Chapter 5 (Profit-Sharing Plans, 401(k) Plans, Stock Bonus Plans, and ESOPs)

Accountants, Inc., has decided to adopt a profit-sharing plan that allocates profits in excess of $10,000 to participants by the ratio that the compensation for a participant bears to the compensation of all participants. Anne with $100,000, Bob with $70,000, and Cassie with $30,000 in compensation are the plan's only participants. How much will be contributed to each participant's account if Accountants, Inc., has $30,000 profit?

$20,000 in excess of $10,000 in profit Anne = 50% = $10,000 Bob = 35% = $7,000 Cassie = 15% = $3,000

The same special tax rules that apply to stock bonus plans also apply to ESOPs; however, there are additional special tax rules that apply only to ESOPs. What are they?

* Investment in employer stock* An ESOP must be invested primarily in employer securities. *Allocation formula* Allocation formula may not be integrated with Social Security since plan allocations must be based on total compensation. *Deductibility of contributions* Contributions are generally limited to 2% of the compensation of employees covered under the plan. However, a special rule provides that contributions used to repay interest are deductible without any percentage limit. *Diversification requirement* A special diversification requirement applies to ESOPs. Participants who have reached age 55 with 10 years of service are entitled to an annual election requiring the employer to diversify investment in the participant's account. *Deferral of gain for shareholder sales* To encourage sales of employer stock to ESOPs, the shareholder may elect nonrecognition of gain on the sale of the ESOP owns 30% of the company stock after the sale, the seller held the stock for 3 years, and the seller acquires replacement securities of another domestic corporation.

Because of the risks and other unique aspects of stock bonus plans, there are three additional special rules for these plans. What are they?

*Accelerated Distributions* Distributions from a stock bonus plan or ESOP must occur no later than one year after the end of the fifth plan year after the employee's separate from service, and no later than one year after retirement, disability, or death. The distribution must be in the form of substantial equal annual (or more frequent) payments over a period not longer than 5 years (except for certain large accounts) *Put Option* A participant that receives stock not traded on an established market must have the right to require that the employer repurchase the securities under a fair valuation formula. this option must be available for a minimum of 60 days following distribution, and, if the option is not exercised in that period, for an additional 60-day period in the following year. The participant must be paid over no more than 5 years. *Voting Rights* If the employer stock is publicly traded, participants must be permitted to vote on all issues. For closely held stock, participants must generally be given the right to vote on stock held for them in the plan on corporate issues requiring more than a majority of the outstanding common shares. Under most state corporate laws, very few issues require more than a majority vote, so this requirement may not be burdensome.

List the common 401(k) features.

*Salary deferrals* *Employer matching contributions* *Employee profit-sharing contributions* *Employee after-tax contributions*

How do stock bonus plans and ESOPs differ from profit-sharing plans?

- Both stock bonus plans and ESOPs typically invest plan assets primarily in the employer's stock (in fact, an ESOP is required to invest primarily in employer stock). Profit-sharing plans, on the other hand, are usually structured to diversify investments and do not concentrate investments in employer stock (even though they are legally permitted to do so). - Both stock bonus plans and ESOPs are chosen because they provide a market for employer stock. If the stock is purchased from the company, the purchase generates capital for the corporation and helps finance a company's growth. Profit-sharing plans, however, are not viewed as a way to finance company operations but are more concerned with providing tax-favored deferred compensation that can be used for retirement purposes. - Stock bonus plans and ESOPs are required to allow distributions to participants in the form of employer stock. Profit-sharing plans can allow this option, but often do not. This creates a distinct advantage for participants in a stock bonus plan or an ESOP because they receive a tax break inasmuch as the unrealized appreciated (gain in value) is not taxed until the stock is sold.

Even though they are not used as a pension vehicle, profit-sharing/401(k), stock bonus, and ESOP plans have become an important tool for employers to meet the need for an adequate pension. Why?

