Pension and profit-
sharing plans, long
tools, are more valuable
than ever thanks to
legislation passed early
in this decade. Here’s
an overview for business
advisors about these
plans and what they
can do for employers.
A Primer on Qualified Pension
and Profit-Sharing Plans
he Economic Growth and Tax Relief Reconciliation Act
of 2001 (EGTRRA)1 made defined benefit, profit-sharing,
and 401(k) plans even more attractive than before. In
addition to (i) disproportionately large contributions that
By Stephen M. Margolin and can be made by an employer on behalf of key employees, (ii) income tax
Harvey S. Shifrin deductible contributions to the employer, (iii) tax free accumulation of
plan assets, (iv) asset protection from non-family creditors, (v) no current
taxability to the employees, and (vi) the accumulated benefits being tax
deferred until payment to a participant or his beneficiary, possibly over
decades, EGTRRA provides for higher levels of compensation which
can be taken into account in calculating benefits as well as removing
participants’ elective deferrals from the deduction limit.
1. PL 107-16, 115 Stat 38, effective for plan years beginning after December 31, 2001, available at
Stephen M. Margolin is a partner in the Chicago firm of Chuhak & Tecson, PC. He
has written and lectured widely on wealth transfer/estate planning and related issues.
Harvey S. Shifrin <email@example.com> is an attorney with Chuhak & Tecson, PC.
He is also a CPA and a contributing author of The CPA’s Guide to Retirement Plans for
Small Businesses, published by the American Institute of Certified Public Accountants.
The Pension Protection Act of 2006 Susan) cannot receive an allocation rals without regard to the limitations
(PPA)2 makes permanent the EGTRRA greater than $45,000 for a total contri- that ordinarily apply to elective defer-
enhancements as well as adding a num- bution of $135,000 ($45,000 x 3 par- rals or annual additions.16 Participants
ber of attractive features. In addition, the ticipants). may make catch-up contributions only
new Bankruptcy Act3 strengthens asset Defined contribution deduction limit. if permitted under the terms of the plan.
protection of qualified plans. For defined contribution plans, the gen- Catch-up contributions are adjusted for
Every advisor to employers should eral employer contribution deduction inflation annually. The 2007 catch-up
have some familiarity with the various limit is 25 percent of total participant contribution limit is $5,000.17
legally encouraged tax and asset shel- compensation.9 Revisiting Wealthmaker, For example, Bill, a 50-year-old plan
ters. This article offers an overview, in- the general employer contribution de- participant, defers $15,500 in 2007. He
cluding an illustration of the deductions, duction limit of 25 percent of partici- also has profit-sharing contributions of
contributions, or benefits available to pant compensation equals $125,000 $29,500 for total annual additions of
key employees, and the total costs to ($500,000 x 25 percent). The general $45,000. Bill may also elect to defer an
the employer under different fact pat- employer contribution deduction limit of additional $5,000 catch-up contribution
terns. For a related article aimed di- $125,000 applies, since it is less than the for a total 401(k) deferral of $20,500.
rectly at lawyers (especially small-firm aggregate annual addition
lawyers) as employers, see Michael R. limit of $135,000.
Maryn, Choosing the Right Retirement Elective deferral limita
Plan for Your Law Firm, in the April tion. 401(k) plans are profit-
2007 Journal. sharing plans with a cash
The Bankruptcy Abuse and
or deferred arrangement. 10
Consumer Protection Act of
What is a qualified plan? These “cash or deferred
arrangements” allow par- 2005 increased the protection for
Qualified plans are plans of deferred
compensation sponsored by employers ticipants to make elective qualified plans afforded debtors
on behalf of employees which satisfy the deferrals of their compen-
requirements of the Internal Revenue sation otherwise includible electing bankruptcy protection.
