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Qualified pension and profit sharing plans are an important part of today's business environment. A "qualified plan" can provide excellent benefits for both employers and employees. For example, employers can use a qualified plan to help attract and retain good employees while obtaining tax deductions for plan contributions. Participating owners and employees benefit because annual employer contributions are not taxed to the participant. Add tax deferred compounding of growth and income and you accentuate the retirement benefits that can be produced over time through deferred compensation planning.

Yet many small to medium sized businesses either use poorly designed plans or fail to take advantage of qualified pension and profit sharing plans because of the costs involved in providing benefits to employees. The costs that concern most employers stem from the nondiscrimination rules imposed by the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (IRC).

The nondiscrimination rules must be complied with in order to qualify the plan for tax favored status. Other rigid administrative and reporting requirements enforced by the IRS and Department of Labor (DOL) add to the compliance burden. The result is that the bar seems to be set too high for many small business owners. But is that really the case?

The nondiscrimination rules are aimed at preventing employers from providing benefits solely to owners and other highly compensated employees without providing like benefits to lower compensated employees. While the nondiscrimination rules appear to be a major hurdle, a closer look at the rules opens up planning opportunities that are made to order for many businesses owners and professionals.

What many people fail to realize is that employers can discriminate in favor of highly paid employees and participating owners within certain limits. Additionally employers can discriminate in favor of older employees who are closer to retirement or to a select group of highly compensated employees so long as benefits to other employees meet minimum standards.

The first type of permitted discrimination arises out of the ability of the employer to integrate or coordinate the benefits of social security with benefits provided under certain qualified plans (Social Security Integration). The idea of a Social Security Integrated Plan is that social security is intended to provide retirement benefits which benefit lower paid individuals more (as a percentage of their compensation) than higher paid individuals. Since the employer already contributes to the employee's Social Security Retirement Benefits, lower contribution levels are allowed for compensation amounts not to exceed the social security wage base of $68,400 (for 1998).

For instance, a money purchase pension plan can have two contribution levels -- one level (e.g., 4%) for pay up to a specified amount (e.g., $50,000) and another level (e.g., 8%) for compensation above that amount. The point at which the contribution percentage changes is called the "integration level." The integration level (i.e., the cut-off point between the lower and higher rates) can be anything from $1.00 to $68,400 dollars in 1998. The difference between the contribution rates is known in pension jargon as the "permitted disparity." In general the higher contribution percentage cannot be more than twice the lower contribution percentage and in no event may the permitted disparity be more than 5.7%.

A second type of permitted discrimination can be quite favorable for those small business owners who are older than the bulk of their employees. An "age-weighted" plan is a profit sharing plan that factors age into the compensation formula to benefit older employees who have fewer years to accumulate sufficient funds for retirement. At first glance, this type of formula would appear to violate nondiscrimination rules since larger contributions are made to older employees, who tend to receive higher compensation. Annual allocations to the plan are converted to "equivalent benefits" based on projections as to retirement date in order to pass the nondiscrimination test. Because younger employees have a much longer investment horizon before retirement, a much smaller allocation can produce an "equivalent benefit" at retirement. The appeal of an age-weighted plan will depend largely upon the distribution of ages among a company's employees. Another type of plan known as the "new comparability profit sharing plan," has been successfully employed to get around the design limitations of an age-weighted plan while still providing greater benefits to a select group of employees. Like an age-weighted plan, a new comparability profit sharing plan permits greater discrimination. However, rather than basing the discrimination strictly on age it is based on "allocation groups." An allocation group can be defined based on any reasonable criteria, including percentage of ownership, status as a key or highly compensated employee, job description (e.g., doctors, attorneys, or dentists), length of service, age, or management role.

The point is, when it comes to qualified pension and profit sharing plans, business owners, professionals and highly compensated employees should know that there are ways to play by the rules while still providing much greater pension benefits to themselves. As the following table shows, the differences in the results achieved by various plan designs can be substantial:

Because qualified pension plans are subject to complex nondiscrimination testing and other ERISA compliance rules, you should seek the assistance of qualified professionals before designing and implementing a pension and profit sharing plan.

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