3 options with regards to these plans

Qualfiied plans with a CODA must meet two special nondiscrimination tests known as the ADP test and ACPt test. Testing is NOT required anually. Employers have 3 options with regads to these test: 1. Peform ACP and ADP test and take corrective action if plan fails 2. Institute an automatic enrollment feature and comply with the new safe harbor 3. Comply with the old safe harbor

Diversifcation issues ....qualiied pariticapnts can force diversification of their holdings

Qualified participants may force diversfcation of their holdings if they are a qualified partiipant during the qualified eleciton period - "Qualified partiiaptn is someone who completed at least 10 years of participation under the plan and obtained age 55 - Qualfiied election period: 6 year perioid beginning the plan year in which the individaul first became a qualified participant - If they meet these requirments, must have either the oppriubinty to receive a disitrbutoin from the ESOP or alternaitve investment options for a % of the account. Must be offered a diversification option within 90 days after the close of each plan year, beginning with the year in which they become qualfiied. - Particiapnt may elect to diversify up to 25% of the account balance into nonemploer stock at this time. Election is diversible in cumautlve: up to 25% for first 5 years; and up to 50% for 6th year.

Allocations for Profit Sharing plan

SEE EXAMPLE 5-2. Profit sharing plan must provide a definte predetermined formula for allocating plan contirbutions to employee's accounts. The standard method is to allocate based on a % of each employees compensation. - Ex. An employee recives a contribution of 13.5% of their coverd comepnsation. This 13.5% was selected based on the amount the employer wanted to contribute to the plan, which was approximately 70,000. (it could have ranged from 0 to 25% of total compensation...aka a max of 131,250). Employee A is the owner and an employee...A recieves a contribution of 33,750, or almost 48% of total plan coverage. This method benefits highly comepnsaed more than non highly compensated in terms of absolute dollars but is nondiscriminatory with regards to percnetages of total contribution because contirbuitons are based on % of total compensation.

Permitted dia pairity (SS intergration)

SS retirement benefits are designed to rplace a greater % of wages for lower income than higher income workers. Private pension plans are permitted to provide larger benefits to higher paid workers than to lower paid workers in an attempt to reduce the gap in total wage replacement. A defined contribution plan intergrates its retirement benefit fomrula using the "excess method." - Permitted (SS intergration): is a technique or method or allocating plan contributions to employees accounts that provides higher contributions to employees whose compensation is in excess of the SS wage base for the plan year. Ex. All plan participants recieved a contirbuiont of 13.5% of their coverd compensation. However, a permitted disparitity formula provides an even higher % contribution for the highly compensated employees (those above SS wage base) than the NHC (those below SS wage base) - An intergration level is chosen by the plan sponsor (employer). This intergration level is usally the SS wage base (132,900) for 2019. With an intergrated fomrula, there are two contirbution rates establsihed...base contribution % rate and excess contribution % rate. Base rate is applied on income earned up to the intergration level but only up to the mximum coverd compensation limit for the year (280,000) for 2019. Excess rate is genrally 5.7% higher than base rate. Excess rate is limited to the lesser of twice the base rate of maximum difference of 5.7%. Ex. If base rate is 1%, excess rate is 2% (maximum dispaity 1%), If base rate 2%, excess rate is 4% (maixum dispairryy 2%) If base rate 8%, maximum dispairty is 13.7% - Althoguh the intergration level is genrally equal to SS wage base, it can be reduced to allow for larger amounts of income to be subject to the higher excess rate. However, as the intergrated level is reduced, so is the maximum differnce between the base rate amd excess rate. Higher income employees will genrally have higher contributions as the intergration level is reduced, but this may also result in addiotional contirbuiohns for other employees. If the intergration level is less than SS wage base, but more than 80% of the wage base, then the 5.7% is reduced to 5.4%. If the intergration level is less than or equal to 80% of SS wage base but greater than 20%, then the 5.7 is reduced to 4.3. At 20% or less rate remains at 5.7%. - Intergratin is genrally use when the owenr wants to increase or skew the contribitons toward higher paid employees or theirself. SS intergration is not considerd discriminatory becuase the employees who are recieving the excess contributions are not recieving SS retirement contribitons on their wages in excess of SS wage base.

Vesting and Profit Sharing Plans

Same as those for other qualified plans. 3 year cliff or 2-6 year graduated.

"Put Option"

Stock Bonus plans and ESOPS are required to provide employees with a "put option" (repurchase option) where the employer buys back the employer stock distirbuted at a fair market value.

