FP 515 Module 3 Profit-Sharing and Other Defined Contribution Plans

When a profit-sharing plan is age-weighted, however, owner still limited to a dollar contribution of the lesser of

$57,000 (2020) or 100% of compensation with no more than $285,000 (2020) of annual compensation taken into account for plan contribution purposes.

If sold at any time for less than $100 per share, it would reduce his NUA amount. For example, sold shares at $90 per share. His basis was $25 per share, so his long-term capital gain from NUA is

$65 per share. Since Net Unrealized Appreciation (NUA) amounts are already tax advantaged, they do not receive a stepped-up basis if he dies holding the shares.

When he retired, had $1 million from his 10,000 shares in company stock. Made the NUA election to distribute the 10,000 shares directly into his non-retirement brokerage account with his Series 7 financial planner. Fair market value of stock contributed over the years $250,000.

$750,000 treated as NUA and is not taxed upon distribution. In the year of the lump-sum distribution, $250,000 taxable as ordinary income so adjusted taxable basis $250,000.

32, needs $10,000 for a primary residence. No other source of funds. 401(k) plan allows participant loans. Current value of deferral account $14,000, of which $9,500 is her aggregate vested balance. What is the maximum loan she can take?

$9,500, which is her aggregate vested balance. When the vested account balance is less than $20,000, loans up to $10,000 are available without regard to the half the vested balance rule.

Traditional profit-sharing plan qualified, so

Contributions must be made in a nondiscriminatory manner to not violate coverage rules. Treasury Regulations require contributions on a substantial and recurring basis, usually interpreted as three of every five years.

Traditional Profit-Sharing Plan Qualifying distribution because of financial hardship must meet following tests:

Financial needs test: hardship must be due to an immediate and heavy financial need; Resources test: must not have other sufficient financial sources.

Actual contribution percentage (ACP) test

Follows ADP procedures but uses employer-matching contributions and employee after-tax contributions in the calculations.

Automatic contribution arrangement (QACA) will automatically qualify with Section 401(k) nondiscrimination testing if it

Employer contributions become 100% vested after employee has completed no more than two years of service;

Elective deferrals not subject to income tax but are subject to

FICA and FUTA taxes. FICA is how Social Security benefits are funded. FUTA funds federal contributions to unemployment benefits.

Leveraged Employee Stock Ownership Plan ESOP (LESOP)

If borrows money in the plan's name, referred to as a LESOP and engages in a series of transactions: 1. Plan trustee secures a bank loan and purchases employer stock with it. Stock pledged as loan collateral.

Employers that sponsor qualified plans in which a portion of the plan accounts is invested in the employer's publicly traded stock must permit participants to

Immediately divest themselves of the stock and diversify proceeds into other plan investments. This rule not applicable to employee stock ownership plans that do not hold employee contributions.

In addition, under the PPA, non-safe harbor automatic enrollment arrangements will have additional time to test for

discrimination under the ADP or ACP tests and, if needed, make corrective distributions six months after the end of the plan year rather than the normal 2.5 months.

To satisfy the ADP test, a traditional 401(k) plan must meet one of the following two tests: first

1. ADP for eligible HCEs must not be more than ADP of all other eligible employees multiplied by 1.25.

The new comparability plan will only satisfy nondiscrimination rules if the plan design satisfies one of two minimum gateways:

1. Each eligible non-HCE must receive an allocation of at least 5% of compensation. 2. If provides an allocation rate of less than 5%, minimum allocation rate for non-HCEs one-third of highest allocation rate. If top 12%, minimum for non-HCEs 4% = 12% divided by 3.

Safe harbor rules for 401(k) plans: Employer can avoid ACP and ADP testing if it matches:

100% up to 4% of compensation for non-highly compensated employees or if it makes contributions of 3% or more of compensation for all eligible to participate, whether or not the employee chooses to participate.

To satisfy the ADP test, a traditional 401(k) plan must meet one of the following two tests: second

2. ADP for eligible HCEs must not exceed ADP for other eligible employees by more than 2%, and ADP for eligible HCEs must not be more than the ADP of all other eligible employees multiplied by 2.

