New Developments In Cross-Tested Plans

Traditional profit sharing plans are often inadequate to cost-effectively provide for a family business owner’s retirement. Age-weighted plans were developed to address the cost issues, but were often inadequate. Now new developments in cross-testing can flexibly and cost-effectively address almost any family business’s needs.

Under regulations issued within the last several years, the government acknowledged that contributions to a profit-sharing plan could be made in such a manner that favors older employees, in an “age-weighted” or “age-based” plan. The logic of this is that as an employee gets closer to retirement, the need for larger contributions to the plan becomes greater. This is particularly true where an employee has not funded fully for retirement at earlier ages because the need for spendable dollars outside of a qualified plan was so great.

By using an age-weighted formula, the employer can give the largest portion of the plan contribution to older employees. Often, the older employees include the founder of the business. Notwithstanding this, the contribution for any one employee may not exceed 25% of pay or $30,000, and the overall contribution to the qualified plan may not exceed 15% of eligible compensation for all employees.

Dilemma of Age-Weighted Plans
While age-weighted plans in their simplest form make a lot of sense, family business owners often found them unsatisfactory. Sometimes such a plan may be a disincentive to the business to hire older employees. Sometimes, the fact that there are a few older employees in the lower-paid group can be an incentive not to use the age-weighted formula. Finally, sometimes it was just bad for morale to have employees of different ages who are in the same job classification receiving different percentages of pay as their profit-sharing contribution. These elements combined to push family business owners to search for something better.

In response to these needs, the cross-tested plan was developed. Sanctioned by the same regulations, the cross-tested plan (1) tends to lump employees together in groups, (2) allows the employer to make contributions to entire classes of employees at the same pay percentage, and (3) allows employers to test the plan under formulas that allow groups with overall older employees to receive greater benefits as a percentage of compensation. In addition, by lumping employees of similar class but of different ages together, the negative impact of a few older employees in the rank and file could be offset by the existence of younger employees in the same group.

Flies in the Ointment
Despite this, family business owners often found that simple cross-tested plans did not produce the kind of relative contributions to employees that would make the plan attractive. Traditional concepts of excluding employees with less than one year of service and those under the age of 21 took employees who would help produce a favorable overall contribution to the plan out of the plan. Also, the traditional cross-tested plan could not accommodate a situation where several highly compensated employees desired different contributions to the plan.

Recent advances in the cross-tested area, however, have addressed these and other issues. Having worked with the regulations for several years now, qualified plan designers have become more sophisticated in structuring plans for the family business.

One concept, previously unheard of in the small family business qualified plan, is an intentional design to include seasonal and part-time employees in the plan, as well as employees who work in areas with a high turnover rate. Since many of these employees are younger, they tend to ameliorate the impact of older employees in the rank-and-file group. In addition, because they may never vest in their benefit, contributions on their behalf are often forfeited. Thus, while these employees are included for purposes of testing a cross-tested plan, they may never receive an actual benefit from the plan.

In addition, by providing flat-dollar benefits to selected rank-and-file employees, particularly those who work part time or seasonally, dramatic results can be accomplished in testing under the regulations.

Group Stratification
When several highly compensated individuals are included in the plan and each have different needs, a creative plan designer can vary the contribution to different officers of the company by stratifying the group.

One way would be to provide a different percentage of pay for different types of officer groups. Senior management, for example, can get a larger percentage of pay than junior management, and highly compensated employees may be grouped in such a fashion as to take advantage of this stratification.

The net result of these and other techniques can make a cross-tested profit sharing plan extremely attractive to a small family business. There is almost no group of employees in a typical family business that cannot be used in such a manner as to make a cross-tested plan appealing to the owners of a family business.

If you would like to explore further the possibilities under a cross-tested profit sharing plan, please call our office.