Code of 1986, as amended (the Code). in their income. Elective
Qualified plans are established to pro- deferrals are treated some-
vide for the payment of definitely deter- what differently from non-
minable benefits over a period of years, elective contributions.12 The maximum The $5,000 contribution acts to increase
or for life, after retirement.4 The two deductible elective deferrals for 401(k) the annual addition limit of $45,000 to
main types of qualified plans are defined plans are adjusted annually for inflation. $50,000. Furthermore, the $5,000 con-
contribution (e.g., profit-sharing/401(k)) For 2007, the maximum 401(k) deferral tribution is not subject to any 401(k) dis-
and defined benefit plans. A defined con- is $15,500.13 crimination testing.
tribution plan provides each participant Elective deferrals not subject to limi Compensation limitation. The term
with his own account.5 Defined benefits tations on deductions. Elective deferral “compensation,” defined in the plan,
plans are all plans that are not defined contributions to a 401(k) plan are no may include base compensation, bo-
contribution plans.6 longer subject to the employer contri- nuses, commissions, and salary reduc-
Upon application by an employer, the bution deduction limit of 25 percent.14 tion deferrals not included in an employ-
Internal Revenue Service is liberal in is- So, the full 25 percent employer deduc- ee’s income.
suing a favorable determination letter on tion for contributions is allowed in addi- In year 2007, the maximum annual
plan qualification. tion to the above maximum elective de- compensation used to determine alloca-
ferrals limits. tions or benefits is $225,000 (inflation
Deductions and limits For example, Bill and Hillary’s cor- __________
Annual addition limit. The Code im- porate compensation each is $100,000. 2. PL 109-280, HR 4, with various effective dates,
poses an individual participant limit on Their employer establishes a profit-shar- available at http://www.dol.gov/ebsa/pdf/ppa2006.pdf.
annual additions to defined contribution
ing plan with a 401(k) (cash or de- Act ofThe Bankruptcy Abuse and Consumer Protection
2005. PL 109-08, available at http://www.dpw.
plans. The sum of employer contribu- ferred) arrangement. The profit-sharing com/practice/code.blackline.pdf.
contribution deduction limit is 25 per- 4. Employee Retirement Income Security Act of
tions, employee contributions, and for- 1974 (ERISA), PL 93-406, 88 Stat 829, §3(2)(A),
feitures (“annual addition”)7 which are cent of the $200,000 compensation, or available at http://www.ssa.gov/OP_Home/comp2/
allocated to an individual participant’s $50,000. If, however, each of them made F093-406.html.
5. IRC §414(i).
account cannot exceed the lesser of 100 a 401(k) elective deferral, then each can 6. IRC §414(j).
percent of his compensation or $45,000 have an additional $15,500 withheld 7. IRC §415(c)(2)
and contributed, making the company 8. IRC §415(c)(1).
(inflation adjusted).8 9. IRC §404(a)(3)(A).
For example, Fred age 60, George age contribution $81,000. 10. IRC §401(k).
49, and Susan age 35, are owner em- “Catchup” contributions. Individuals 11. IRC §401(k)(2)(A).
ployees of Wealthmaker Corporation.
who participate in 401(k) plans and at- salary Employer contributions. which are other than
They have compensation of $200,000, tain age 50 by plan year end are permit- 13. IRC §402(g)(1)(B) as modified by IR 2006-162.
ted to make additional “catch-up” con- 14. IRC §404(n).
$200,000 and $100,000, respectively. 15. IRC §414(v)(1) and (5).
The annual addition limit operates so tributions. These individuals are al-
16. IRC §414(v)(3).
each participant (i.e. Fred, George and lowed to make these “catch-up” defer- 17. IRC §414(v)(2)(B)(i).
