What should be done when a profit sharing contribution exceeds the fix

[John A]

A profit sharing plan with a discretionary, fixed profit sharing formula has a last day rule. The plan sponsor funded the profit sharing formula during the year based on participants who were expected to be employed on the last day. Because some participants were unexpectedly not employed on the last day, the amount the employer contributed exceeds the amount of the fixed formula.

What should be done at this point?

[actuarysmith]

Unless I'm missing something, the answer seems obvious - reallocate the total contribution among the other participants who ARE eligible for accrual. (In effect, each participant will end up with what they should have gotten in the first place if the ineligibles were excluded).

This answer assumes that your document stipulates the total employer contribution as a specific formula related to profit.

[John A]

The fixed profit sharing formula is X% of comp., unrelated to profit. Sorry, I should have specified that in the question.

[Guest]

I didn't think that was possible.

If it's profit sharing, the contribution is generally discretionary. A money purchase has a required formula, and as such, is subject to minimum funding.

are you implying that you have a profit sharing subject to minimum funding????

I have seen some cross tested plans that appear to have 'fixed' formulas, but they also have wording such as "If the amount of contribution is less than....then the allocation will be..."

or "If there is still $ left after the above allocation then..."

[John A]

No, I am not saying that the profit sharing plan is subject to minimum funding. The plan sponsor can certainly choose not to make a contribution at all. However, if the plan sponsor chooses to make a profit sharing contribution, the plan document specifies a fixed profit sharing formula of X% of comp., unrelated to profit. So the plan sponsor's choice each year is between $0 and $X% of compensation.

[david rigby]

This sounds to me like an issue of timing and defintions.

If the Plan states a contribution of X% of comp, then there must be a definition of comp somewhere. It may be defined but may not be used in the determination of actual deposits.

[Edited by pax on 09-25-2000 at 03:34 PM]

[actuarysmith]

I truly believed I had at least half a clue as to what the original question was..... After reading through the additional responses and the authors replies, I am confused as to WHO is confused - is it me, is it the other readers, or is it the author? (no offense intended to anyone!)

Let's start with the basics.

1) If it is a profit sharing plan, then it is up to the sponsors discretion as to how much to contribute (unless the document stipulates the contribution as a fixed percentage as profit - rare, but still legal)

2) It appears, as the author states, there is no fixed amount of contribution.

3) It appears that there is a last day of employment requirement.

4) the employer chose to voluntarily fund all or a part of the years contribution prior to the last day of the year based upon certain assumptions about who would be eligible.

5) The employer profit sharing forumula is allocated according to a formula expressed as either a) the same percentage of pay for all participants, or b) a formula integrated with Social Security, or c) a tiered formula

6) Some of the participants who received "early" contributions (i.e. before they were actually accrued) were not employed on the last day, even though contributions were already made on their behalf.

Assuming all of my assumptions are correct (Of course, Im an actuary!!) then your question is, "what happens to the funds for these participants who have money in accounts that doesen't belong to them?"

First of all, the IRS only allows a plan sponsor to take money out of a plan under certain circumstances such as; to pay distributions, or in the event of af "mistake in fact". I have not read the literature recently on mistake in fact contributions, but my recollection is that it refers to minor clerical errors, such as contributing $23,875.63 instead of $23,578.63. It is definitely not because you exceeded 415 or 404, or becasue you changed your mind about how much to contribute.

Therefore, I would say that you cannot take the money back out of the plan, the plan will reallocate the funds from the participants who had not yet accrued contributions for the year to the other eligible contributions. The net result will be that the participants who were eligible will get greater allocations than was originally intended.

[Guest]

(I am somewhat confused myself)

I would agree with the argument you can't take the money out of the plan.

can you say excise taxes for over contribution?

I am still puzzled over the formula involved.

1. Its unrelated to profits (In the old days you could have a formula '10% of profits would be contributed'

but the comments indicated this was not the case.