LESOP is the only defined contribution plan that can fund more than

25% of employees' covered compensation. Normal contributions to a LESOP has the 25% limitation. But interest on plan loan can mean total contribution to the LESOP is more than 25% of employee compensation.

Second way to figure out self employment tax deduction:

80,000 x .0765 = 6,120. 1 - .0765 = .9235. 6,120 x .9235 = 5,652.

If ADP test fails, employer has two options: first

A corrective distribution can be made that will decrease the ADP of the HCEs, converting pretax dollars of the HCEs to taxable dollars.

This ordinary income recognition when the stock is irrevocably distributed outside of any possible retirement account establishes

A tax basis in the employer stock for the employee-participant that is recovered tax free as a return of basis upon sale of the stock from the person's normal brokerage account as opposed to an IRA or other type of retirement account.

If a tax-sheltered annuity (TSA) plan provides for employer-matching contributions, which of the following tests apply?

ACP only. ACP and ADP both apply to 401ks.

Age-based profit-sharing plan

Allocations to participants made in proportion to the participant's age-adjusted compensation. Cross-tested plan where compliance with the nondiscrimination rules is tested in accordance with benefits rather than contributions.

Compliance with the ACP test is only a concern if the employer

Allows after-tax contributions, automatically contributes to all eligible plan participants, or matches the employee elective deferrals. If the employer does not do any of these things, only the ADP test must be satisfied.

51, made an initial contribution of $10,000 to a Roth 401(k) in 2013. He made subsequent contributions of $6,000 annually for next four years. In 2020, took a $50,000 distribution from his Roth 401(k) to purchase a boat. Distro taxation?

Although took distro after five taxable years from date of initial contribution, did not meet one of the other requirements for a qualified distribution: made after 59½, or disabled, or for beneficiary or estate after death, or first-time home purchase.

A defined benefit plan that is not top-heavy could go up to 5-year cliff and 3-to 7-year graded vesting. But a defined contribution plan

And top-heavy defined benefit plans vesting is either 2- to 6- year graded or 3-year cliff.

Qualified matching contributions (QMACs) and qualified nonelective contributions (QNECs) count in

Application of annual additions limit, $57,000 in 2020. Employer QMACs and QNECs must be immediately 100% vested to the employee. QMAC and QNEC contributions made by the firm but counted as worker contributions.

At Company A, non-HCEs average 1.5% deferrals so HCEs for Company A can only average deferring 3%. This will incentivize the HCEs to make deferring into the 401(k) more attractive to the non-HCEs by providing matching funds, etc.

At Company B, the non-HCEs average deferring 4%. This allows the HCEs to average deferring 6%. At Company C, the non-HCEs average deferring 9%. This allows the HCEs to average deferring 10.25%.

Pension Protection Act of 2006 (PPA) Automatic Enrollment in Traditional 401k Plans after January 1, 2008

Automatic enrollment, or negative election, allows an employer to enroll employees without their consent, as long as have right to opt out.

As in all qualified plans, the employee is immediately 100% vested in all elective deferrals and their accrued earnings.

Because the participant has the right to receive cash compensation, a Section 401k plan is an exception to the constructive receipt rules of income taxation. Amounts contributed to the Section 401k plan are not taxable until withdrawn.

The only way shares instead of cash can be distributed is

By the former plan participant making the NUA election at the initial withdrawal.

Net unrealized appreciation (NUA) on employer securities if the distribution of the stock is in a lump sum

Can be deferred. Major tax advantage of a stock bonus plan

If sells shares of stock, his adjusted taxable basis for tax purposes will equal $25 per share and any gain over the $75 per share that is NUA will be subject to

Capital gains tax, short or long term, depending on holding period since the distribution to his brokerage account. On the other hand, if sells the stock for less than $25 per share, his NUA amount decreased by the loss.

Traditional Profit-Sharing Plan Contribution Allocations

Contributions usually allocated to individual participant accounts on a pro rata basis determined by a given participant's covered compensation in relation to the aggregate covered compensation of all participants.

