A new look at profit-sharing plans in 2002. (Employee Benefits & Pensions).

Many small employers (particularly professional service firms) want to maximize their deductible contributions to qualified retirement plans. To maximize these contributions employers commonly offer "paired" plans, consisting of a money purchase pension plan (MPPP) and a profit-sharing plan.

Both types of plans are defined contribution plans, providing participants with individual account balances. A major distinction is that MPPPs provide a fixed contribution, generally tied to plan participants' compensation, Eligible participants receive a fixed percentage of their compensation as an employer contribution, regardless of the plan sponsor's financial performance.

Profit-sharing plans typically allow for a discretionary employer contribution. Generally, the plan sponsor's board of directors determines annually whether to make a profit-sharing contribution for a particular plan year, as well as the contribution amount.

Paired plans may consist of an MPPP that provides a fixed contribution of 10% of compensation, along with a profit-sharing plan that allows the employer to contribute a discretionary amount ranging from 0%-15% of participants' compensation. Through the use of paired plans, employers receive income tax deductions for contributions to both types of plans, as well an ability to maximize the annual addition limits (Sec. 415) for plan participants in the years they maximize profit-sharing contributions.

The maximum deductible profit-sharing contribution (Sec. 404) for plan years beginning before 2002 was generally 15% of eligible compensation. The annual addition limit for individual participants was the lower of 25% of compensation or $30,000 (indexed to $35,000 for plan years beginning in 2001). The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) increased both the employer profit-sharing plan deduction limit and the individual annual addition limit, making it easier for employers and participants to maximize their qualified retirement plan benefits through a single profit-sharing plan.

Under the EGTRRA, effective for plan years beginning after 2001, the profit-sharing plan deductible contribution limit increased to 25% of eligible compensation. While many employers achieved this contribution level previously through paired plans, they now may take an income tax deduction of up to 25% of eligible compensation by making only a discretionary profit-sharing contribution.

For limitation years beginning after 2001, the individual annual addition limit is the lower of $40,000 or 100% of compensation. Thus, a profit-sharing plan that provides a discretionary employer contribution up to 25% of compensation is well within the annual addition limit.

Two additional favorable EGTRRA retirement plan provisions allow employers and participants to increase the plan contribution level over that of previous years. First, the maximum compensation that an employer may consider for an individual plan participant (Sec. 401(a)(17)) increased to $200,000 for plan years beginning in 2002; for 2001, this limit was $170,000. Thus, an employer with participants earning $200,000 or more can maximize these participants' annual additions to the plan through a 20% profit-sharing contribution ($200,000 X 20% = $40,000).

Second, for plans that contain Sec. 401(k) salary deferral features, the participants' elective deferrals no longer count toward an employer's deduction limit. Thus, as long as the employer monitors plan participants' annual addition limits, participants can now make salary deferral contributions not subject to income tax, and the employer can still provide a profit-sharing contribution of up to 25% of compensation.

An outcome of these favorable provisions is that many employers are choosing to merge their existing profit-sharing plans and MPPPs. To do this, employers must generally take the following steps:

1. Give at least 15 days advance notice to participants that MPPP contributions will be frozen (ERISA Section 204(h)). Along with this notice, employers may want to include a memo indicating their intent to provide future benefits only through the profit-sharing plan.

2. Update and restate both plans to meet GUST and EGTRRA requirements.

3. Execute a board of directors' resolution and plan amendments to merge the MPPP into the profit-sharing plan.

4. Prepare and furnish to participants an updated summary plan description or material modification summary.

5. Merge the plan assets and file a final Form 5500, Annual Return/Report of Employee Benefit Plan, for the MPPP within seven months of the merger.

6. Review and update the administration of the profit-sharing plan to ensure that certain protected benefits, such as the joint and survivor distribution requirements applicable to pension plans, are preserved for the merged assets.

One outstanding issue on which the IRS recently provided guidance is whether to fully vest participants in their MPPP balances. Full vesting is a requirement on plan termination. In Rev. Rul. 2002-42, the Service ruled that full vesting is not required solely because of a merger of an MPPP into a profit-sharing plan. Of course, employers are well advised to review the facts of this ruling to determine whether it applies to them.

In summary, employers may achieve several advantages by merging their MPPP and profit-sharing retirement plan, including:

1. Lower cost of administering a plan, due to maintenance of only one plan document, filing one Form 5500, etc.

2. Simplified reporting to plan participants, who receive only one benefit statement, summary annual report and summary plan description.

3. Potential cost savings through the investment of plan assets in a single trust.

4. Replacing a required annual pension contribution with a discretionary profit-sharing contribution that may be adjusted based on the employer's financial performance during the year.

As with any substantial changes to qualified plans, employers should consult with a qualified ERISA attorney or other adviser to ensure that they satisfy the qualification requirements.

FROM DAVID S. HORVATH, CPA, OAK BROOK, IL