Accounting

A. Introduction
There are many types of profit-sharing plans. Basic ones include cash, deferred, and combination plan options. However, these types can either be a traditional plan, social security integrated plan, age weighted plan or new comparability plan. Moreover, Solo K plans, 401(k) plans, and profit-sharing401(k) plans also exist. No matter the type of profit-sharing plan that an employer or employee chooses, each plan has its own rules and requirements when it comes to taxes. The purpose of this research is to discuss the taxation of profit sharing plans.
B. Assessment
1. An overview of profit sharing plans
Profit sharing plans have tax deductible employer contributions. The contributions and investment earnings have deferred taxes until they are withdrawn. Employers are obligated to include employees over the age of 21 in the plan that has at least 2 years of employment with them. In 2007, tax deductible contributions of 25 compensation, up to 225,000 or up to 45,000 for the employer and each eligible employee (Merrill Lynch Wealth Management, 2009, p. 2).
While the employee cannot contribute to his or her profit sharing plan, the employee may contribute loans to the plan. One of the benefits of having a business is that the employer can deduct employer contributions as a business expense. Those eligible can also opt to take a 50 nonrefundable income tax credit of the first 1,000 administrative and retirement education expense incurred in each of the first three years of the program (Merrill Lynch Wealth Management, 2009, p. 2).
All employers participating in the profit sharing plan and have over one participant in the plan, need IRS Form 5500 to file. If the employer has only one participant in the plan, they should file the form once the plans assets exceed 200,000. The plan can be vested. It can also have a vesting scheduled (Merrill Lynch Wealth Management, 2009, p. 3).
Vesting of the plan depends on the type of plan the employer selects. Each plan is either 100 vested or has a vesting schedule. In order to establish a profit sharing plan, the employer must adopt it by the end of the businesss fiscal year (Merrill Lynch Wealth Management, 2009, p. 3). Regardless of whether the employer has a small business or a large corporation or the employee works for a large or small company, profit sharing plans should be understood completely as tax deductions to not apply to everyone at the same time.
2. Basic profit sharing plans
Traditionally, there are three basic types of plans. In fact, they are cash, deferred, and combination plans. A cash plan has profit paid directly to the employee as cash, checks or stock. It is taxed as ordinary income. The deferred plan has delayed or deferred payments where the contributions go to the account that each individual employee has setup. Benefits-and any investment earnings accrued-are distributed at retirement, death, disability, and sometimes at separation from service and other events (6. Profit-Sharing Plans, n.d., Deferred plan, para. 1).
A combination plan allows the employee to defer all or a portion of the contribution allocated to the plan. Sections of the contribution that are deferred go directly into the employees account. It is tax free, along with other investment earnings, until it is ready to be withdrawn. The cash amount taken is immediately taxed as ordinary income. For tax purposes, the Internal Revenue Services (IRS) (sic) qualification of profit-sharing plans is restricted to deferred or combination plans (6. Profit-Sharing Plans, n.d., Combination plan, para. 1).
Profit sharing plans can receive preferential tax treatment, if they meet rules and requirements set forth by the Employee Retirement Income Security Act of 1974 (ERISA). The rules help employees rights be protected. Additionally, they provide assurance to employees that pension benefits will be there when they are ready to retire. This is guaranteed (6. Profit-Sharing Plans, n.d., Plan Qualification Rules, para. 1).
Moreover, The rules govern requirements for reporting and disclosure of plan information, fiduciary responsibilities, employee eligibility for plan participation, vesting of benefits, form of benefit payment, and funding (6. Profit-Sharing Plans, n.d., Plan Qualification Rules, para. 1). The plans must also meet Internal Revenue Code (IRC) requirements, sections 401(a) (4), 410(b), and 401(a) (26). Significantly, these IRS nondiscrimination rules are designed to insure that a plan does not discriminate in favor of highly compensated employees (6. Profit-Sharing Plans, n.d., Plan Qualification Rules, para. 1). In order to maximize the benefits of the contributions and minimize tax burdens, both the employer and employee should understand the features of these basic profit sharing plans.
3. Additional profit sharing plans
There are four other types of profit sharing plans. Consequently, they include the following The Traditional Plan, The Social Security Integrated Plan, The Age Weighted Plan, and The New Comparability Plan. These plans help employees benefit from their jobs by having money put away for retirement. In some cases, since a plan can also have immediate cash value, an employee is able to set aside money in an account for emergency purposes.
