Retirement Plan Correction Solution
Women of Questionable Allocations:
Correcting Errors in Profit Sharing Contributions
By: Adrienne I. Moore, Esq.
Lorelei and Sookie run a bed and breakfast, the Dragonfly Inn. The Dragonfly has prospered ever since receiving a rave review in a travel and leisure magazine, and they want to reward their employees. Lorelei and Sookie decide to make a profit sharing contribution to the retirement plan for the 2021 plan year. For Michel, their inimitable concierge, they contribute 5% of his compensation. For the rest of the staff, they contribute 3% of compensation. Lorelei and Sookie award themselves a contribution of 10% of compensation. They announce the contribution at the holiday party and deposit the funds to the plan before the end of the year. Because the employees were not expecting anything extra, everyone is overjoyed!
In January 2022, Lorelei sends the annual census information to Emily, the TPA, and lets her know about the funded profit sharing contribution. Emily immediately calls the Dragonfly. “Lorelei! What were you thinking? Your plan requires a pro rata allocation. That means everyone has to receive the same percentage of their pay as a contribution. And what’s worse, your plan has allocation conditions! Employees must have worked 1,000 hours in a year and still be employed on the last day of the plan year to receive an allocation. Why didn’t you tell me before you did this?” Lorelei pretends to be driving through a tunnel and losing the cellphone connection and hangs up. She can’t believe that her attempts to do something nice have put her into trouble. What can she do to fix her plan and get Emily off her back?
The Ins and Outs of Allocations
Luckily, Lorelei can call Rory, who also works for the TPA firm and is less prone to hysterics. Rory has the answer. To know how to fix the plan, Lorelei must first understand how the allocation would have looked if it had been done correctly. Rory confirms that the Dragonfly plan has a pro rata allocation formula. That means the profit sharing allocation must be proportionate for each employee – that is, each employee must receive a contribution equal to the same percentage of pay. Employers often accomplish this in one of two ways. Using the first method, the employer decides on the total contribution it wants (or is able) to fund to the plan for the year and allocates it proportionate to compensation among all the employees. Using the second method, the employer decides on a percentage of compensation it will use and funds whatever is required to meet this.
Suppose Dragonfly is able to fund $19,000 to its plan for the year. It is allocated to each employee proportionate to that employee’s compensation, as compared to the total of all employees’ compensation, for that year. The allocation ends up being an even percentage of compensation.
|Employee||Compensation||Comp % to Total Comp||Profit Sharing Allocation||PS Allocation as % of Comp|
|Lorelei||$75,000||30%||$5,700 ($19K x 30%)||7.6% ($3K / $75K)|
|Sookie||$75,000||30%||$5,700 ($19K x 30%)||7.6% ($3K / $75K)|
|Michel||$50,000||20%||$3,800 ($19K x 20%)||7.6% ($2K / $50K)|
|Kirk||$30,000||12%||$2,280 ($19K x 12%)||7.6% ($1.2K / $30K)|
|Rune||$20,000||8%||$1,520 ($19K x 8%)||7.6% ($800 / $20K)|
Suppose instead that Dragonfly decides to fund a contribution of 3% of compensation for each employee. The allocation is calculated using that percentage for each employee and the employer funds the total to the plan.
|Employee||Compensation||PS Allocation as % of Comp||Profit Sharing Allocation||PS Allocation as % of Comp|
|Lorelei||$75,000||3%||$2,250||7.6% ($3K / $75K)|
|Sookie||$75,000||3%||$2,250||7.6% ($3K / $75K)|
|Michel||$50,000||3%||$1,500||7.6% ($2K / $50K)|
|Kirk||$30,000||3%||$900||7.6% ($1.2K / $30K)|
|Rune||$20,000||3%||$600||7.6% ($800 / $20K)|
What’s the Correction?
The plan document requires any profit sharing contribution to be allocated on a pro rata basis, which means the failure to allocate appropriately is an operational failure – that is, a failure to properly follow the plan’s terms. The correction is to put things right so that the plan is being operated compliantly and to put the participants in the position that would have been if not for the failure. This could be accomplished a couple different ways. Here is the allocation as it stands before correction:
|Employee||Compensation||PS Allocation as % of Comp||Profit Sharing Allocation|
Correction Option 1: Additional Contributions
Lorelei and Sookie can make additional contributions to the plan to bring everyone’s allocation percentage up to the highest level. Because Lorelei and Sookie each received 10% contributions, this correction would require them to fund the difference for all other employees so that each employee is ultimately provided a 10% allocation. This will require a corrective contribution of $6,000, as is illustrated below.