- They have become part of a comprehensive retirement package that combines these plans with other plans to fund for retirement needs. - They have become "pension-like" in their actual application (for example, regular reoccurring substantial contributions, even if the employer has no profits).

What are some of the organizational objectives that a profit-sharing plan serve?

- allowing discretionary contributions - permitting withdrawal flexibility (plans can be designed to allow employees to withdraw funds from participant accounts as early as 2 years after they were contributed by the employer. - controlling benefit costs - improving productivity - providing legal discrimination in favor of older owner-employees

What business attributes identify candidates for profit-sharing plans?

- cash-flow problems - less economic stability (new businesses/capital-intensive businesses) - young, well-paid key employees - no desire to ensure the adequacy of an employee's retirement income

To get the most out of a profit-sharing plan (so employees appreciate the value of the plan), the employer should consider taking what steps?

- clearly communicate the amount of the contribution and how it was derived - make regular and reoccurring contributions, if at all possible - provide clear and comprehensive benefit statements - identify circumstances that would result in larger employer contributions

What are the design features of stock bonus plans?

- employer contributions to the plan may be made in cash or directly in the form of employer securities, newly issues or otherwise - cash contributions and shares of stock are allocated to participant's accounts under a formula that must meet the same nondiscrimination requirements as the allocation formula in a profit-sharing plan - a stock bonus plan can also include a 401(k) salary deferral feature - distributions must be available in the form of employer stock, although the plan can give participant's the option to receive cash of equal value

Candidates for profit-sharing plans grade the following as "least valuable" when filling out a fact finder.

- maximizing benefits for long-service employees by accounting for past service - providing a specified replacement ratio

What rules are Roth accounts subject to that do not apply to Roth IRAs?

- non-qualifying distributions from a Roth account are subject to a pro rata tax rule - the 5-year rule (for determining whether a distribution is qualified) applies to each 401(k) plan with a Roth account - Roth accounts in a 401(k) plan are subject to the requirement minimum distribution rules

Candidates for profit-sharing plans grade the following as "very valuable" when filling out a fact finder.

- placing the investment risk on the employee - avoiding an annual financial commitment - allowing employees (including owner-employees) to withdraw funds. - motivating the workforce

What special rules apply to 401(k) plans?

- salary deferral contributions are subject to an annual limit - 401(k) salary deferrals are immediately 100% vested are cannot be forfeited - in-service withdrawals can be made only if an individual has attained age 59.5 or has a financial hardship - a nondiscrimination test called the actual deferral percentage (ADP) test applies to salary deferral amounts - plans with matching contributions and/or after-tax contributions are subject to the actual contribution percentage (ACP) test

How can life insurance be used by a profit-sharing trust to protect plan participants from an economic downturn in the event of the death of a key profit maker?

A profit-sharing plan can invest a portion of the plan's assets in key person life insurance, if the key person dies, the plan receives the proceeds of the policy, which is then allocated to the participants.

ABCO, Inc. has adopted a 401(k) plan whose participants, their compensation, and their percentage contributed are as follows: Abner (75% owner) - $150,000 - 8% Barbara (25% owner) - $80,000 - 8% Cindy - 60,000 - 5% Don - $40,000 - 5% Ewer - $30,000 - 9% Frank - $20,000 - 5% Gary - $20,000 - 5% In 2015, what will be the maximum deferral percentage for highly compensated employees under the actual deferral percentage test?

Abner and Barbara are highly compensated employees 5.8% average deferral from NHCE *Calculate maximum salary deferral for HCEs* *Test 1* - 5.8% x 1.25 = 7.25% *Test 2* - lesser of (a) 200% of deferral percentage for NHCEs (5.8% x 2 = 11.6%) or (b) the deferral percentage for all NHCEs plus 2% (5.8% + 2% = 7.8%) Therefore the maximum deferral percentage is HCE is 7.8%

Describe the advantage ESOPs have with regard to borrowing to fund the plan.