Stock Bonus Plans and Distributions: Tax benefits to distirbutons of stock vs distirbutons of cash; Inservice withdrawls allowed with stock bonus plans?

Stock bonus plan distributions are generally made in the form of emplyoer stock. The distribution of stock provides addtional income tax benefits because there is a deferral of income on the stock's apprecated value until the stock is later sold. - Although its usally distributed to the employee, the plan may provide the employee with the choice of recieving the cash equivalent of the shares of stock at the time of the distributon. However, if the cash equivlant is recieved, this defferal of income tax on the stock's apprecation is lost. - Generally, stock bonus plans do not permit in-service withdrawls, except upon hardship, termination, disability, or retirement. They could permit it if employees have 2 years of participation in the plan, however. - Like other profit sharing plans, loans are avalble if the plan permits and the loans are avalible in a nondiscriminatroy manner. Generally employers do not allow them

Stock Bonus Plans: What is it? Differnces between profit sharing plan and stock bonus plan? Advnatages and disadvantages

Stock bonus plans are defined conitrbuiont profit sharing plans that allow employers to conitrbute stock to a qualified plan on behalf of their employees. As with all qualified plans, earnings within a stock bonus plan are tax deferred until the stock, its value in cash, or other securities are distributed from the plan. Because stock bonus plans are not subject to mandnatory funding, contirbutoins are made on a discresionary basis. However, when contirbutions are made, they must be nondiscirminatory. - It IS a varation of a profit sharing plan, but there are distrinct differnces: 1. Stock bonus plan participants must have pass through voting rights on employer stock held by the plan 2. Participants must have the right to demand employer securities on plan distributions. 3. Participants must have the right to demdn that employer repurhcase the employer's securities if they are not publically traded 4. Participants must be able to elect to have distirbutoins begin within one year of normal retirement age, death, or disability, or within 5 years for other employment modes of termination 5. Distributoins must be fully paid within 5 years of commencements of distributions - Emplyoers get an income tax decution for contributions, give employees a vested interest in the business, distributions not required to be fixed in an amount - Disadvantges to the employees: risk associated with a nondiversified portfolio, there entire portfolio would be loss if the corporaiton failed - Disadvantages to employer: Owenrship and control of corporation is dilluted as shares are given to employees. Has a greater impact on smaller, closely held corpoations. The required "repurchase" option (put option) would also depelete the cash of the corporation. This option allows a terminating employee the choice to recieve the cash equivlant of the employer's stock if the stock is not readily tradeable on an established makret.

Stock bonus plan's elidgibility rules

Subject to standard elidgibility rules of qualfieid plans: greater of 21 and one year of service; employee can do the wait 2 years and 100% vested option.

Taxation on stock distributions: Treatment of lump-sum distirbutons vs partial distirbutons

Taxation on the distribution of employer stock or securities from a stock bonus plan depends on whether the distirbution is a lump-sum distribution or partial distributon. - Lump-sum: ordinary income tax in year of distribtuon on FMV of stock at the time it was given. The NUA (excess of FMV at time of distribution over this amount) is NOT taxed at time of lump-sum distributon but rather as a long-term capital gain when the stock is ultimately sold - Partial distirbuton: If distributons of employer stock is made in installments (partial distributon), FMV of all employer securites distributed in the installment distribution attriubatle to employer contributions will be taxable as ordinary income. - If employer securites are rolled into a different type of account, NUA benefits are lost.

Us Governemnt Thrift Savings Plans

This is a plan for federal employees and service members. There are 3 contirbutions to the TSP: 1. Employee contributions: same as 401K salary deferrals and have the same limit, inlcuding catch up contribuiotns (19,000 or 25,000). Includes an automatic enrollment feature so that 3% contirbuiton is automatically deducted from salary and contirbuted to the plan. The negative election can be changed by the participant. 2. Agency automatic contributions: Employees covered by the FERS automically recieve contirbutoins of 1% of basic pay to the TSP. These contirbutoins are called Agency Automaitc Contirbuoitns are gnerally vest after 3 years 3. Matching contirbutoins: Employee defferals matched up to 3% of pay and 50% from 3-5%. If 5 or more defferal, match si 4% of compensation. Matching contirbuotins always fully vested. - total contirbutoins limited to the IRC limit of 56,000.

