PAYROLL PROFIT SHARING ANALYSIS

There are many potential motives in establishing benefit plans beyond the direct compensation:

• Attraction of key personnel from other employers
• Retention of key personnel using “golden handcuffs”
• Siphoning profits to owner/employees
• Protection of earnings from general creditors

Several items must be considered in relation to payroll and profit sharing when evaluating various options:

• Consider the use of independent contractors

Review with an accountant and/or attorney the possibility of making some employees independent contractors. The savings that will result in FICA, FUTA, SUTA and SDI employer payments and reduced bookkeeping may make the difference between success and failure of the business. In employing independent contractors, have a written contract of the terms of employment.

Self-employed independent contractors could make tax-deductible contributions to Keogh plans. In addition, they may make tax-deductible contributions. They also may write off more expenses against taxable income as a self-employed worker than as an employee.

• Consider a non-qualified deferred compensation plan

This can be in addition to or an alternative for a qualified plan, such as a pension, profit sharing or 401 K Plan.

A non-qualified deferred compensation plan is not tax deductible and is not subject to IRS qualifications. However, it may be individually tailored to benefit specific employees while excluding others. This type of plan is often used to provide benefits to owners and key employees.

This form of compensation has been termed “Golden Handcuffs” as many non-qualified plans are designed to provide benefits to an employee if he or she stays with the company.

An example of a non-qualified plan may be to give company stock bonuses to employees who stay with the company for five years.

• Consider establishing a qualified retirement plan

One example is a profit sharing plan integrated with social security and including forfeiture provisions.

This type of plan must conform to IRS regulations if the company desires to take a tax deduction for contributions.

The rules and regulations are fairly complicated. If you do not need the deduction, consider a non-qualified deferred compensation agreement funded with cash or stock.

For a company with employees under age 40, a scenario like the following might be developed:

QUALIFIED PROFIT SHARING PLAN - SAMPLE TERMS

A. Employer Contributions:

1. Discretionary - depends on existence of sufficient profits. Employer determines sufficiency.

2. Contributions may be integrated with social security payroll contributions, such as the following:

a. Employer contributes an amount equal to a base percentage of each employee’s salary. (It is possible, but more complicated; to differentiate among employees based on age.)

b. Employer contributes an amount equal to a larger percentage of each employee’s salary over the base amount(s) in 2a.

A certain percentage difference is allowed because of Social Security contributions on wages of up to the current amount of the FICA wage base.

c. Thus, a plan might provide for 6 % of all wages up to $60,000 (or the maximum FICA wage base) and 11.7% of the excess.

B. Participation Requirements - Who will be admitted to plan?

1. One to three years of service.

a. Service means 12 months and/or 1,000 hours.

2. Minimum age: 21.

C. Vesting Requirements.

1. Vesting determines how much of each year’s contribution a plan participant can claim a right to if he or she quits.

2. Minimum vesting schedules must be complied with.

D. Forfeitures.

1. If an employee terminates before benefits become vested, funds set aside in plan for his or her account may be divided among the remaining participants. These are divided proportionately to participant’s interests or may be applied to reduce future employer contributions or administrative costs.

E. Borrowing Provisions.

1. Consider including borrowing provisions. Valued employees may have an emergency where they need the vested money in their plan. Borrowing provides them with an alternative to termination if they need the vested benefits.

a. Borrowing terms must be spelled out in plan documents. Terms would probably be something like “18 to 36 months amortized at the prime rate when the loan is made,” or other reasonable repayment schedule.

b. Borrowing is limited, and determination of how much an employee may borrow is geared to the total unpaid loan balances that cannot exceed $50,000.

F. Retirement.

1. Benefits are paid to plan participant in either a lump sum or annuity.

2. Normal retirement age is defined in plan. Young participants may prefer a normal retirement age or earlier.

3. Payments must begin 60 days after the end of plan year during which participant attains the plan’s normal retirement age or terminates.

G. Funding.

1. Sufficient liquidity must be maintained to pay vested benefits to employees who terminate or wish to borrow from the plan.

a. Money Market Funds are perhaps the ideal vehicle. They offer relatively high yields, low risk and high liquidity with no commissions.

b. As the plan fund grows, suggestions may be made for diversifying the fund to increase yield potential.

H. Establishing the Plan.

1. Because of the complex requirements of a qualified plan, a pension specialist should draw up an agreement for submission and approval by the IRS. A pension specialist will have standard plans and have the ability to customize a plan to fit your needs. The cost could range anywhere from $1,000 to $2,500.

2. If a standard plan is acceptable, some companies that offer investment vehicles (i.e. insurance companies, stock brokerage firms) may charge $250 for their model plan that has been approved by the IRS.

I. As your profitability increases, a defined benefit plan may be added to increase accumulations for retirement.

Sources: Tax Facts 2002, National Underwriter Company
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www.southwestsecurities.com