Eligibile to Participate, but no Allocation

[JRG]

I have run across this situation and cannot find a definitive answer. Can a profit sharing plan have employees who are "eligible" to participate in a profit sharing plan and receive an allocation for a nonelective (profit sharing) contribution, but then also be in a group under which the document provides that group with a 0% contribution.

For example, to be eligible for the PS plan and to receive an allocation, an employee must be 21 years old and complete 1 year of service. However, the plan provides that the profit sharing allocation will be as follows: Employees with 1-3 years of service 0% (of compensation). 4-10 Years - 3%, 11+ years of service - 4%.

Assume that due to the demographics of the company, nondiscrimination testing is not an issue.

An employee with 1 or 2 years of service is "eligible to participate" in the plan (and is a participant), but isn't getting a contribution/allocation (thus, technically not eligble to receive a contribution).

Is this permitted?

[ETA Consulting LLC]

Sure, they can. I see your issue; and it is one of semantics.

1) You must distinguish between plan eligibility and eligibility for a contribution. An employee enters the plan as an 'eligible employee' upon meeting the age, service, and entry date requirements. That does not mean he actually received a contribution. For DOL purposes, he's part of the participant count.

2) Plans must operate under a definitely determinable allocation formula. Any "eligible employee" (as defined above) may be in a group that receives a zero allocation during the year. This can be due to failure to meet the actual accrual requirement (e.g. last day or 1000 hours) or being member of an allocation class (Cross-tested) that receives a zero allocation for the year at the discretion of the employer.

Being eligible for the plan does not guarantee you a contribution. The plan's document is the best resource for this plan. It will be very important to understand the definitions section of the plan document to understand the particular terminology the plan uses to classify employees.

Hope this helps.

Good Luck!

[Tom Poje]

maybe, maybe not. I vaguely recall that a formula like that might be considered a 'disguised' eligibility that the IRS takes a dim view of.

which then of course gets into the issue of the fact I could put everyone in their group and achieve the same results, but that's another story.

[rcline46]

I agree with Tom. A plan with this type of formula, even if it passes the bright line tests, would need to get IRS approval.

[Kevin C]

How do plan provisions that require four years of service before receiving a contribution avoid being considered to have the effect of imposing a four year of service requirement for eligibility?

1.410(a)(3)-3(e)Age and service requirements

(1)General rule.—

For purposes of applying the rules of this section, plan provisions may be treated as imposing age or service requirements even though the provisions do not specifically refer to age or service. Plan provisions which have the effect of requiring an age or service requirement with the employer or employers maintaining the plan will be treated as if they imposed an age or service requirement. In general, a plan under which an employee cannot participate unless he retires will impose an age and service requirement. However, a plan may provide benefits which supplement benefits provided for employees covered under a pension plan, as defined in section 3(2) of the Employee Retirement Income Security Act of 1974, satisfying the requirements of section 410(a)(1) without violating the age and service rules.

[ESOP Guy]

This is clearly an example of someone trying to be too clever. The problems noted above could be solved by giving the 1-3 year group a 0.5% contribution. I would guess that the additional cost would not be very large, but it solves a number of problems.

Or use an allocation formula that uses years of service since you are already doing general testing to prove non-discrimination.

I once worked on an ESOP that 25% of the contribution was allocated on years of service for vesting/ sum of all eligible person’s YOS for vesting. The remaining 75% was on compensation/compensation. It was truly amazing how much more it rewarded the long term employees vs a simple compensation/compensation formula.

[GMK]

It was truly amazing how much more it rewarded the long term employees

This is true.

FWIW, using both years of service and compensation as the basis for contribution allocations, you may wish to consider whether the higher paid employees are mostly the same people who have been around the longest, and more importantly, whether they are likely to continue to take the lion's share of the contributions for the next 10, 15, 20 years. Consider how that could affect testing, employee relations, and like that.

[ESOP Guy]

It was truly amazing how much more it rewarded the long term employees

This is true.

FWIW, using both years of service and compensation as the basis for contribution allocations, you may wish to consider whether the higher paid employees are mostly the same people who have been around the longest, and more importantly, whether they are likely to continue to take the lion's share of the contributions for the next 10, 15, 20 years. Consider how that could affect testing, employee relations, and like that.

Yeah, that formula worked so well in part because that company had a number of very long term rank and file employees. In fact that plan had a factory worker who had been there since he graduated from high school. As a percentage of compensation he was getting a larger contribution then the newly hired CFO. That was the other interesting fact. Since the family had sold out of the company and they had been the management, the new upper management had relatively short tenure with the company.

So you are correct a years of service component like I described will be more dependent on demographics.

[ETA Consulting LLC]

Typically, this type of class differentiation is included in a profit sharing plan containing a 401(k) feature. When everyone is eligible to defer into the plan, then the zero profit sharing class becomes a moot point because the zeroed employees would've already met the definition of eligible employees for deductibility purposes. I think we're on the same page with respect to anything being disguised; always an issue of effective availability (reality) in addition to current availability (stated intent). It always helps to include as much details regarding the situation as possible so we continue to speak apples to apples.

Good Luck :-)

Oh, btw, you guys rock!