The Traditional Plan
Each traditional plan enables business owners to make discretionary retirement plan contributions on behalf of their employees. The premise behind these contributions was to provide rewards to the employees for their contribution to the profits of the company (Solo-k Retirement Group, 2005, p. 1). The plans are included in a percentage of eligible payroll deductibles. Employees cannot be taxed on the plan by the employer. Profit sharing plans have fourteen (14) features. These features include the following attributes
Only a business owner can establish a profit sharing plan.
The 2006 maximum employer contribution limit is 25 of eligible payroll.
The maximum allocation per participant is lesser of 44,000 or 100 of eligible compensation. Special calculations apply to sole proprietors and partnerships.
The interplay between the 25 of payroll deductibility of the profit sharing contribution and the maximum limit of the contribution of 44,000 or 100 of compensation per participant will cause the contributions to be substantially lower than that allowed.
Any type of company can adopt a profit sharing plan including non-profit businesses.
Company contributions are discretionary, flexible and can be changed from year to year.
The contributions can be made subject to profitability or not.
Profit sharing contributions are tax deductible.
Profit sharing plans may require vesting.
Loans and hardships withdrawals may be made available.
Company contributions are non-taxable when made for the employee and grow tax-deferred until removed.
Can be combined with a 401(k) plan.
Minimum distributions are required, but may be delayed until retirement.
Distributions are taxable and may be subject to penalty taxes when taken before age 59 (Solo-k Retirement Group, 2005, Traditional Plans, pp. 1-2).
The Social Security Integrated Plan
This plan can be allocated as a proportion of pay. A plan equal to 10 of pay means each participant receives 10 contribution of their pay. Another method deals with Social Security. Social Security is considered to be discriminatory and favors employees with compensation below the Social Security taxable wage base (94,500 in 2006) (Solo-k Retirement Group, 2005, p. 2). This represents a higher percentage of a lower paid employees compensation. It does not reflect the percentage of compensation from a higher-paid employee.
Nevertheless, The Internal Revenue Code and the Internal Revenue Services regulations permit the company to offset the effect of this discrimination against the higher paid employees by integrating the plan with Social Security (Solo-k Retirement Group, 2005, p. 2). Here is an example of how the plan works an upper management person earning 150,000 per year is able to allocate 10.6 or 15,849 from pay to the plan. Yet, an employee who earns only 30,000 per year can only allocate 7.2 or 2,151 of pay to the plan. Since the compensation amount is significant, so is the percentage that can be allocated to the profit sharing plan (Solo-k Retirement Group, 2005, p. 2). An employee who does not think this is fair should also consider the tax bracket a person earning 150,000 is in versus the low tax bracket of someone with 30,000 worth of earnings per year.
The Age Weighted Plan
The formula for the plan was part of the evolution process of profit sharing plans. It is Based on the principle used to fund a defined-benefit plan, a higher allocation percentage can be contributed on behalf of an older participant to compensate for the fact that the contributions made on his behalf will have less years to accumulate investment earnings to retirement than the contributors made for a younger participant (Solo-k Retirement Group, 2005, p. 3). An example is a 65 year old retiring at normal time and the plan has two participants. One person is 55 and the other 35.
Contributions for the 65 year old is based on 65-35 or 30 year period of funding. The contribution for the 35 year old is based on 65-35 or 30 year period of funding. Without considering interest the burden for the 55 year old to contribute to his retirement is 3 times greater (3010) than that of the 35 year old to achieve the same outcome. Nevertheless, investment earnings can be discounted and interest can be compounded (Solo-k Retirement Group, 2005, p. 3). However, these components of the plan are taxable.
The New Comparability Plan
The remaining profit sharing plan is comparability one. On October 20, 2005, the IRS announced the 2006-dollar limits on compensation and benefits for qualified retirement plans and the new Social Security Taxable Wage Base (Solo-k Retirement Group, 2005, p. 3). The owners may think it is unrealistic or perhaps they do not fully understand the benefits and features. Whatever the case, the comparability plan was designed to ease the tax burdens of the small business owner.
The older employees have a higher cost of contributing a 1 benefit per month when they reach age 65 than the 25 year old employee. Using actuarial assumptions permissible under the 401 (a) (4) regulation, the cost of providing a benefit of 100 per month payable at age 65 is 4,200 for a 55-year-old compared to 363 for a 25-year-old (Solo-k Retirement Group, 2005, p. 3). With both employees earning the same compensation per year, the plan would earn the 55-year-old a 4,200 profit sharing contribution. Due to the actuarial assumptions of 401 (a) (4) this can be considered equal to the 25-year-olds 363 contribution (Solo-k Retirement Group, 2005, p. 3).