New comparability plan: works particularly well when there is more than one owner of a business, with each owner of a substantially different age, thus precluding the age-based profit-sharing approach

Cross-tested profit-sharing retirement plan. Employee-participants divided into groups. Common group classifications job category, age, or years of service receiving a different level of employer contribution as a percentage of compensation.

Has Simplified employee pension (SEP). Makes $50,000 of self-employment income, what is maximum amount could contribute to a SEP this year? Self-employment tax $7,065 each year.

Deduct half of self-employment income $50,000 - ($7,065 ÷ 2) = $46,467.50. Second, adjusted contribution rate 20% (.25 ÷ 1.25) times adjusted self-employment income: .20 x $46,467.50 = $9,293.50.

Hardship Withdrawal Taxation

Distribution is taxable and a 10% early withdrawal penalty will apply for all distributions except un-reimbursed medical expenses over 10% of AGI. Education withdrawals still penalized unlike with IRA's.

If ADP test fails, employer has two options: second

Employer can make an additional qualified matching or qualified non-elective contribution for non-HCEs.

Age-based profit-sharing plan weightings

Each participant's compensation is weighted by an age factor. The employer contribution is then allocated to create an actuarially equivalent benefit at the normal retirement age under the plan for each participant. Older, get more.

To Receive Net Unrealized Appreciation (NUA) Treatment departing worker must

Elect to receive the stock in shares instead of cash. Shares received cannot be rolled over while cash received from the stock bonus plan can be rolled over to allow continued deferral of income tax.

401k Rules: Hardship withdrawals must come only from

Employee deferrals and cannot include matching contributions or earnings. Salary reduction elections must be made before compensation earned. Special safe harbor provisions can be used to comply with actual deferral percentage (ADP) tests.

Basic provisions of an IRC Section 401(k) plan

Employee elective deferrals are subject to FICA and FUTA taxes. Employer's deduction for a vested contribution to a Section 401(k) plan cannot exceed 25% of covered payroll, which is not reduced by employees' elective deferrals.

Traditional 401(k) plan is appropriate when continued

Employees relatively young, substantial time to accumulate; employers want to encourage employees to save for their own retirement. Also helps guard against older employees who stay too long because cannot afford to retire.

401k Limitations

Employer deductions for plan contributions cannot exceed 25% of the aggregate covered compensation of plan participants. The annual additions limit of $57,000 (2020) applies to individual participants

Actual deferral percentage (ADP) test pressures major decision makers to encourage rank-and-file to save for their futures

Employer must compare average percentage of eligible HCEs' pretax elective deferrals to the average percentage of eligible non-HCEs' elective deferrals. HCE: more than 5% ownership or compensation above $130,000.

Traditional 401(k) plan is appropriate when

Employer wants to provide a qualified retirement plan at minimal expense beyond existing salary costs. Plan can be funded entirely from employee salary reductions, except for installation and administration.

Traditional profit-sharing plan may be appropriate when

Employer's cash flow fluctuates; qualified plan with an incentive feature where account balance increase with employer profits; majority under 50 with time to accumulate or employees willing to accept investment risk in individual accounts

The two mandatory Safe Harbor minimum employer contribution methods are: Second

Employer-matching contribution of 100% on first 3% of non-HCE compensation plus 50% match on next 2%, total of 4% for those non-HCEs deferring salary into 401(k) plan. Matching for HCE's must not exceed matching for non-HCEs.

401k: Employer can make matching contributions or profit-sharing contributions. Can also commit itself to contribute a set amount even if the worker does not contribute.

Employer-matching contributions usually dollar-for-dollar match or $0.50 match for each dollar the participant defers, up to a specified limit.

Safe Harbor Section 401k Plan

Employers can avoid having to comply with special nondiscrimination testing, ADP and ACP tests, if plan meets one of the safe harbor provisions under IRC Section 401(k)(12) and the Treasury Regulations.

Automatic contribution arrangement (QACA) will automatically qualify with Section 401(k) nondiscrimination testing if it

Has automatic deferral percentages between 3% and 10% of employee compensation. If automatic deferral percentage less than 6%, automatic deferral percentage must be increased each year by 1% until reaching at least 6% of compensation.