An ESOP can borrow to purchase a large block of stock at one time and the employer pays the loan off with the employer's tax-deductible contributions to the ESOP.

Describe the concern about the discretionary nature of the profit-sharing plan and the strategies to ensure than the plan is successful.

Because of the discretionary nature of a profit-sharing plan, it may be difficult to get employees to appreciate the value of the plan. To get the most out of the plan, the employer should clearly communicate the amount of the contribution and how it was derived, identify circumstances that would result in larger employer contributions, and be sure to provide clear and regular benefit statements to participants.

Dr. Jones, age 47, works for Mega Hospital and makes a $18,000 salary deferral election to the plan in 2015. If Dr. Jones has a medical practice that includes a 401(k) plan, what is the maximum salary deferral he can make in that plan?

Dr. Jones will not be able to make any salary deferral contributions to the 401(k) plan because the salary deferral limit applies to all 403(b), 401(k) and SIMPLEs in which an individual participates.

T/F: If a 401(k) plan has a Roth feature, participants may request that company matching contributions be made on an after-tax basis.

False A participant may not make a Roth (after-tax) election on employer matching (or profit-sharing) contributions.

T/F: Opening up eligibility to all employees should help a 401(k) plan satisfy the ADP nondiscrimination test.

False Non-highly compensated employees who are eligible to participate fail to do so make it harder to satisfy the ADP test. Making those who are unlikely to contribute ineligible to participate is one way to resolve this problem.

T/F: Salary reductions made under a 401(k) plan will reduce the amount of Social Security taxes that are owed.

False Social Security FICA taxes are based on the employee's unreduced salary regardless of whether a salary reduction is taken.

T/F: The employer must have current or accumulated profits in order to make contributions to a profit-sharing plan.

False The employer does not need to have profits in order to make contributions to a profit-sharing plan.

T/F: An IRA is a better tax-advantaged savings option than a 401(k) plan for most employees.

False The maximum amount that can be saved on a pre-tax basis in a 401(k) plan is $18,000 (for 2015) while the maximum deductible contribution to an IRA is only $5,500 (in 2015). Many individuals are not allowed to make deductible IRA contributions at all. Because of this, the 401(k) plan is almost always a better pre-tax savings vehicle.

T/F: Under a 401(k) plan, an employee may make salary reduction contributions of up to $53,000 in 2015.

False The maximum salary reduction that can be taken under a 401(k) plan is $18,000 (as indexed for 2015), not including after age 50 catch-ups. The limit described in the question applies in total to all types of contributions to the 401(k) plan, including salary deferrals, employer matching contributions, profit-sharing-type contributions, and after-tax contributions.

T/F: Under the technique known as leveraging, the employer borrows funds from the participants' ESOP account to pay future contributions to the plan.

False Under the technique know as leveraging, the plan trustee acquires a loan from the bank and uses the borrowed funds to purchase employer stock. Shares of this purchase stock are allocated to participant accounts when contributions are made to the plan. The employer is entitled to a deduction when contributions are made, as is the case for contributions to any qualified plan. Concurrently, the money that would normally be used to make contributions is used to pay off the bank loan. The result is that the employer receives the full proceeds of the bank loan immediately and pays the loan off through tax-deductible contributions to the ESOP.

T/F: Withdrawals can be made from a 401(k) salary deferral account after participants have been in the plan for two years.

False Withdrawals from a 401(k) plan are restricted to retirement, death, disability, separation from service, attainment of age 59, or financial hardship. The general two-year distribution rule for plans that fall into the profit-sharing category does not apply to 401(k) plans.

What is the maximum salary deferral in a 401(k) plan?

For 2015, the maximum salary deferral is $18,000 for individuals under the age of 50 and $24,000 for individuals who are aged 50 or older.

How might automatic enrollment help the participation rate in a 401(k) plan?

Forcing employees to elect out of the plan means that those who choose inaction will become participants in the plan.

What are 401(k) safe harbor contributions?