adjusted).18 In the earlier Wealthmaker For example, Wealthmaker employs Characteristics of defined
example, if Fred and George each earned Fred, George, and Susan. If favoring key contribution plans
$300,000, the contribution limits would employees (i.e., Fred and George) is de- Any benefit under a defined contribu-
change, but the increase would be lim- sirable, it could adopt both a defined tion plan is based solely on the amounts
ited as only the first $225,000 of com- benefit plan and a 401(k) plan. EGTRRA contributed to such participant’s ac-
pensation could be considered, not the added subparagraph (n) to Section 404 count, plus any income, expenses, gains
full $300,000. of the Code. It provides that elective or losses, and any forfeitures of the ac-
Defined benefit deduction limits. The deferrals are not subject to limitations counts of other participants allocated to
deduction limits for contributions made on deductions. Therefore, it promotes his account. Though the contribution to
for key employees in defined benefit both a defined benefit pension plan and a defined contribution plan is definite,
plans are very flexible. Limits to defined a stand-alone 401(k) plan. The 401(k) the ultimate accrued benefit is not.
benefit plans are based upon the maxi- permits only elective deferrals and ac- Employer contributions under a
mum amount a participant may receive cepts neither employer contributions nor profit-sharing plan may be either a fixed
upon retirement (generally at age 65), matching contributions. percentage of an employee’s income for
currently $180,000, and adjusted annu- Furthermore, the employer may con- a plan year or a completely discretionary
ally for inflation.19 amount. The employer has great flexibil-
tribute an additional 6 percent of eligi-
Defined benefit plan contributions ity in allocating these contributions pro-
ble compensation to a profit-sharing or
are actuarially determined based on age, vided the plan document allows for such
401(k) plan for years beginning after
earnings assumptions, compensation and flexibility and certain participation and
December 31, 2005.24 By having both a
years of service. The deduction20 could nondiscrimination tests are met.25 When
defined benefit plan and a 401(k) plan,
approximate the amounts listed in the a distributable event occurs, such as re-
sidebar, assuming $225,000 compensa- Fred and George can each contribute
an additional $15,500 to the 401(k) in tirement, a participant’s account balance
tion of a participant. will consist of the contributions made to
The defined benefit plan’s flexibility 2007. In addition, Fred (over age 50)
could make a $5,000 catch-up contribu- the trust for every plan year in which he
can be best demonstrated by examining was a participant and any forfeitures and
the sidebar on this page in conjunction tion to the 401(k) plan.
All three employees could participate earnings or losses allocated thereto.
with the following example. Most new defined contribution plans
Jack is a high-powered attorney who in both plans. Because of the great flexi-
are profit-sharing plans with or with-
practices in Washington, DC. Jack is 50 bility of these plans, Fred and George
out 401(k) features. Under EGTRRA,
years old and is the sole owner of his could enjoy massive defined benefit and
profit-sharing plan contributions after
business, Jack, PC. Jack, PC has one 401(k) contributions and Susan more __________
other employee, Jill. Jill is a 30-year-old modest contributions, if the employer 18. IRC §401(a)(17).
assistant, paralegal, and office adminis- desired. 19. IRC §415(b)(1)(A) as modified by IR 2006-162.
In short, employers can mix and 20. IRC §404(a)(1).
trator. Jack’s practice is very prosperous 21. IRC §401(a).
and he desires to maximize the deduc- match plans to achieve contribution and 22. IRC §410(a).
tions created for his company at mini- allocation objectives. There are more so- 23. IRC §§401(a)(4), 401(a)(5), and 410(b), and in
Profit Sharing Plan with cash or deferred arrangements
mal costs. phisticated techniques which can be ap- must satisfy the Actual Deferral Percentage (ADP) and
The defined benefit plan works nicely plied to provide even higher disparity in Actual Contribution Percentage (ACP) test under IRC
here due to the age disparity of Jack, Section 401(k) and 401(m) of the Code, respectively.
contribution between key employees and 24. IRC §404(a)(7)(C)(iii), as added by PPA.
PC’s employees. The highly compensated the rank and file. 25. IRC §§401(a)(4), 401(a)(5) and 410(b).