Immediately sells some of his shares for $101 per share soon after shares arrived in his brokerage account. Will not be taxed on $25 per share from the sale as was already taxed as ordinary income on $25 per share on all 10,000 of his shares when the shares were originally distributed.

He has a long-term capital gain on $75 per share due to this being the Net Unrealized Appreciation (NUA) amount/share. He also has a short-term capital gain on $1 per share.

In this case, the first $34,000 is counted against

His contributions so no tax or penalty on $34,000. There are no conversions, so the rest of the distribution is earnings and thus subject to income tax and the 10% early distribution rules.

More than a year after the shares were distributed, sold some of his shares for $110. He is not taxed on $25 per share. The NUA of $75 per share is always considered long-term gain by definition.

His final $10 per share is also considered a long-term capital gain because he waited a year and a day or longer to sell these shares.

Under a SIMPLE 401(k), an employer does not have the option to change the percentage used for the matching contribution. Employers who begin using the 3% matching contribution do not have any option available to modify the company's contribution.

However, the employer can use the 2% non-elective contribution instead of the 3% matching contribution.

Summary of ADP Rules

If ADP for non-HCE: less than 2%, Maximum ADP for HCE is: 2 × ADP of non-HCE If ADP for non-HCE: greater than 2% but less than 8%, Maximum ADP for HCE is: 2% + ADP of non-HCE If ADP for non-HCE: greater than 8%, Maximum ADP for HCE is: 1.25 × ADP of non-HCE

Traditional Profit Sharing Plan Major Advantage

In-service distributions: participant can access the individual account balance prior to retirement. Not a federal mandate. Employer makes the decision whether or not to include this option when plan document is accepted.

Cross-Tested Plans

Increasingly popular. Such plans are a means of legally discriminating in favor of older, more experienced employees, who are generally also highly compensated employees (HCEs).

Traditional Section 401(k) plan also known as a qualified cash or deferred arrangement (CODA)

It is a qualified profit-sharing or stock bonus plan where participants have an option to contribute money on a pretax basis, known as an elective deferral, or receive taxable cash compensation.

Owner wants to retire and get his money out of his company. Should amend the profit-sharing plan, making it a LESOP. Then, as the LESOP trustee, can borrow $3 million in LESOP's name from a bank.

LESOP receives $3 million from the loan and uses it to buy owner's $3 million worth of stock and thereby becomes the owner of the company. Former owner receives the $3 million in cash and retires. Only a LESOP can borrow money.

Stock Bonus Plan disadvantages

Largely undiversified, or concentrated, portfolio dangerous if company goes bankrupt. Another disadvantage is dilution of existing ownership that occurs under both a stock bonus and employee stock ownership plan.

Many small businesses that wish to adopt a 401k plan will opt for safe harbor arrangement as

Less expensive to operate, does not need to be tested annually, permits high salary deferrals without annual discrimination testing. Hardship withdrawals and loans permitted. Like all 401k plans, maximum one year waiting period to be eligible.

Traditional Profit-Sharing Plan Annual Contribution Limits

Limited to lesser of 100% of employee compensation or $57,000 with only the first $285,000 of employee compensation taken into account. The deduction for employer contributions is limited to 25% of aggregate covered compensation.

Safe Harbor Rules Continued

Matching and non-elective contributions must be immediately 100% vested. Employer must provide notice to each eligible employee about rights and obligations under the plan.

The maximum amount that may be contributed to a 401k plan by the participant on a pretax basis is indexed for inflation.

Maximum elective deferral is $19,500 (2020). Participants at least age 50 by the end of the taxable year can make additional catch-up contributions of $6,500 (2020).

Safe harbor 401(k). Makes $100,000 and defers at least 5% in the plan. What are the minimum and maximum contributions employer could make to his safe harbor 401(k)?

Minimum: 3% nonelective contribution of $3,000. Maximum: Matching formula is 100% for the first 3% ($3,000) plus 50% of the next 2% = $1,000. Matching plan would cost company $4,000. Contributing 5% have total savings of 9%.