Actual contribution Percentage Test (ACP Test); Safe Harbor 401K plans; automatic enrollment feature for safe harbor plans; QACA

This is calculated the same as the ADP test, except instead of testing employee elective defferal contributions, the ACP test calculates a contribution based on the sum of the following: employee after-tax contirbutoins and employer matching contirbutoins. - After calculating ACP for both NHC and HC employees, the two are compared using the same scale as the ADP test. If it doesn't pass the ACP test, the same corrective measures are used to either reduce the ACP of the HC or increase the or increase the ACP of the NHC - Plans that provide a CODA are subject to the nondiscrimination rules discussed earlier as well as the top-heavy rules discussed in chapter 3. For many employers, the burden of these rules is costly, therefore the IRC provides a safe harbor provision whereby the employer is not required to comply with the ADP test, the ACP test, or top-heavy testing if it meets the safe harbor test. An election must be made 60 days prior to the begging of the plan year to convert a 401K to safe harbor status, and a minimum contirbution must be provided thats 100% vested (either a 3% minimum nonelective contribution or a matching contirbution); under the nonelective contirbution all employees would recieve a 100% vested contribution equal to 3% of their compensation from their employer. If they use a match instead of the nonelective contribution, the employer will match 100% of the first 3% of the employee elecitive defferals and 50% of employee elective defferals greater than 3% and less than 5%. SEE PAGE 240. Employer can also provide a fomrula that is at least as generous as this formula and satify the same habor provisions - Automatic enrollment for Safe Harbor plans: Same 401K's have an automatic enrollment/negative elction feature. Such plans provide that elective contirbutions by the employee are made at a specified rate unless the employee elects otherwise (aka electing not to or elcting to make defferals at a differnet rate. However, the employee must have an elective opporunity to recieve cash rather than contributions. This feature is used to increase deferrals of the NHC in an attempt to meet the nondiscrimination test applicable to 401K plans. - Ex. After one year of service, Adrian meets the elidgibility requirements for the ABC comapny 401K. The plan provides a negative election in which the employer will deposit 5% of participant's compensation to the 401K. If Adrian earns 40,000 the plan sponsor will contribute 2,000 to her compensation unless she says otherwise.

QACA: 3 things it must satisfy (automatic defferal, matching or nonelective contirbutoins, notic to employees)

Under PPA of 06, plans that contain an enrollment feature are elidgible for a new nondiscrimination safe harbor and are treated as meeting the ACP and ADP test and aren't subject to top heavy rules. This is called a Qualified Automatic Contribution Arrangement. Effective for plan years after 2007. Must meet certain requirments with respect to 1. Automatic defferal: Must provide that, unless employees says otherwise, the employee is treated as making an election to make elective defferals equal to a stated % of compensation not in excess of 10 and at least equal to 3% for the first year, 4% 2nd year, 5% 3rd year, and 6% 4th year and thereafter. Stated percentage must apply uniformly to all employees. 2. Matching or nonelective contirbutoins: genrally satifies if matching contirbution on each NHC equal to 100% of their elective defferals up to 1% of compensation and 50% of their elective defferals between 1 and 6% of compensation 3. Notice to employees: each employee elidgible to participate in the QACA must recieve notice of the feature informing the employee of such right to not have automatic contributoins made and or not in that amount and obligations and is wrriten in a manner to be understood by average employee. Must also explain how contirbutions made under the automatic enrollment arranagment will be invested in abscnese of an investment election by the employee. - Reduction of safe harbor contibutions: companines can reduce contributions if operating at an economic loss for the plan year or they give notice to employees of a reduction

Elidgible Automatic Contribution Arrangement

Under a EACA, a participant is treated as having elected to have the meployer maker contributions in an amount equal to a unifrom % of compensaton. This automatic election will remain in place until the participant specially elects not to have such deferral % made or elects a different %. There is no required defferal % and there is no required matching or non-elective contributoin as is required with QACA.

Stock Bonus Plans vs Profit Sharing Plans (valuation of employer stock in stock bonus plan): Why are valuations carried out by the corporation?

Valuations are performed to determine the value of the contribution for the corporation's income tax deduction purposes and the corporations financial statement, as well as to periodically inform the participant of the stock's value. The employer will track the value of the contributions and therefore the amount of ordinary income that the employee will have to reconize about distribution. - Valuations must be done by a neutral appriaser

Put options

When beneficary has the right to recieve a distirbutoin from the plan, the participant has the right to demand that the benefits be distrbuted in the form of employer securites. If they are not readily tradable on an estabished market, the partcipant has the right to require that the employer repurhcase the employer securies under a fair market valuaiton forumla. - Must be avalble during two time periods: one for no less than 60 days immediately following the distributoin and the second, if not excercised then, for an additional period of at least 60 days in the following plan year