Page 335 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 6. Employee Benefits and Perquisites 321

“profit-sharing” plans, the 1986 Tax Reform Act stated that profits are not required to make
a contribution. The contribution can either be by predetermined formula or determined
annually in a discretionary manner. However, IRS regulation 1.401-1(b)(2) requires that the
contributions be “substantial and recurring” in order to meet tax-qualified status requiring
a degree of permanency. In addition, the plan cannot discriminate in favor of highly
compensated individuals.
Although benefits may be paid at the end of the year, this is currently not a form of prof-
it sharing eligible for preferential tax treatment. This form will be reviewed in Chapter 7
(“Short-Term Incentives”). Benefits that are credited to an individual’s account at the end of
the year but not available until the attainment of a stated age or with the occurrence of a pre-
scribed event (e.g., disability or severance of employment due to layoff, death, or retirement),
are deferred profit-sharing plans. They are eligible to be treated as tax-qualified plans under
Section 401 of the IRC. This enables the company to take a tax deduction at time of contri-
bution, whereas the individual is not taxed until the later date when funds are withdrawn. If
the deferred profit-sharing plan does not meet requirements for tax qualifications, the com-
pany cannot take a tax deduction until the individual receives the benefit. If the company takes
a tax deduction at time of contribution, the individual has a tax liability on income not
received. This is not a good situation for the individual. Alternatively, the company has to
defer the tax deduction until the monies are withdrawn years later. This is not very attractive
to the company.
To be tax qualified, Section 404 of the IRC stipulates that the maximum annual tax
deduction allowable to the company is 25 percent of the compensation paid or accrued
during the taxable year. Although not required for tax qualifications, some plans permit
employee contributions. Furthermore, it is the lesser amount of 25 percent or the dollar
amount prescribed by statute, which limits its attractiveness to highly paid executives.
Allocations to individual accounts can be either a uniform amount for each or based on
compensation, or compensation and years of service credit, or compensation and age. A uni-
form amount for everyone would give the lowest-paid employee the largest percentage of pay,
whereas the highest-paid executive would receive the lowest percentage. For allocations based
only on compensation, a person earning $100,000 with a covered payroll of $10 million would
receive 1 percent of the profit-sharing contribution since the person’s pay is 1 percent of the
covered payroll. If the profit-sharing contribution were $100,000, the individual’s share would
be $1,000. Under a combination compensation and years-of-service plan, points are assigned
by formula. Perhaps the individual is assigned 1 point for every $100 of earnings and 2 points
for every year of service. In the earlier example, if the person had 10 years of service, it would
result in 1,020 points ($100,000 100) (10 years 2). If the total points of all employees
were 105,250, each point would be worth $9.50 ($1 million divided by 105,250 points) and this
person would receive $9,690.
Planners must determine the desired relationship of pay to service. In the previous for-
mula, if it were one point for every $10 not $100 of pay, service would be much more impor-
tant, relatively. Compensation and age formulas can be designed in much the same manner,
providing greater weight for older employees. However, such plans must be careful to ensure
they do not discriminate in favor of highly compensated individuals. Since older employees
are typically more highly compensated than younger employees, this could be a problem.
Also, one must view the formula in light of the federal requirement of either equal costs or
equal benefits, as prescribed in the Older Worker Protection Act of 1990.