Two types of defined contribution plans that use mandatory annual contributions to help fund retirement:

Money purchase and target benefit pension plans. However, when most speak of a defined contribution type of qualified plan, referring to some form of discretionary profit-sharing plan.

Qualified Stock Bonus Plans Distributions:

Must be allowed to receive distributions in shares of employer stock that is publicly traded. If employer's securities not readily tradable on an established market, must be provided a put (sell) option available for at least 60 days after distribution.

Like the stock bonus plan, an ESOP provides the tax advantages of

NUA for employer stock distributed in a lump sum to employee shareholders. With cash from sale of stock, employer makes a cash contribution to the ESOP; thus, in selling stock to employees, employer is now making them owners of the business.

Because the new comparability plan is a form of a cross-tested plan, it may also be tested for

Nondiscrimination on the basis of benefits rather than contributions, thus permitting considerable flexibility in plan design. Goal to skew plan contributions in favor of highly compensated, key employees, management, and owners.

The two mandatory Safe Harbor minimum employer contribution methods are: First

Nonelective contribution of 3% of compensation for all eligible employees regardless of whether these employees are deferring salary into the Section 401(k) plan or not; or

38, president and 100% owner makes $120,000, employs five rank-and-file employees making $20,000 to $50,000 ages 28 to 56; turnover low. Wants qualified plan to maximize retirement benefits and minimize corporate income taxes. Advantages of adding a 401(k) provision to the profit-sharing plan?

Participants save money pretax. By maximizing her deferrals, owner can lower amount of the profit-sharing contribution allocated to other participants. 401(k) allows company to make contribution of 25% of covered compensation.

Traditional Profit-Sharing Plan hardship withdrawal can be made only for the following reasons:

Payment of un-reimbursed medical expenses or funeral costs; Purchase of a primary residence; higher education expenses for participant or family; Payment to prevent foreclosure on primary residence

A Section 401(k) plan must satisfy the general nondiscrimination tests

Percentage coverage, ratio, or average benefits percentage test. Must also satisfy special nondiscrimination tests: actual deferral percentage (ADP) test and actual contribution percentage (ACP) test. Costly/complex.

Safe harbor Section 401k plan

Permits high elective deferrals by employees without annual discrimination testing. Not subject to top-heavy plan provisions, but a mandatory minimum employer contribution required in which employee must be 100% vested immediately.

Stock bonus plan

Profit-sharing plan with one major difference from a traditional profit-sharing plan: employer contributions distributed from the plan made in the form of employer stock, not in cash.

Automatic contribution arrangement (QACA) will automatically qualify with Section 401(k) nondiscrimination testing if it

Provides an employer contribution to non-HCEs of either an employer match of 100% of first 1% deferred plus 50% of the next 5% or a 3% profit-sharing contribution in lieu of the matching contribution

Traditional profit-sharing plan

Qualified defined contribution plan with flexible, discretionary employer contribution provision. Employer's contribution purely discretionary, can even contribute when no profits from retained earnings, or per a formula related to a percentage of employer profits.

Although Roth IRAs have an additional reason for qualified distributions, up to $10,000 of first-time homebuyer expenses, a distribution from either type of Roth account after five years and over age 59½:

Qualified distribution. No type of Roth contribution is deductible. Roth IRAs are not subject to RMDs while original owner alive, but employer Roth accounts have normal RMD rules. Roth IRAs phased out, but not employer Roth accounts.

Profit-sharing plans permitted to invest plan assets in

Qualifying employer securities. They are not subject to Employee Retirement Security Act of 1974 (ERISA) diversification requirements for investments made in qualifying employer securities.

Automatic contribution arrangement (QACA) will automatically qualify with Section 401(k) nondiscrimination testing if it

Requires that, within 30 days prior to enrollment and annually thereafter, employees given automatic enrollment notice and a qualified default investment notice and allow employees not to make any contributions, if they so choose.

Under Net Unrealized Appreciation (NUA) tax benefit

Retirees not taxed on full FMV of employer stock when it is distributed. Instead, NUA taxed as long-term capital gain when stock sold. At time of distribution, recognizes as ordinary income an amount equal to stock value at time of contribution.