Jack (“HCE”), is 20 years older than his
Under the sidebar example, if the
Jack, PC defined benefit plan contained Defined benefit deduction limits
a normal retirement age of 62, Jack’s Based on the 94 GAR Mortality Table (as published in Rev Rul 2001-62)
estimated per annum deduction would at 4.5 percent and 6.5 percent post-retirement interest.
be at least $123,000. He anticipates a
prosperous year, and even considering Present Age Retire Age 62 Retire Age 65 Retire Age 70
the $123,000-plus deduction created for
him and Jill, he felt it would not shelter 35 $32,000-$47,000
his income. Could he obtain a larger de-
Maximizing plan benefits
A company may use multiple plans 50 $123,000-$154,000 $84,000-$106,000
to maximize plan benefits for key em-
ployees. These strategies are permissi- 55 $174,000-$208,000 $148,000-$180,000
ble provided the plans meet Code quali-
fication,21 participation22 and discrimi-
nation testing,23 some of which are de- 65 $152,000-$175,000
2001 are subject to the same employer the final or the consecutive high number quarterly or monthly).
deduction limit of 25 percent as money of years (typically the final 10 years or
purchase pension plans, but are more the consecutive high three or five years). Vesting and forfeitures
flexible; since the contributions are dis- A qualified plan may impose vest-
cretionary from year to year, whereas Plan participation ing standards that require the partici-
money purchase pension plans require A qualified plan must satisfy the mini- pant to complete a certain number of
annual contributions defined by for- mum participation rules of Code Section years of service before his accrued bene-
mula. Thus, the use of money purchase 410(a). Under these rules, a plan may fit derived from employer contributions
pension plans has diminished. Other de- only impose limited minimum age re- is fully vested or nonforfeitable. A “year
fined contribution plans are stock bonus quirements and may not impose maxi- of service” is a calendar or fixed year
plans, target benefit pension plans and mum age requirements for participation. designated by the plan, during which the
employee stock ownership plans. Certain employees may be excluded in participant completes 1,000 hours of
Profit-sharing plans theoretically pro- determining the statutory requirement service (although some plans operate
vide for participation by employees in for participation. using an elapsed time system). Code
the employer’s profits. Previously, the For example, a unit of employees cov- Section 411 provides two minimum vest-
Code required any profit-sharing contri- ered by a collective bargaining agree- ing schedules for defined benefit pen-
butions be made from current or accu- ment between employee representatives sion plans:
mulated profits. and one or more employers in which 1) Five year cliff vesting, under which
However, it is now permissible for retirement benefits were the subject to an employee must be fully vested in bene-
contributions to be made solely at the good faith bargaining can be excluded. fits attributable to employer contribu-
discretion of the employer without re- It’s important to note that retirement tions when he has completed at least five
gard to profits.26 The plan must pro- benefits do not have to be provided,
vide for allocating contributions among years of vesting service; and
but merely that they were the subject of 2) Three to seven year graded vesting,
the participants and for distributing the good-faith negotiation.
funds accumulated under the plan after a under which an employee must be vested
For defined benefit plans, Code in a percentage of benefits derived from
fixed number of years, the attainment of Section 401(a)(26) imposes an addi-
a stated age, or upon the occurrence of employer contributions according to the
tional employee coverage requirement. following table:
some event such as disability, retirement, The plan must cover the lesser of 50 eli-
death or severance of employment. gible employees or 40 percent of all eli- Years of service Vesting percentage
gible employees. In a two-person plan, 3 years of service . . . . . . . . . . 20%
both employees must be covered. 4 years of service . . . . . . . . . . 40%
defined benefit plans
A qualified plan generally may not re-
5 years of service . . . . . . . . . . 60%
Defined benefit plans provide for pay- quire an employee to complete a period
ment of definitely determinable benefits of service extending beyond the later of 6 years of service . . . . . . . . . . 80%
over a period of years, or for life, after the date the employee attains age 21 or 7 or more years of service . . 100%
retirement.27 Retirement benefits are gen- the date on which he or she completes If key employees are credited with
erally based on some combination of one year of service. However, an em- more than 60 percent of a plan’s
age, years of service, and compensation ployer may require that an employee accrued benefits, it is considered “top
of each employee.28 complete two years of service to par- heavy.” Then, in lieu of five-year cliff
Employer contributions to the plan ticipate, if it provides that after the two vesting, three-year cliff vesting applies.