2. Its a fixed formula (e.g. 10% of comp, just for reference in this discussion)

3. Its discretionary.

so they either put in 10% of comp or nothing.

That is how I understand the formula to be - but maybe I am reading too much into it.

I would want to see something in the document that says i can allocate the excess amount to others as well. If I have a fixed formula I'm not sure about this.

If the last contribution was made after the end of the plan year, then I could apply and deduct the following year as well

[actuarysmith]

Me again....

I assumed that the author meant that there was a fixed method for allocating any profit sharing contribution that was put in - 1)comp to comp 2)integrated or 3) tiered or cross-tested, but that the amount of the total contribution that the employer could put in each year, in the aggregate was completely discretionary.

Assuming that is the case, I don't believe that the document needs any revision at all. The amount the employer has already put in does not appear to be the problem. The problem is that some participants who were not eligible were given allocations. The sponsor should go back and revise the allocation worksheet showing the total amount actually contributed for all, but allocate only to those eligible. (This will require some adjustments, such as moving funds from non-eligilbe accounts to eligible accounts)

Note: The employer may have INTENDED to contribute some fixed amount, such as 8% of pay for everyone eligible, but now with the adjustments, eligible participants may actually get 10% or whatever, after reallocating contributions from the other accounts.

P.S. This is why it is not a good idea to pre-fund plans with a last day of employment provision.

[KJohnson]

FOR WHAT ITS WORTH, THIS IS FROM THE PLAN DEFECTS Q&As. NOTE THE VERY LAST SENTENCE. R&L IMPLIES THAT IN A FIXED FORMULA CONTRIBUTION PS PLAN YOU SHOULD USE A SUSPENSE ACCOUNT TO OFFSET NEXT YEAR'S CONTRIBUTION.

Question 136: A profit sharing plan requires an employee to be employed on the last day of the plan year in order to receive an allocation of the employer discretionary contribution for that year. The plan's allocation date is the last day of the plan year. In operation, the employer actually makes and allocates its discretionary contributions a couple of months before the end of each plan year. If a participant receives an allocation for the year and then terminates his or her employment before the last day of that year, the plan "refunds" to the employer the amount allocated to the terminated employee's account for that year. Does the ‘refund' result in a plan defect? If so, under what IRS remedial program can it be corrected?

Answer: The IRS might view the refund as a violation of the "exclusive benefit rule" or, more likely, a prohibited transaction. Or the IRS might view the refund as resulting from a failure to follow the plan's terms, which could be corrected under the Voluntary Compliance Resolution Program ("VCR").

Code section 401(a)(2) requires that a qualified plan be maintained for the exclusive benefit of the participants and their beneficiaries. This rule is commonly referred to as the "exclusive benefit rule," and it prohibits the plan sponsor from taking or using plan assets for its own benefit. It is the exclusive benefit rule that generally makes employer contributions to a qualified plan irrevocable. Exclusive benefit rule violations involving diversion or misuse of plan assets cannot be corrected under any of the IRS remedial correction programs. (See Section 4.08 of Rev. Proc. 2000-16). However, and as a practical matter, the IRS does not generally assert exclusive benefit violations if a relatively small amount of assets is involved, as we assume is the case here.

The IRS is more likely to assert that the refund is an improper taking of money from the plan by the employer, in violation of the prohibited transaction rules under Code section 4975. The correction is to return the money to the plan, with earnings. The employer also would be required to file a Form 5330 and pay a 15% excise tax on the amount refunded.

Alternatively, it might be possible to convince the IRS that the defect in this case arises from a failure to follow the plan's terms regarding the allocation date. That is, if the plan had allocated the discretionary contribution on the last day of the plan year, as required under the plan's terms, the allocations would have gone only to those participants eligible to receive an allocation (e.g., those employed on the last day of the plan year), and refunds would not have occurred. A failure to follow the plan's terms results in an "operational failure," as described in Section 5.01(2)(B) of Rev. Proc. 2000-16.

