Enhancing an age-weighted profit-sharing plan.

A profit-sharing plan that uses an age-weighted allocation method can significantly improve the level of benefits provided to a business owner over those based on more conventional allocation techniques. With proper planning, particularly in determining the appropriate interest assumption for the present value factor and the adjustments necessitated by the maximum benefit limitations, the age-weighted allocation method can be even more beneficial to the plan sponsor.

The age-weighted profit-sharing plan relies on a contribution allocation technique that evolved from the "cross testing" rules set forth in Sec. 401(a)(4). The cross testing rules are intended to help determine comparability of benefits between defined contribution plans and defined benefit plans. This is analogous to the ageweighted a]location in that the allocation resu]t, for testing purposes, converts to an equivalent benefit unit, similar to a defined benefit plan funded to normal retirement age on a unit credit basis.

A simple method for making the age-weighted allocation is as follows.

1. For each participant, obtain a "present value factor" (PV factor) equal to the participant's current compensation multiplied by 1/ {1 + i} to the "nth" power, in which "i" is an assumed interest rate {not less than 7.5%, nor more than 8.5%1 and "n" is the normal retirement age under the plan minus the participant's current age.

2. Divide the contribution to be allocated by the sum of the PV factors. This will result in an "allocation factor."

3. Multiply each participant's PV factor by the allocation factor.

4. The result is the participant's preliminary contribution allocation.

The schedule shown above illustrates the result of using the age-weighted allocation in comparison to a contribution of 10% of pay allocated in a straight compensation ratio. {This schedule {now modified principally by adjusting the interest rate} previously appeared in the Tax Clinic item, "Age Weighted Profit-Sharing vs. Target Benefit Plans," TTA, Aug. 1991, at 510.)

This schedule assumes an 8.5% interest rate {rather than, the previous schedule's 7.5 %}for arriving at the PV factor. This higher interest rate causes a greater allocation to the o]der participants as a percentage of salary, and a lower allocation to the younger employees. For example, in allocation A, the three key employees enjoy an allocation of 76.4% of the total contribution using the 8.5% interest assumption {versus 73.0% at 7.5% ).

The preliminary allocation shown in A uses an age weighting that can be compared to the straight ratio of compensation method. Allocation A is preliminary because it does not give effect to any maximum {Sec. 415} or minimum {Sec. 416)allocation requirements. Under A, employee 1 receives an allocation greater than that allowed by the Code, and several employees are tentatively allocated an amount below the topheavy minimum amounts. The Sec. 415 and 416 requirements are met in allocations B and C.

Allocation B provides for refinement of the preliminary allocation by adjusting the allocations, on an individual basis, to meet the requirements of Secs. 415 and 416. Allocation C illustrates a method of allocation keyed to the maximum allocable to the highest paid employee.

Allocation B simply allows for a maximum allocation of 9.5% of compensation by reducing employee l's excess amount and, 515 since the plan is top heavy, provides a minimum allocation of 3 % of compensation for nonkey employees.

Allocation C, on the other hand, is an effort to meet the requirements of Secs. 415 and 416 by maximizing the age-weighted leverage to employee 1 and by basing all other allocations on the maximum allowable to employee 1:

1. Determining the maximum allowable allocation to employee 1 as a percentage of the PV factor for employee 1; this will become the "allocation factor" for all other participants.

2. Applying the allocation factor to the PV factor for each participant.

3. Since the plan is top heavy, providing a minimum allocation of 3% of compensation for any participant.

Note that although the total amount allocated to employees 1, 2 and 3 increases by approximately 1/2%, the allocation to employee 1 increases by slightly less than 5%.

In addition to these allocation methods, a plan may also employ permitted disparity for integration with Social Security in pre-Tax Reform Act of 1986 parlance) as now set forth in Sec. 401111. In order to do so, the defined benefit permitted disparity rules must be followed. Note, however, that any additional allocation derived from the use of permitted disparity may be offset by the time and expense involved in additional nondiscrimination testing procedures.

Although the age-weighted formula can substantially improve benefits for business owners, it may create a morale problem for participants with very low allocations. This problem may arise, for example, even among highly compensated (but very young) participants. One possible way to ease this problem is to mix the age-weighted allocation with a more conventional formula, such as allocating 50% of the contribution on an age-weighted basis and 50% based on a straight compensation ratio.

The plan must also consider the possibility of older employees becoming participants. Although the cross testing rules require a consistent normal retirement age, a plan may require a five-year participation minimum. For example, the normal retirement age could be "the later of Age 65 or 5 years of participation." When using a five-year minimum, however, one must use the same PV factor in each year for any participant entering the plan within five years of retirement. In other words, the PV factor originally determined for such a participant at plan entry must be used in each year to retirement.

Finally, do not forget that the plan is a profit-sharing plan and as such can include the provision of a Sec. 401(k) feature. With a heavy emphasis on contribution allocations to the highly compensated, it is conceivable that the highly compensated would have minimal participation in the Sec. 401(k) portion, and thus facilitate passing the nondiscrimination tests even with relatively low participation among nonhighly compensated employees. An added Sec. 401(k) feature could also offset negative attitudes due to the low age-weighted allocation, and could be further enhanced by a modest fully vested matching contribution.

From Norman Gerber, CPA, Hood 03 Strong, San Francisco, Cal.