|Employee||Compensation||Original PS Allocation||Corrective Contribution||Corrected PS as % of Comp|
Correction Option 2: Reallocation
If an employer cannot (or does not want to) make additional contributions, the employer can instead reallocate the original contribution to the employees pro-rata based on compensation. This will average out the employees so that those who received the highest contributions will have some money forfeited and those who received the lower contributions will receive additional allocations. After a reallocation, each employee will have received an allocation that is the same percentage as every other employee. Calculating a reallocation starts much like the first method of a correct allocation shown above. The allocation is calculated using the total profit sharing contribution that was already funded to the plan (i.e., $19,000). Once the correct allocation is determined, employees who received too much will forfeit the excess and employees who received too little will receive corrective allocations.
|Employee||Compensation||Original PS Allocation||Corrected Allocation||Corrected PS as % of Comp||Change|
|Lorelei||$75,000||$7,500||$5,700 ($75K x 30%)||7.6%||– $1,800|
|Sookie||$75,000||$7,500||$5,700 ($75K x 30%)||7.6%||– $1,800|
|Michel||$50,000||$2,500||$3,800 ($50K x 20%)||7.6%||+ $1,300|
|Kirk||$30,000||$900||$2,280 ($30K x 12%)||7.6%||+ $1,380|
|Rune||$20,000||$600||$1,520 ($20K x 8%)||7.6%||+ $920|
Lorelei and Sookie cannot afford to make additional contributions. When Rory shows them that reallocating will take some money from them but will ensure Michel does not lose any of his allocation, they decide reallocation is the best option for the plan.
Don’t Forget the Earnings!
Remember: When corrective contributions are made, the contribution must be adjusted for lost earnings from the date the amount should have been funded through the date the full correction (with earnings) is funded to the plan. The same is true for reallocation – participants who received too much do not get to keep the earnings that accrued on the excess allocation. The earnings will be removed from the participant’s account, along with the excess allocation, and reallocated as appropriate. For more guidance on calculating lost earnings, see our prior Solution here.
And What About the Last Day Requirement?
In November 2021, Kirk left the Dragonfly to start a pest control business. The Dragonfly plan requires a participant to be employed on the last day of the plan year (i.e., December 31, 2021) to be able to share in a profit sharing allocation for that year. That means Kirk should not have received an allocation for the 2021 plan year. To correct, Kirk’s allocation will be removed from his account. When the reallocation is done, the profit sharing contribution will be allocated among the remaining participants. Once again, calculating the reallocation looks like the first method of a correct allocation shown above. This time, however, the allocation is calculated based on the compensation only of the employees other than Kirk (instead of the full $250,000). As before, any correction would also need to be adjusted for earnings.
|Employee||Compensation||Original PS Allocation||Corrected Allocation||Corrected PS as % of Comp||Change|
|Lorelei||$75,000||$7,500||$6,477.27 ($19K x 34.09%)||8.64%||– $1,022.73|
|Sookie||$75,000||$7,500||$6,477.27 ($19K x 34.09%)||8.64%||– $1,022.73|
|Michel||$50,000||$2,500||$4,318.18 ($19K x 22.73%)||8.64%||+ $1,818.18|
|Rune||$20,000||$600||$1,727.27 ($19K x 9.09%)||8.64%||+ $1,127.27|
The percentages work out so there is a rounding error that leaves one penny unallocated. Lorelei allocates this to Rune so that his total allocation is $1,727.28. This small rounding error does not cause an operational violation.
Where You Lead, I Will Follow
Lorelei and Sookie are relieved that Rory was able to help resolve their allocation failure without additional funding. Going forward, they know how to plan for a pro rata allocation. But what if they need more flexibility? On a call with the TPA firm, Emily tells Lorelei all about another allocation formula that would allow her to fund a different allocation percentage for each employee. Isn’t that fabulous? Rory explains to Lorelei that one major benefit of a pro rata allocation method is that it is a “safe harbor allocation formula.” This means that it is deemed to be nondiscriminatory. She also warns Lorelei that different allocation methods will come with different restrictions and require additional testing, but Lorelei is already sold.
A plan may be amended to change allocation formulas up until one or more of the participants have locked in their right to their share of the contribution based on the current plan formula. Because the Dragonfly plan requires employment on the last day of the plan year to earn a right to an allocation, no one has yet accrued (or locked in) the right to a profit sharing contribution for the 2022 plan year. Therefore, Lorelei can amend the plan mid-year and it will apply for the whole year. Emily has Rory prepare an amendment to the plan effective January 1, 2022, to change the allocation formula from pro rata to individual allocation groups. Rory makes a note on her calendar to check in with Lorelei in December (hopefully) before she funds anything to make sure that the desired allocation will pass the nondiscrimination testing. Their work complete, Lorelei, Sookie, and Rory all walk over to Luke’s Diner for a nice afternoon mocha.
If you have questions about a plan’s allocations or how to correct when they’ve gone awry, call us. We are your ERISA solution!