If an employer makes safe harbor contributions either to the 401(k) plan or other defined contribution plan of the sponsor, the plan does not have to satisfy the ADP/ACP tests, and is is also deemed to have satisfied the top-heavy requirements that normally apply. *Options* The following must be made for all eligible employees, regardless of how many hours they work during the year, and all contributions must be fully vested. 1) make a nonelective contribution for all eligible non-highly compensated employees in the amount of 3% of compensation 2) make a different matching contribution as long as the enhanced formula provides an aggregate amount of matching contributions at least equal to the aggregate amount of matching contributions that would have been provided under the basic matching formula (1) Only applies to plans that provide for automatic enrollment. 3) Can allow automatic deferrals of up to 10% of compensation, but as a minimum must require an automatic deferral of 3% for first year of eligibility; 4% for second year; 5% during third year; and 6% during 4th+ years.

How can an employer use life insurance to fund the repurchase obligation in an ESOP?

Life insurance on the lives of the key employees gives the plan a source of funding to purchase stock from terminating or deceased employees.

In addition to discretionary contributions and withdrawal flexibility, name several other strengths of a profit-sharing plan.

Profit-sharing plans promote fiscal responsibility because the employer is not tied to a set contribution. Profit-sharing plans can be used to improve productivity by linking contribution levels to the company's performance. Also, some employers will choose an allocation formula in the plan that directs a large portion of the contribution to the owners.

What are the disadvantages of a profit-sharing plan to the business and business owner?

Rank-and-file employees might perceive the plan as a hollow benefit if discretionary contributions are not made or if the lion's share of profits goes to the business owner

Explain the salary deferral limitations of a 401(k) plan.

Salary deferral amounts can never exceed a specified limit for a calendar year. For 2015, the limit is $18,000. Additional $6,000 allowed for individuals who have attained age 50 by end of current year. The limit applies across plans and across unrelated employers (it is an individual limit)

Under what circumstances may withdrawals be made from a 401(k) plan?

Salary deferral contributions can only be withdrawn upon termination of employment, attainment of age 59.5 or for a financial hardship. The plan could provide for more liberal in-service withdrawals for other types of employer contributions.

Why would employees be interested in a Roth 401(k) feature?

Similar to a Roth IRA, Roth 401(k) contributions can result in the tax-free accumulation of earnings. In some ways the Roth 401(k) is better than a Roth IRA since the contribution limits are substantially higher with a Roth 401(k) and all individuals, regardless of income, can make Roth 401(k) salary deferrals.

What happens if plans fail the ADP or ACP tests?

The employer has to correct the failure by the end of the following year to avoid plan disqualification. *Correction Approaches* 1) return contributions to the highly compensated (contributions and earnings attributable to the contributions) - make additional contributions for non-highly compensated employees - re-characterize excess contributions as after-tax contributions.

Explain allocation formulas in terms of a profit-sharing plan.

The formula must be definite and predetermined. The most common allocation formula allocates the total contribution so each participant receives a contribution that is the same percentage of compensation (ex. 3 or 5%)

Describe the types of contributions that can be made to a 401(k) plan.

The four types of 401(k) contributions are employee salary deferrals, employee after-tax contributions, employer-matching contributions, and employer profit-sharing-type contributions.

What is the effect of making a safe-harbor contribution to a 401(k) plan?

The plan does not have to perform the ADP non-discrimination test.

What are the reasons candidates choose stock bonus plans and ESOPs?

They give employees a stake in the company through stock ownership. Delayed taxation of gain on stock distributions. Enhanced cash flow because the employer makes a cashless contribution to the retirement plan. They help to create a market for employer stock.

T/F: A 401(k) plan with an employer matching contribution creates a retirement planning partnership between the employer and employee.

True

T/F: A candidate for an ESOP is similar to a candidate for a profit-sharing plan except that a candidate for an ESOP would like to create a market for employer stock and/or leverage the purchase of employer stock.