Second Step in Determining Max Owner-Employee Contribution: Owner-Employee can only contribute .2 not .25:

Schedule C net profit, business profit, $80,000 minus income tax deduction allowed of 1/2 self-employment tax of $5,652 = Net earnings from self employment $74,348 times .20 = Owner's contribution $14,870

52, sole proprietor, Schedule C net income $80,000 this year. Only plan participant. What is the maximum that can be contributed to the plan on owner-employee's behalf?

Self employment tax deduction two ways: Schedule C net income $ 80,000 times .0765 = 6,120. 80,000 - 6,120 = Self-employment income subject to self-employment taxes $73,880 times 15.3% Self-employment tax $11,304 divided by 2 = 5,652.

Any further appreciation of the stock subsequent to the time of the lump-sum distribution is then subject to

Short or long-term capital gain tax treatment, depending on holding period after lump-sum distribution. NUA portion of lump-sum distro will always be treated as long-term capital gain, regardless of holding period after lump-sum distro.

Pension Protection Act (PPA) includes safe harbor rules that would relieve a qualified automatic contribution arrangement (QACA) from

Special nondiscrimination testing, with lower required employer contributions than under the current safe harbor 401k plan rules.

Qualified stock bonus plans, some provisions:

Taxation of the capital gain on employer stock held in the plan may be deferred beyond the distribution date. Like profit-sharing plans, stock bonus plans allow for flexible employer contributions. Social Security integration not allowed in ESOPs.

An ESOP may not be integrated with Social Security.

That is because Congress determined that ESOPs already had enough advantages for the owners.

Because most employers do match employee elective deferrals, satisfaction of the ACP is also relevant for most employers sponsoring a traditional Section 401(k).

The ACP test has the same percentage rules as the ADP test.

Basic provisions of a 401k plan continued

There can be a two-year period of service requirement if the participants are 100% immediately vested. Employee elective deferrals may be made from salary or bonuses. Qualified profit-sharing or stock bonus plan.

401k: Point of qualified matching contributions and qualified nonelective contributions

To boost nonhighly compensated employee contributions so the contributions of the highly compensated employees do not have to be withdrawn from the retirement plan. Corrective distributions have no effect on the non-HCEs.

Four types of Section 401(k) plans:

Traditional Section 401(k) plan; safe harbor Section 401(k) plan; SIMPLE 401(k); and Roth 401(k)

Most common types of profit-sharing plan today

Traditional profit-sharing plan with a 401k feature, which is an arrangement within a qualified profit-sharing or stock bonus plan that allows an eligible employee to make pretax elective deferrals into it.

Employee stock ownership plan (ESOP)

Type of stock bonus plan in which individual participant accounts are invested primarily in employer stock. Advantage over every other type of qualified plan in that may borrow money in plan's name without violating prohibited transaction rules.

A stock bonus plan is appropriate for an employer with

Unstable cash flow who does not wish to deplete needed cash and, instead, wishes to make contributions in the form of listed or closely held stock. Employer contributes cash or employer securities per normal defined contribution rules.

The ACP test applies to

Voluntary employer contributions, employer-matching, and employee after-tax contributions, not pretax contributions or elective deferrals.

Actual deferral percentage (ADP) test only counts

What employees actually deferring into the plan. Does not count employer contributions. Catch-up elective deferrals are not considered. Not counting catch-up contributions favorable to owners, upper management as tend to be older.

With sporadic earnings, best choice is a plan from the profit-sharing category

While there are several types of plans in this category, entire pension plan category inappropriate so all "Be my cash target plans" (benefit in defined benefit, money purchase, cash balance, and target benefit plans) should be eliminated.

401k deferrals and matching contributions may not

be integrated.

Leveraged Employee Stock Ownership Plan (LESOP) Transactions Continued

With the cash from the stock sale, the employer makes a contribution to the ESOP. The employer's cash contribution is used to pay off the loan. The bank releases the stock to the ESOP.

SIMPLE 401k's vesting schedules are

not permitted. Employees are always 100% vested in employer contributions.