Operational failures can be voluntarily corrected without IRS supervision under the Administrative Policy Regarding Self-Correction ("APRSC") or by filing an application with the IRS in Washington D.C. under VCR and paying a filing fee. Under either APRSC or VCR, the employer would be required to "restore the plan to the position it would have been in" absent the defect. (See Section 6.02(1) of Rev. Proc. 2000-16). Therefore, for each year in which there was a failure to follow the plan's terms regarding the allocation date and, as a result, "refunds" were made to the employer, the employer would have to return those amounts to the plan and reallocate them to the accounts of participants who were eligible to receive an allocation for that year. In accordance with Section 3 of Rev. Proc. 2000-16, the corrective allocations would need to be adjusted for earnings.

Under the Employee Plans Compliance Resolution System ("EPCRS"), which is the consolidation of the IRS' remedial correction programs for qualified plans, there is no "safe-harbor" correction for your situation. In addition, there is at least some uncertainty regarding how the IRS would view the issue of the refund. That is, does the refund constitute a violation of the exclusive benefit rule, a prohibited transaction, or is it a product of failing to follow the plan's terms regarding the allocation date? Therefore, it would be imprudent to attempt to self-correct this failure under APRSC. The safer approach is for the employer or its professional advisor to contact the IRS on a "no names" basis to discuss these issues, and then file a VCR application (if the IRS indicate that it would entertain such an application) to ensure proper resolution of the defect.

For purposes of this Q&A, we have assumed the employer contribution for each year was an aggregate amount that was allocated to participant accounts in proportion to compensation. Therefore, when the employer corrects by returning to the plan the improper "refund" amounts (plus earnings) for each plan year, that amount must be allocated to the accounts of participants entitled to receive an allocation for that year. However, if the employer contribution consisted of a specific percentage of pay to be allocated to each participant's account, then the money returned would have to be placed in a suspense account and used to reduce future employer contributions.

AS TO SOME OF THE OTHER COMMENTS, I KNOW THERE ARE FIXED CONTRIBUTION FORMULA PS PLANS OUT THERE AS THE LAST SENTENCE IN THE Q&A IMPLIES. THESE EXIST ESPECIALLY IN THE COLLECTIVELY BARGAINED WORLD WHERE THE EMPLOYEES DO NOT WANT TO RELY ON AN EMPLOYER'S DISCRETION. THE EMPLOYERS/PLAN ADMINISTRATORS, ON THE OTHER HAND, DO NOT WANT TO DEAL WITH 412

FOR EXAMPLE IN A MULTIEMPLOYER MONEY PURCHASE PENSION PLAN, IF AN EMPLOYER IS DELINQUENT THE IRS TAKES THE POSITION THAT THESE DELINQUENT AMOUNTS MUST BE CREDITED TO THE ACCOUNTS OF PARTICIPANTS BECAUSE THE FAILURE TO CONTRIBUTE AND ALLOCATE WOULD CREATE EMPLOYER "DISCRETION". (WHERE YOU GET THIS MONEY IS ANYBODY'S GUESS). AT LEAST IN THE IRS's VIEW, CONVERTING THE MONEY PURCHASE PLAN TO A PS PLAN SOLVES THIS PROBLEM WHILE IT IS "INVISIBLE" TO THE PARTICIPANT BECAUSE THERE IS STILL A REQUIRED CONTRIBUTION FORMULA.

[John A]

Time out! Putting aside my embarrassment:

First, both many thanks and my apologies to those that have responded. As it turns out, I had the details of the original question incorrect, and I will get to what the correct details were, but first I want to address the question of a fixed profit sharing formula.

I do work with an Adoption Agreement in which it is possible to make choices so that it would read as described below.

The section of the document is called "Non-Integrated Fixed Formula - Non-Discretionary with Optional Profits Contingency."

With certain allowable choices, the Adoption Agreement would read, "The Employer Regular Profit Sharing Contribution for each Plan Year will equal a fixed amount for each eligible Participant. The amount of the contribution will be 10% of Plan Compensation for the Plan Year. The Employer Regular Profit Sharing Contribution is not contingent on Net Profits. The Employer does not have the discretion to direct that an additional Employer Regular Profit Sharing Contribution be made for a Plan Year.