True

T/F: A hardship withdrawal will generally be taxed as ordinary income, as well as be subject to the Section 72(t) 10% penalty tax for those who have not yet attained age 59.5.

True

T/F: A plan that elects current year ADP testing can allow highly compensated employees to contribute more this year if the average ADP of the nonhighly compensated employee group improves this year

True

T/F: A popular use of the 401(k) plan is to include it as one of the benefits available under a cafeteria plan.

True

T/F: A profit-sharing plan can be set up to provide for discretionary employer contributions.

True

T/F: A profit-sharing plan is a defined-contribution plan that also falls within the profit-sharing category.

True

T/F: An employer that makes one of the qualifying safe-harbor contributions to a 401(k) plan does not have to satisfy the ADP test.

True

T/F: Candidates for a profit-sharing plan usually put contribution flexibility at the head of their priority list, usually opt for a low income-replacement ratio, and typically come from an organization or industry with an unstable cash-flow history.

True

T/F: Employee salary deferral contributions to a 401(k) plan are always 100 percent vested.

True

T/F: Employer-matching contributions can be fixed or can be made on a discretionary basis.

True

T/F: Employers can set a cap on the amount of profits that will be contributed to a profit-sharing plan.

True

T/F: If a profit-sharing plan is used, the organization's deduction for contributions to the plan is limited to 25 percent of aggregate participant payroll.

True

T/F: In 2014 and 2015, Sally owns 6 percent of the employer's stock and earns $65,000. Sally will be considered a highly compensated employee for purposes of the actual deferral percentage test for 2015.

True

T/F: In addition to salary deferrals, an employer can make both matching contributions and profit-sharing contributions to a 401(k) plan, or neither contribution to the plan.

True

T/F: In most profit-sharing plans, the board of directors is given the discretion whether or not to make contributions each year.

True

T/F: Integration with Social Security, age-weighting, and cross-testing are all allocation approaches that can be used to skew the employer's contribution to the older, more highly compensated employees.

True

T/F: It is prudent for a closely-held corporation with an ESOP to buy life insurance on the lives of its key employees as a way to fund the 'put' repurchase requirement.

True

T/F: One of the advantages of receiving a distribution in stock from a stock bonus plan or an ESOP is that the unrealized appreciation is not taxed until the stock is sold.

True

T/F: Profit-sharing plans can be designed to allow employees to withdraw funds from participant accounts as early as two years after they were contributed by the employer.

True

T/F: Stock bonus plans and ESOPs are defined-contribution-type plans.

True

T/F: The 401(k) plan is the only type of qualified plan that can be part of a cafeteria plan.

True

T/F: Under prior year testing, the average ADP of the nonhighly compensated employees in 2014 determines the average ADP of the highly compensated group in 2015.

True

T/F: Under the safe-harbor rules, a withdrawal to pay a child's college tuition is considered a safe-harbor event.

True

T/F: One of the primary strengths of a profit-sharing plan is that the employer can make contributions on a discretionary basis.

True An employer can also make a contribution to a plan whether or not there are profits.

T/F: Under the American Taxpayer Relief Act of 2012, a participant can elect to convert any type of 401(k) contributions into a Roth account.

True The participant will not be allowed to later undo the transaction through a re-characterization.

T/F: A plan that has employer matching contributions generally has to perform the ACP nondiscrimination test, which is quite similar to the ADP test.

True matching contributions and/or employee after-tax contributions

Umbrella, Inc., is a business with a cash flow that literally fluctuates with the weather. Umbrella, Inc., would like a qualified plan, despite its erratic cash flow. In addition, the owners of this small business would like to be able to withdraw their funds if they decide to expand the business. What type of qualified plan should Umbrella, Inc., have? Explain.

