A Profit Sharing Plan is typically the first type of qualified retirement plan that an employer should consider. Profit Sharing Plans are among the many types of Defined Contribution Plans. All Defined Contribution Plans provide an individual account for each participant. Plan assets may be co-mingled for investment purposes. A participant's retirement benefit under a Defined Contribution Plan is based solely on the amount in the participant's account. This arrangement provides a certain measure of security for the employer maintaining the Plan because, unlike a Defined Benefit Plan, a Defined Contribution Plan does not promise any specific level of benefits; therefore, if the Plan suffers poor investment experience, the employer will not be called on to underwrite the unanticipated shortfall in funds necessary to provide guaranteed benefits. A necessary corollary is that participants in a Defined Contribution Plan bear the burden of poor investment experience and reap the benefit of favorable investment experience.

Profit Sharing Plan contributions no longer must be based on the current or accumulated profits of the small business. Since contributions may be totally discretionary on the part of the Board of Directors, Partners, or Proprietor, a Profit Sharing Plan is among the most flexible of tax favored employee benefits.

Amounts that are contributed to a Profit Sharing Plan are allocated to each participant based on the percentage of the total compensation of all participants that his or her individual compensation represents. However, if the Profit Sharing Plan is integrated with Social Security, then the allocation pertaining to the portion of a participant's compensation that is in excess of the Social Security wage base will be increased when allocating employer contributions to the participant's individual account.

Amounts that are allocated to participant accounts are held by the Trustee of the Plan, and the earnings and losses arising from Plan investments are allocated on an annual basis to the accounts of the participants. As noted, no guaranteed retirement benefit exists under a Profit Sharing Plan because a retiring participant is entitled to receive only the amount in his or her account, which may be more or less than the total of the contribution actually made to the account, depending on the investment experience of the Trust.

A participant's account balance also may change due to forfeitures. A forfeiture is the non-vested portion of a participant's account that is forfeited by the participant on his or her early termination of employment. Forfeitures may be reallocated among the remaining participants, thus increasing the accounts of those participants who continue their employment with the small business.

Section 404(a)(3) of the Internal Revenue Code limits deductible contribution to a Profit Sharing Plan to 15 percent of the covered compensation of all Plan participants. If a contribution of more than 15 percent is made during a given year, then the amount of the excess may be deducted in the next subsequent year(s) to the extent that the total Profit Sharing deduction for any such subsequent year does not exceed 15 percent of the compensation of all Plan participants for the given year.

A Profit Sharing Plan certainly should be considered by any small business, primarily because Profit Sharing Plans allow the amount of contributions to be based entirely on the profitability of the business and/or the discretion of the owners. For example, Profit Sharing Plans may be very useful for owners of new small businesses who desire to implement some type of qualified retirement plan but are unsure of exactly how successful the small business will be ? many small businesses experience wide fluctuations in income from year to year. Although the contributions to a Profit Sharing Plan may be discretionary, employers should be aware that Plan contributions must be substantial and recurring. In order to meet this test, the general opinion is that contribution must be made at least once every three years. In any event, however, the failure to make contributions because of insufficient profits will not disqualify the Plan.

We have many years of experience in the design maintenance of qualified pension and profit sharing plans. We would be pleased to show you how you can optimize your retirement savings through the use of such plans.

In a special type of Profit Sharing Plan, called an Age Weighted Profit Sharing Plan, contributions are allocated based on both compensation and age. The older participants are allocated a larger contribution as a percentage of pay than are younger participants.

Another special type of Profit Sharing Plan is called a New Comparability Profit Sharing Plan. Under such a Plan the allocation of contribution is flexible and can be designed to meet the company total compensation goals. This type of Plan must meet a complex, demographically based non-discrimination test. As an example, an older company executive might be able to be allocated the limit of 25% of pay up to $30,000 while the younger rank and file employees would be allocated a flat percent of pay which would be much lower. In this example the complex non discrimination test would determine the required flat percentage for the rank and file employees which is required to provide the older executive the desired level of contribution.

There is another special type of Profit Sharing Plan called a Cash or Deferred Plan (CODA), Salary Reduction Plan or 401(k) Plan. Under such a plan Participants must elect to make deductible contributions for their own benefit. Because the right to elect to contribute for highly compensated participants is tied to whether other participants elect contributions, this type of plan is more feasible for larger companies where there are relatively few highly compensated participants.