are mandatory.29 Contributions, how- years of service each participant is fully Instead of cliff vesting, an employer
ever, are not a ‘fixed percentage’ of com- vested.
pensation inasmuch as they are calcu- may utilize the following top heavy
A year of service for this purpose is
lated using applicable funding rules and schedule.
a 12-month period during which the
actuarial assumptions. The amount of employee has completed at least 1,000 Years of service Vesting percentage
contribution must be sufficient to bring hours of service. Typically, the 12-month 2 years of service . . . . . . . . . 20%
the assets to the appropriate levels each period begins on the date the employee
year to fund the benefits offered under 3 years of service . . . . . . . . . 40%
the plan. An employer may choose less restric- 4 years of service . . . . . . . . . 60%
Unlike defined contribution plans, tive entry conditions. Thus, a plan may 5 years of service . . . . . . . . . 80%
no individual accounts are established allow employees to participate as soon as 6 or more years of service . . 100%
under a defined benefit plan. Generally, they commence employment, if desired.
participants earn additional benefits over Once an employee has attained both
time, but no assets are segregated within 26. IRC §401(a)(27)(A).
the minimum age and service require- 27. ERISA, PL 93-406, 88 Stat 829, §3(2)(A) and
the plan for those benefits. ments, he must participate on the first IRC §414(j).
Rather, participants’ benefits are day of the plan year or six months after 28. BNA – Tax Management Portfolios, Plan
Selection – Pension and Profit Sharing Plans, No 350,
stated as amounts payable at a specified he satisfies these requirements, which- III.C.2.c.
time, normally, the participant’s retire- ever is earlier.30 January 1 and July 1 are 29. IRC §412(h). This subsection provides six
ment. Benefits may be based upon com- typical entry dates for plans that oper- exceptions when the “minimum funding standards” of
IRC §412 do not apply. A defined benefit pension plan
pensation earned during the employee’s ate on the calendar year, although entry does not fall within any of these six exceptions.
entire career or on the average of either dates may be more frequent (such as 30. IRC § 410(a)(4).
For plan years beginning after assets in a retirement plan are exempt payments over the life expectancy of the
December 31, 2006, these two vest- from distribution to a participant’s credi- employee or for a period of 10 years or
ing schedules also apply to all match- tors. The general exception to the in- more, are not exempt from the bank-
ing contributions in defined contribu- alienability of a participant’s benefit is a ruptcy estate. Once in the hands of the
tion plans.31 Of course, an employer may qualified domestic relations order relat- debtor, they are subject to creditors.
have a less restrictive vesting schedule. ing to child support, alimony, or mari-
An employee must be fully vested in tal property rights of a spouse, former Distributions
his benefit under the plan when he at- spouse or dependent. Participants in qualified plans are not
tains normal retirement age.32 Normal subject to income tax on contributions
retirement age is the later of his 65th New bankruptcy act when made to the plan by the employer
birthday or the fifth anniversary of com- The Bankruptcy Abuse and Consumer or employee. Earnings on contributions
mencement of participation, or the age Protection Act of 2005 increased the pro- are not taxed while they accumulate
specified in the plan, whichever is ear- tection for qualified plans afforded debt- within the plan. Taxation occurs when
lier.33 An employee is always fully vested ors electing bankruptcy protection. money is distributed from the plan.
in benefits attributable to his own elec- All assets held in qualified retirement If the participant does not incur a
tive deferrals (i.e. 401(k) contribution). plans are exempt from the
Also, an employee is fully vested upon bankruptcy estate. SEP
termination of the plan.34 and SIMPLE IRAs as well
Once an employee is fully vested in as rollover IRAs and the Thanks to EGTRRA,
his benefits, such benefits are nonfor- earnings thereon are simi-
feitable. In other words, the employ- larly exempt. In contrast, disproportionately large income
ee’s rights to vested benefits are uncon- Roth IRAs and Traditional tax deductible contributions
ditional and may not be conditioned on IRAs funded with individ-
any subsequent event. ual taxpayer contributions can be made by an employer
Generally, all years of service are are only exempt up to $1 on behalf of key employees.