Umbrella, Inc., should adopt a profit-sharing plan. A profit-sharing plan suits the company's needs because it can be designed to work around the cash-flow problem by structuring the plan's contribution formula so the company makes contributions only in the year it has substantial profits. For example, a portion of profits in excess of $50,000 will be contributed to the plan. A second advantage that a profit-sharing plan holds for Umbrella, Inc., is the ability for participants to withdraw funds from their accounts as early as 2 years after they were contributed by the employer. By adopting this feature in the plan, the owners of Umbrella, Inc., will have access to most of their retirement funds when it comes time to expand the business.

Explain in-service withdrawals as it applies to 401(k) plans.

Withdrawals from the salary deferral account are restricted. No distributions from the salary deferral account will be made before separation from service unless the employee either has attained age 59.5 or has incurred a financial hardship.

stand-alone plan

a 401(k) plan that only provides for employee pre-tax contributions. The employer does not make any matching contributions or profit-sharing contributions.

automatic enrollment

a feature in a 401(k) or 403(b) plan that provides that eligible employees will be enrolled in the plan at a set default salary deferral rate unless the participant makes an affirmative election to forgo participation or to contribute an amount other than the default amount

cash or deferred arrangement (CODA)

a feature of a profit-sharing or stock bonus plan that allows participants to defer a portion of their compensation on a pretax basis

Roth 401(k)

a feature that allows participants to establish a designated Roth account by making a Roth election on some or all of their salary deferral contributions. If an employee makes a Roth election, salary deferrals will be made on an after-tax basis and qualified distributions will be tax-free similar to a Roth IRA.

designated Roth account

a feature that can be added to a 401(k), 403(b), or government sponsored 457 plan that allows participants to elect to make salary deferrals on an after-tax basis in exchange for tax-free withdrawals of qualifying distributions, similar to a Roth IRA

financial hardship

a financial need that is "necessary in light of immediate and heavy financial needs of an employee" and no other resources can be reasonably available to meet this end - medical expenses - purchase of a principal residence for the participant - payment of up to 12 months of tuition and related expenses for postsecondary education for a participant, his or her spouse, children, or dependents - payment of amounts necessary to prevent the eviction of the participant from his or her principal residence or from foreclosure on his or her mortgage - payments for burial or funeral expenses for the participant's deceased parent, spouse, children, or dependents - expenses for the repair of damage to the participant's principal residence

actual contribution percentage (ACP) test

an annual mathematical nondiscrimination test that applies to matching contributions and/or employee after-tax contributions in a qualified plan. The mathematical test works in essentially the same manner as the ADP test.

actual deferral percentage (ADP) test

an annual mathematical nondiscrimination test that applies to salary deferrals in a 401(k) plan. The test compares the level of salary deferrals of highly compensated employees with those of non-highly compensated employees. In order to pass the ADP test, one of two requirements must be satisfied: *the 125 requirement* The actual deferral percentage for highly compensated employees for the current year cannot be more than 125% of the actual deferral percentage for non-highly compensated employees for the previous year. * the 200%/2% difference requirement* The actual deferral percentage for highly compensated employees for the current year cannot be more than 200% of the ADP for non-highly compensated employees for the previous year, and the spread between the two cannot be more than 2%.

stock bonus plans

defined-contribution profit-sharing-type plans in which the participants have the right to receive distributions in the form of employer stock

leveraged ESOP

in order to have the funds to purchase large blocks of stock, an ESOP can borrow the funds and repay the loan with the contributions (deductible) that the employer makes to the plan each year.

highly compensated employees (HCEs)

individuals who are 5% owners in the current or previous year as well as individuals who earned over a specified dollar limit in the previous year ($120,000 for 2016). The employer can elect to limit this second category to the top-paid group which includes 20% of the workforce that is most highly paid.

How can employees access funds in a 401(k) plan?

participant loan programs are quite common because they allow at least limited access to funds without tax consequences hardship withdrawals make employer profit-sharing or matching contributions available to participants as in-service withdrawals

discretionary contributions

profit-sharing-type plans that provide the employer with the discretion to choose how much to contribute to the plan each year