Prefunding Contributions

[Guest Paul Hinderegger]

A company has had a profit sharing plan for many years and the contribution made in the January following the plan year end typically equals about $1,000,000.

This year, they had some extra cash sitting around in July and so they contributed $900,000 to the plan which was invested in a money market account. By the time January rolled around, this $900,000 contribution had grown to $1,000,000 which equalled exactly the contribution required under the plan for the previous year (not probable, but just go with it).

My questions are:

1) Is this legal? The $100,000 of earnings in the trust is basically tax free. If the company had put the $900,000 contribution in a corporate checking account and it earned $100,000 there, the company would incur $100,000 of taxable income. If prefunding was legal, it seems like too good of a planning technique for the company - - the company prefunds the contribution early in the plan year and then uses the tax free build up of the earnings to offset the company's contribution. I understand that the company would also be required to make up any difference if the value of the $900,000 decreased during the year, but given the performance of the stock market in the last couple of years, prefunding would have been a good bet.

2) Is the company allowed to use the $100,000 of earnings to reduce their required/discretionay contribution? Or must the company actually fund the full $1,000,000 contribution - - in other words, they make a deposit of $900,000 in July and then another deposit of $100,000 in January. If this is the case, what do you do with the $100,000 of earnings?

3) Must the plan document have enabling language for the company to prefund?

4) What other issues (i.e.-415 and 404) should I be aware of if a company is using prefunding?

Thanks for any help.

[david rigby]

Not sure I understand all the facts.

In your second paragraph, you state that it was "contributed to the Plan" does this mean it was actually deposited into the trust? If so, then the earnings are part of the trust and would be allocated to participants under the terms of the Plan. The company has a $900K deduction.

If the $900K was merely in an account owned by the company, then the $100K appears to be earnings, which is probably part of the company's taxable income.

What has been deducted? What fiscal year and what plan year does this apply to?

[Ervin Barham]

You don't say what kind of plan this is, so the answer may vary greatly from what is said here, depending on the type of plan.

Most plan documents allow for the employer to deposit the contribution in one or more installments without interest. If not, the plan should have similar language.

If, in your example, the plan is totally discretionary, and the money market account you speak of is in the plan,then you would allocate the $900,000 as the contribution and allocate the earnings as defined in the plan document. A lot of companies use a "contribution" account to pre-fund and then allocate the earnings on the basis of the contribution.

If the $1,000,000 is a required contribution (i.e. 5% of profit), then the company would make up the difference

at the end of the year and the earnings would be allocated. They could not use the earnings to offset a required contribution.

Biggest danger in pre-funding is that you don't know what your 404 deduction limit is for the year, so you if you go over, then the penalty applies. Plan sponsors are not happy when that occurs. This is much easier to control in a smaller company than a large one.

Also check the plan document carefully- is there a 1,000 hour, last day rule? If not, you may run into allocation issues.

Check the document carefully to make sure it doesn't preclude what the company is trying to do, particularly the pre-funding and allocation of earnings. Check with the document sponsor if this is a prototype sponsor or with the drafter if this is an individually drafted plan.