taken into account under the vesting million of value.
rules although the employer may exclude No creditor, including
years of service before age 18, years of the federal government,
service with an employer when the em- may reach assets that are
ployer did not maintain the plan or pre- exempt from the bankruptcy estate. tax when the money is placed into the
decessor plan, and certain years of ser- However, a “fine, penalty, or forfeiture plan, a tax is incurred when the money
vice when the employee has a five-year payable to and for the benefit of a gov- is distributed from the plan. Taxation
break in service. ernmental unit” is not discharged by a can be further deferred by having the
A plan may not amend its vesting bankruptcy.38 distribution proceeds transferred, or
schedule unless the vested percentage of In addition, the following taxes are “rolled over,” to another qualified plan
every employee is at least as great as it not discharged by the bankruptcy: fed- or an individual retirement account
was before the amendment.35 eral income tax for any return due in the (“IRA”).
past three years, property tax for any re- Distributions from qualified plans
Asset protection – common turn due in the past year, withholding may be taken in several different forms.
law employees tax for all years, employment tax for Among the forms of distributions that
Code section 401(a)(13) and the any return due in the past three years, may be made are lump sum distribu-
Employee Retirement Income Security excise tax for any return due in the past tions, installments over a fixed period of
Act (“ERISA”) section 206(d) provide three years, customs tax for any return time and life annuity distributions.
due in the past year, penalty for actual In general, when a participant re-
that a plan must include language that ceives a distribution, such distribution
benefits may not be assigned or alien- pecuniary loss in any year. Such claims
ated. In Patterson v Shumate,36 the will remain valid after the bankruptcy is is taxed as ordinary income in the year
United States Supreme Court held that completed and can be collected after the of receipt. Distributions of non-deduct-
for a qualified plan subject to ERISA, bankruptcy, both from assets that were ible employee contributions are possi-
benefits are protected from a partici- exempt from the bankruptcy estate and ble (but not typical). When they are part
newly acquired assets. of a lump sum distribution, they may be
pant’s creditors in bankruptcy. A plan is
subject to ERISA when it covers at least Required minimum distributions are withdrawn from the plan without any
one common law employee. not exempt from the bankruptcy estate. tax on the basis.
Once in the hands of the debtor, they 31. IRC §411(a)(2)(B) as amended by PPA.
are subject to creditors. No distinction is 32. IRC § 411 (a).
No common law employees
made between the federal government as 33. IRC § 411 (8)(A).
34. IRC § 411 (d)(3).
For plans covering only owner em- a creditor and other creditors. 35. IRC §411(a)(10).
ployees, state law, not ERISA, controls. All other distributions, including 36. 504 US 753, KTC 1992-198 (S Ct 1992).
For example, in In re Stern,37 the ninth 37. 317 F3d 1111 (9th Cir 2002).
hardship distributions and those part of 38. 11 USC §523(a)(7).
circuit held that, under California law, a series of substantially equal periodic 39. 11 USC §§523(a)(1) 507(a)(2) and 507(a)(8).
Conclusion key employees. Earnings and gains ac- is made, possibly over decades. In addi-
Qualified plans are extraordinarily crue tax free. tion, the Internal Revenue Service read-
attractive, today more than ever before. While in trust, plan benefits are pro-
ily and routinely issues favorable deter-
This is because disproportionately large tected from non-family creditors even in
income tax deductible contributions can bankruptcy. Tax is deferred until distri- mination letters on plan qualification be-
be made by an employer on behalf of bution to a participant or his beneficiary fore implementation. ■
Reprinted from the Illinois Bar Journal,
Vol. 95 #7, July 2007.
Copyright by the Illinois State Bar Association.