Is this wording allowable? Can there be a "Non-Discretionary" profit sharing contribution? This particular adoption agreement makes me think yes.

------------------------------------------------------------

Now to correct the details in my original question:

The question was described to me by a colleague and I was under the mistaken impression the plan was on the Adoption Agreement described in part above. It turns out the situation related to an individually designed plan.

The actual details are:

1) It is a profit sharing plan and it is up to the sponsor’s discretion as to how much to contribute.

2) The employer profit sharing contribution is allocated according to a formula expressed as a formula with permitted disparity (integrated with Social Security).

3) An ineligible employee was included in the allocation (had not met minimum age and service).

4) The ineligible employee has not yet received a benefit statement, but a voice response system did reflect the incorrect allocation to the ineligible employee’s account.

5) This particular individually designed document seems to be silent about what to do when participation errors occur.

Since the error occurred in the last few months, what should be done at this point?

The possibilities being considered are:

1) Treat the amount that was allocated to this participant’s account as a forfeiture that will be allocated in the following year. Redo the allocation excluding this ineligible employee and subtracting the amount allocated to his account from the contribution to be allocated. Make sure all participants have received at least what they would have been entitled to in this corrected allocation calculation. Document the correction for the file, but do not do an APRSC.

2) Same as 1) but do an APRSC.

3) Same as 1) but do the current year allocation without changing the contribution amount (do not subtract the amount allocated to the ineligible employee).

4) Treat the inclusion of an ineligible employee as a mistake of fact and refund the amount allocated the ineligible employee to the employer (I have seen an Adoption Agreement that specifies treating the inclusion of an ineligible employee as a mistake of fact).

5) Other?

So I guess the questions come down to:

How should the correction be done when the document is silent (up to Plan Administrator?)?

Can this be treated as a mistake of fact as seems to be implied by at least one adoption agreement I’ve seen (I had always been under the impression that this was very limited, and should only be used for clerical errors such as transposition errors like the one actuarysmith describes above)?

Can or must an APRSC be done for this minor of a problem (minor in the sense that it involves a very small amount of money, basically one participant – the one ineligible, and will be corrected within about 3 months of the problem)?

Again, my thanks and my apologies to those who have responded. While I think this thread has been more interesting due to my mistake, I did not intend to cause so much confusion.

[AndyH]

Sorry, John, to continue this discussion to your dismay, but it attracted my interest from a situation I saw a couple of years ago.

What happens if a company has historically contributed a fixed (5%) contribution each year to a discretionary ps plan and an error was made whereby the computation was wrong based upon using comp > $160,000 and the amount was prefunded.

Can the company consider this an error and an advance toward the next year? I think not, but I'm not sure. There was no 415 or 404 violation. Could it be returned as a mistake of fact? If it is treated as an "errant" advance, would this be subject to a 10% penalty?

In fact, this was done for both an MP and PS. A penalty was paid for a nondeductible contribution on the MP. I'm not sure about the PS. What would have been the options?

[actuarysmith]

Me - one last time......

I believe that I said exactly the same thing earlier as the last message, albeit he said it much more eloquently.

Bottom line is still the same, "take" the unearned current-year contributions from the terminated participants (prior to year-end) and reallocate them to the other participants according to the method specified in the document (comp/comp, integrated, whatever).

The net result will be that the other paricipants will end up with larger contributions than maybe was originally intended.

The much riskier approach is to "refund" the contributions back to the sponsor. This may or may not fit under self correction programs, may be handled through vcr/cap, or the sponsor may just sit back and play audit roulette. (If the client opts for this last approach, I would write a big CYA letter to the client advising against this approach and keep it in your files).

Good Luck!

[actuarysmith]

I was actually responding to KJohnson, not the last message. Several new messages slipped in between the one I was responding to.