Pension Plans, as opposed to Profit Sharing Plans, must provide definitely determinable benefits. Pension Plan contributions are mandatory, irrespective of corporate profits, in an amount necessary to fund the benefits provided by the Plan. Further, in the case of Defined Benefit Pension Plans, forfeitures may not be used to increase the benefits of the individual participants, but must reduce the employer contribution.

As a general rule, Defined Benefit Pension Plans apply a greater share of the employer contributions for the benefit of older employees than for younger employees. This result occurs because the Defined Benefit Plan rules fix the amount of the retirement benefit, not the amount of the annual contribution that will produce the benefit. Where both individuals are to ultimately receive the same level of retirement benefit, the portion of each annual contribution that is required to fund the benefit of the older employee is larger than the amount required to fund the benefit of the younger employee, since there are fewer years in which to contribute the assets necessary to produce the older employee's benefit. In contrast, the Defined Contribution Plan rules fix the maximum amount of the annual contribution on behalf of each employee, but do not limit the amount of the ultimate benefit. Thus, employers may produce a larger retirement benefit for younger employees than for older employees in a Defined Contribution Plan because younger employees have more years in which to receive employer contributions before retirement. Thus, Defined Benefit Pension Plans are often very useful in a small business where older employees desire to defer a substantial amount of current income until retirement.

The annual contributions required under a Defined Benefit Pension Plan must be determined actuarially and based on factors such as the ages of the participants, the earnings of the trust fund, and inflation. Consequently, the cost for administration of a Defined Benefit Pension Plan may be higher than that of a Profit Sharing Plan or a Money Purchase Pension Plan.

A Target Benefit Plan is a Defined Contribution Plan that operates as a hybrid of a Defined Contribution Plan and a Defined Benefit Plan. Under a Target Benefit Plan, benefits are defined by using formulas similar to those that are incorporated in Defined Benefit Plans. As in the case of Defined Benefit Plans, employer contributions are determined actuarially. However, as with Defined Contribution Plans, the contributions and the earnings and losses thereon are allocated to the individual accounts of the Plan participants, and actual pension are based on the amounts in the respective individual accounts as of retirement. Thus, a Target Benefit Plan is simply a Pension Plan that sets a "target" benefit that ultimately may or may not be funded by the amount in an individual participant's account. The employer has an obligation to make the contribution required by the Plan formula; the employer has no obligation to make sufficient contributions to produce the actual benefit targeted. The targeted benefit provided under the Plan is not a promise to the participant of a fixed benefit since the ultimate benefit that will be paid is simply that amount that is actually in the participant's account.

A Money Purchase Pension Plan contains a formula that determines the amount of employer contribution to the Plan. The amount of contributions is not subject to the employer's discretion and may not be made a function of profits. Amounts contributed to the Plan are allocated to participant accounts and no guaranteed benefits exist. Consequently, on retirement, the participant will be entitled only to the benefit that can be purchased with the "money" in his or her account; hence, the term money purchase.

Money Purchase Pension Plans typically provide for a contribution based on a stated percentage of a participant's annual compensation. The contribution required under such Plans may be integrated with Social Security benefits.

In an Age Weighted Money Purchase Pension Plan, contributions are allocated based on both compensation and age. Older participants are allocated a larger contribution as a percentage of pay than are younger participants.

As noted, Target Benefit Plans, Money Purchase Pension Plans, and Profit Sharing Plans are all classified as Defined Contribution Plans because benefits are determined by the participant's individual account balance. Under Section 415 of the Code, the annual additions that are made to all such Plans maintained by one employer on behalf of any participant must be aggregated. The aggregate maximum annual addition must not exceed the lesser of (1) 25 percent of the participant's compensation for the year, or (2) $30,000 or, if greater, one quarter of the dollar limitation for Defined Benefit Plans.

A combination of Defined Contribution Plans, each requiring contributions of less than the Section 415 limit, often provides an excellent method of maximizing benefits while also maximizing flexibility. For example, if only a Profit Sharing Plan is maintained, the maximum deductible contribution is limited to 15 percent of compensation paid during the year. Therefore, while the Profit Sharing Plan provides flexibility, the contribution ceiling under Code Section 415 cannot be fully utilized. On the other hand, am employer could adopt only a Money Purchase Plan having a contribution formula that itself requires the maximum contribution allowed by Section 415; however, the full contribution to the Plan will always be required, even in "lean" years, since Money Purchase Plan contributions are mandatory. If, in a given year, the small business experiences cash flow problems and is unable to make the required contribution, a nondeductible excise tax equal to 10 percent of the deficiency will be imposed under Section 4971 of the Code. Moreover, if a timely correction of the deficiency is not made, an additional nondeductible excise tax equal to 100 percent of the deficiency will be imposed. However, exemptions to the funding requirements may be granted by the IRS in situations involving unforeseen business hardships.