3. Solo K Plan
Some employees may choose to put their money in a 401(k) retirement plan. It is sometimes called the solo k retirement plan. A Solo K retirement plan is a flexible and easy way to maximize retirement savings to benefit the (sic) small, single-owner businesses (Knight, 2005, p. 54). This is the type of plan that increases the value of a 401(k) plan. In fact, it enables business owners to increase their contributions. For example, the contribution amount for 2004 was 13,000 for those under the age of 50. If the person was 51 or older, the contribution amount was 16,000. This plan is significant because business owners are able to pay themselves a tax-deductible profit-sharing portion based on net earnings. Solo K plans allow a contribution of up to 20 of modified net profit (net profit minus one-half of the self-employment tax) (Knight, 2005, p. 54).
Solo K plans are very beneficial to business owners in many ways. First, the owners can contribute large amounts to their plans. In 2004, someone that was self-employed could contribute 19,717 if they were over the age of 50. This is interesting because all the individual had to do was net 20,000 worth of income (Knight, 2005, p. 54).
Another benefit of the plan is the person has access to tax-free loans. Loans are not permitted with traditional or Roth IRAs and SEP IRAs (Knight, 2005, p. 54). However, other benefits include, low administrative costs, convenient contribution amounts, and option to consolidate existing plans. Yet, it should be noted that Solo K plans are not for everyone (Knight, 2005, p. 54).
4. Taxation on a self-employed 401(k) plan
Many types of 401(k) plans exist. For the self-employed, this type of plan is good. As of the end of 2001, the 2001 Tax Act maximized the profit-sharing401(k) plan deduction limit for employer contributions from 15 of compensation to 25 of compensation, effective for tax years beginning after December 31, 2001 (Geller, 2002, p. 60). Those earning over 160,000 per year in 2002, receive a deductible contribution of 40,000 from a profit-sharing401(k) plan. Income earnings lesser than 160,000, can take a 25 deductible of their earnings. A business owner with 100,000 can deduct 25,000 from this profit-sharing plan or a money purchase plan. However, they can deduct 36,000 or 36 compensation under a profit-sharing401(k) plan (Geller, 2002, p. 60). The difference is that more opportunities and benefits exist for the combination profit-sharing401(k) plan than they do for a normal profit-sharing plan or regular 401(k) plan.
5. The benefits of a 401(k) profit-sharing plan
Sole proprietors, sole practitioners, owners of single-employee corporations, and limited liability corporations (LLC) can benefit from this type of retirement plan. It is a result of the 2001 Economic Growth and Tax Relief Reconciliation Act (Kozol, 2005, p. 48). This plan enables more tax credits for the small business owner. It is designed for those earning lesser than 210,000 per year. The plan also allows owners to borrow against retirement in the form of a loan which of course, is not taxed. A third benefit is the ability to acquire life insurance, which means that the proprietor can purchase life insurance using retirement plan accumulations (Kozol, 2005, p. 48).
This factor is important because sometimes circumstances beyond the owners control occur (such as bad weather). Insurance enables the owner to recover some of the financial loss when a catastrophe occurs. However, the owner should be aware that the amount of insurance he or she can purchase is limited by the Tax Code. Of course, the plan has to also be a qualified for the participant to be eligible to acquire insurance coverage. In case of an IRC 401(k)-profit-sharing plan, the law allows a plan to use up to 25 of the allocable contributions as a premium for life insurance on behalf of the participant (Kozol, 2005, p. 49).
Again, this type of plan is not like the SEP or SIMPLE IRA. Nevertheless, the business owner can choose to utilize a 401(k) combination and roll money over to the SEP or SIMPLE IRA funds. A venture such as this enables the business owner to utilize old money to purchase life insurance. It also presents an opportunity for utilization of retirement funds for investment purposes into estate liquidity objectives (Kozol, 2005, p. 49).
C. Conclusion
Not all profit-sharing plans are alike. In fact, neither are they all equal in contribution opportunities. Thus, both the employer and the employee should understand what each plan has to offer. As the business owner, the employer should consider those plans which maximize their contributions, reduce tax liabilities, and provide access to loans that can be used to fund the business or purchase insurance. Consequently, those plans providing profit-sharing401(k) combinations are most reasonable for the employee.
From an employee perspective, the employee must consider the plans which enable them to have cash on hand to withdraw from emergencies, allow the option to borrow money, and offer a large contribution opportunity even if he or she is over the age of 55 and near retirement. The employee should also be careful in choosing the plan that allows taxes to be deferred until the money is withdrawn versus ones that immediately tax the plans contributions as ordinary income. As a result, those plans that offer combination features may best suit the employee.