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Defined contribution plans, such as profit sharing, 401(k) plans and to a lesser extent, money purchase pension plans are usually suitable for small business owners. However, they are less popular than IRA based plans, such as SEP IRAs, because they are more complex and sometimes require administrative services and accompanying costs that do not apply to IRA based plans. Most employers who usually shy away from these plans change their point of view after they learn how they operate, and understand the available benefits. Defined benefit plans are even less common, as they are the most complex and costly to maintain.

The following are some high-level features and benefits of these plans.

Eligible Businesses

Qualified plans can be established by any business entity. This includes sole proprietorships, partnerships and corporations.

Choosing the Qualified Plan That’s Right for A Business

When deciding which qualified plan to adopt for a business, the business owner must consider certain features  and benefits before making a decision. These include funding flexibility, the level of complexity, the administrative requirements and the level of ease with which the plan can be communicated to employees. This will help to ensure that the plan that is chosen is the plan most suitable  for the business' profile. Let’s take a look at some features.

More features and benefits are compared in the Employer Plan Comparison Chart available here

Note: Money purchase pension plans are not so important anymore. Prior to the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001( EGTRRA), most small business owners would adopt a paired money purchase and profit sharing plan so as to be able to receive the full deduction of 25% of compensation, while having the flexibility of discretionary contributions on the percentage of contributions allocated to profit sharing plans. However, under EGTRRA, the deductibility limits for profit sharing plans increased from 15% to 25%, making it the same as the deductibility limit for money purchase plans. As a result, employers no longer need to adopt a money purchase pension plan in order to receive the 25% deduction.

Establishing a Qualified Plan

Authorizing the plan adoption

Once the business owner decides which qualified plan is right for the business, the next step is to ensure that the business is authorized to adopt the plan. If the business is a corporation, a corporate resolution may need to be adopted so as to ensure that the plan establishment is authorized by the business. For partnerships, the partnership agreement may need to be amended to allow for the adoption of the plan, if those provisions are not already included.

Choosing the plan document

A business owner has several options to choose from when selecting a plan document. The choices include the following:

• Individually designed plans, where a customized plan document is used. This is usually the most expensive, and requires the assistance of an ERISA attorney and other experts to draft the plan and obtain approval from the IRS. Usually used by larger businesses
• Prototype or Master plans, which are usually offered by approved document providers for use by an unlimited number of employers. The adoption agreements for these plans are usually ‘fill in the blanks’, allowing the employer limited flexibility. However, while flexibility may be limited, the options under the plan are usually sufficient for small businesses
• Volume submitter plans, which is usually a cross section between an individually designed plan and a prototype plan

Establishing employee eligibility requirements
If the business has employees, those who satisfy the eligibility requirements must be allowed to participate in the plan. While an employer can allow all of its employees to participate in the plan, it can also exclude employees who do not meet certain requirements. At a minimum, the following employees must be allowed to participate in the plan :

• Employees who performed service with the company for at least two years (one year for 401(k) plans). It is important to note that if the employer chooses to implement a two-year service eligibility requirement, employer contributions are immediately 100% vested.
• Employees who are at least age 21
• Employees who are not part of a collective bargaining agreement

These eligibility requirements are usually selected or included in the adoption agreement. Once the employer completes the adoption agreement, the next step is to notify eligible employees about the plan.

Notifying Employees

The notification provided to employees must be in an easy-to-understand form, and must include pertinent information, such as features, benefits, requirements for distributions, eligibility requirements and rules regarding contributions. The document that includes these explanations is the summary plan description, which must be provided to eligible employees within 120 days after the adoption of the plan.

Establishment Deadline

A qualified plan must be established by the end of the plan year. For instance, if the plan is maintained on a calendar year, it must be established by December 31. However, unlike employer contributions which can be based on compensation earned for the entire year includling before the plan was established, salary deferral contributions to 401(k) plans must be made from compensation earned after the plan is established and the employee elects to make salary deferral contributions. Therefore, it is only practical that a plan with a 401(k) feature is established earlier in the year, so as to allow participants to make salary deferral contributions.

Contributions

Contributions for an employee can be up to 100% of the employee’s eligible compensation, providing the contribution amount does not exceed $45,000 ($50,000 for 401(k) plans- if the participant reaches age 50 by year end.) For qualified plans, the compensation cap rule applies, which means that no more than $225,000 in compensation can be taken into consideration for purposes of determining plan contributions for an employee.

The contribution formula chosen depends on what is available under the plan document. The following are some options from which you could choose.

• A prorata formula, where each eligible participant receives the same percentage of their eligible compensation as contributions
• A flat dollar formula, where each eligible participant receives the same dollar amount as contributions
• A social security integration formula, where employees who receive contributions in excess on the taxable wage base receive a higher percentage of contributions than other employees
• An age weighted formula, where contributions are based on the age of the participants, resulting in older employees receiving larger contribution percentages.
• New comparability formula, where contribution percentages are determined by groups, such as years of service, age and job classification.

An employer should check to ensure the preferred contribution formula is available under the plan, before starting the adoption process.

Employer Contribution Deadline

Employer contributions must be made to the plan by the employers’ tax filing deadline, including extensions.

Salary Deferral Contributions

Eligible employees may defer up to 100% of their compensation, providing the amounts deferred does not exceed the following dollar amounts.

A plan may be designed to place limits of less than these statutory amounts. For instance, a plan could limit salary deferrals to 10% of compensation.

Salary deferral contribution deadline

Salary deferral contributions must be deposited to the plan as soon as they can be separated from the employer’s assets, but no later than the 15th business day of the month, following the month to which the deferral applies. For instance, salary deferrals withheld from an employee’s salary for January, must be deposited to the plan by the 15th business day in February.

Deduction of Contributions

Profit Sharing and 401(k) Plans

Generally, an employer may deduct an amount up to 25% of the aggregate compensation paid to all eligible employees for the year. This 25% does not include salary deferral contributions, and the compensation used to determine deductibility is calculated before salary deferral contributions are deducted. For instance: If the aggregate compensation paid to employees is $100,000, the maximum deductible contribution is $25,000(25%).  If employees made salary deferral contributions to the plan, those amounts are not included in the $25,000. Further, if employees deferred $10,000 to the plan; it is the $100,000 that is used to determine the deductible contribution amount, not $90,000.

Money Purchase Pension Plans

For money purchase pension plans, the deductible amount is limited to the percentage of contribution elected in the plan agreement. For instance, if the employer elected to contribute 10% of compensation, the deduction is limited to that amount.

Vesting Schedule

One of the attractive features of a qualified plan is that employer contributions can usually be subject to a vesting schedule. This means that employees must work a certain number of years in order to ‘own’ contributions made by the employer. Employees who leave the company before being 100% vested will lose contributions in which they are not vested.

Distributions

The distribution rules are usually determined by the terms of the plan document. For instance, a plan could provide that participants can make withdrawals from the plan after they reach age 59 ½, after they leave the employment of the employer, or that they must meet both requirements. The plan document must be consulted to determine the distribution rules that apply to the plan.

Conclusion

Adopting a qualified plan for a business not only provides tax benefits such as receiving a tax deduction for contributions. It also helps to attract and retain high quality employees. Additionally, employers may be able to receive tax credits for certain expenses incurred as a result of establishing and administering the plan. Before choosing a plan for its business, the employer should consult with a financial planner and/or retirement counselor who should be able to assist with ensuring that the plan chosen is the most suitable for the business.