To escape these restrictions on single Plans, a small business may adopt a Money Purchase Plan requiring the contribution of that part of the total benefit that the employer feels reasonably certain could be paid even in cash?lean years, in tandem with a totally discretionary Profit Sharing Plan. This combination overcomes the inflexible funding requirement created by exclusive use of a Money Purchase Plan, yet it avoids the barrier on making a full "25 percent of compensation" employer contribution that arises with the exclusive use of a Profit Sharing Plan. Also, in this scheme, the Money Purchase Plan may be fully integrated so that the employer always will receive the full benefit of integration even for those years in which substantial contributions are not made to the Profit Sharing Plan.

If a small business employer wants to defer more than the 25 percent of compensation or the $30,000 limit applicable to Defined Contribution Plans, then the only alternative is to adopt either a Defined Benefit Plan or a combination of Plans that includes both a Defined Benefit Plan and a Defined Contribution Plan.

Any combination of Defined Benefit and Defined Contribution Plans is subject to a complex mathematical limitation imposed by Code Section 415(e). Basically, an employer is prevented by this subsection from adopting both (1) a Defined Contribution Plan or Plans providing the maximum contribution, that is 25 percent of compensation or $30,000, and (2) a Defined Benefit Plan or Plans or providing the maximum benefit, that is, $90,000 or 100 percent of the participant's average compensation for his or her high three years. Instead, as the percentage of the Defined Contribution maximum that is provided by a Defined Contribution Plan increases, the percentage of the Defined Benefit maximum that may be provided by a Defined Benefit Plan decreases.

Effective for Plan years commencing after 1988, TRA '86 replaces the three statutory vesting schedules (10-year cliff vesting, 5-15 vesting, and rule of 45) with two more restrictive schedules. The first of these, five-year cliff vesting, requires that a participant be 100 percent vested on his or her completion of five years of service. The second schedule is 3-7-year graded vesting. The 3-7-year graded schedule requires that participants be 20 percent vested after completing three years of service and receive an additional 20 percent for each year thereafter until 100 percent vested after seven years of service.

The vesting schedule is obviously an inducement to employees to continue employment until they are fully vested. If a participant's employment is terminated before he or she if fully vested, benefits that are forfeited either will be distributed to the advantage of the other participants under the Plan or will serve to reduce the employer contributions. Forfeitures may be substantial if the employee turnover rate is high.

Assuming that the accelerated vesting schedules applicable to top-heavy Plans are not applicable, the 3-7-year graded vesting schedule should be adopted for most small businesses, unless a shorter vesting schedule is desired. The 3-7-year-graded schedule should provide a sufficient deferral period during the first three years of employment to eliminate short-term employees from the vesting rules, and the schedule should provide vesting that would induce employees to remain with the employer for at least four years of employment.

A Plan is top-heavy if more than 60% of accrued benefits are attributed to key employees. Most plans of small companies tend to be top-heavy when the owners participate.

A top-heavy Plan must vest accrued benefits derived from employer contributions according to one of two vesting schedules.

1. Three-year cliff vesting, in which the benefits of an employee who has three years of service are 100 percent vested.

2. Six-year graded vesting according to the following chart:

A top-heavy Defined Benefit Plan, must also provide an annual retirement benefit derived from employer contributions to non-key employees that at least equals the lesser of (1) 2 percent of the participant's average compensation per year of service, or (2) 20 percent, multiplied by the employee's average annual compensation during his or her highest consecutive five years. Social Security benefits originating from an employer's contribution to the Social Security system cannot be integrated to reduce the minimum benefit.

For a top-heavy Defined Contribution Plan, the employer must contribute on behalf of non-key employees at least the smaller of (1) 3 percent of the employee's compensation, or (2) the highest percentage contribution made on behalf of any key employee. Social Security benefits arising from employer contribution to the Social Security system cannot be used to reduce the minimum contribution.