73Chapter 7: Profi t-Sharing Plans

CHAPTER 7

PROFIT-SHARING PLANS

IntroductionA profi t-sharing plan is a type of defi ned contribution plan that is some-

times used as a supplement to a primary defi ned benefi t plan. Sometimes these plans are structured in such a way that employees share in their companies’ profi ts and, thereby, potentially gain a greater interest in their fi rms’ success.

About 100 years ago, Pillsbury Mills and Procter & Gamble each estab-lished a cash profi t-sharing plan (defi ned below). In 1916, Harris Trust & Savings Bank in Chicago established the fi rst deferred profi t-sharing plan (defi ned below). In 1939, legislation clarifi ed the tax status of deferred plans. This legislation and the World War II wage freeze resulted in rapid growth of profi t-sharing plans in the 1940s. The Employee Retirement Income Security Act of 1974 (ERISA) furthered the growth by imposing less burdensome regulations on profi t-sharing plans than on defi ned benefi t pension plans, thus increasing their attractiveness.

Types of PlansThere are three basic types of profi t-sharing plans. Cash Plan—At the time profi ts are determined, contributions are paid

directly to employees in the form of cash, checks, or stock. The amount is taxed as ordinary income when distributed.

Deferred Plan—Profi t-sharing contributions are not paid out currently but rather are deferred to individual accounts set up for each employee. Benefi ts—and any investment earnings accrued—are distributed at retire-ment, death, disability, and sometimes at separation from service and other events.

Combination Plan—In this type of plan, the participant has the option of deferring all or part of the profi t-sharing allocation. The portion taken as a deferral is placed into the participant’s account, where it and invest-ment earnings accrue tax-free until withdrawal. Any amount taken in cash is taxed at current rates. For tax purposes, Internal Revenue Service (IRS) qualifi cation of profi t-sharing plans is restricted to deferred or combination plans. Therefore, the remainder of this chapter will focus primarily on these two types of profi t-sharing arrangements.

74 Fundamentals of Employee Benefi t Programs

Plan Qualifi cation RulesProfi t-sharing plans, as other retirement plans, must meet a variety of

requirements to qualify for preferential tax treatment. These rules, created under ERISA and discussed in the chapter on pension plans, are designed to protect employee rights and to guarantee that pension benefi ts will be available for employees at retirement. The rules govern requirements for reporting and disclosure of plan information, fi duciary responsibilities, employee eligibility for plan participation, vesting of benefi ts, form of benefi t payment, and funding. In addition, qualifi ed plans must satisfy a set of IRS nondiscrimination rules (under Internal Revenue Code (IRC) Secs. 401(a)(4), 410(b), and, in some cases, 401(a)(26)) designed to insure that a plan does not discriminate in favor of highly compensated employees.1

ContributionsEmployer Contributions—Plans must defi ne how employer con-

tributions will be allocated to employee accounts. The allocation formula is generally based on compensation. Sometimes the allocation is a fl at percentage of pay, or it may be determined by calculating the proportion of each employee’s compensation relative to the total compensation of all plan participants. For example, if the employee earns $15,000 annually and total annual compensation for all participants is $300,000, he or she would receive 5 percent of the employer’s annual contribution.

Some plans base their allocations on compensation and service credits. These plans must be careful to assure that the wage/service formula meets the regulatory scheme for demonstrating that the formula does not dis-criminate in favor of highly compensated employees. Whether a plan uses compensation or both compensation and service in determining allocations depends on an employer’s objectives. If employee retention is a primary goal, this can be refl ected in a pay-and-service allocation formula. Allocation formulas may be integrated with Social Security within prescribed limits. (See chapter on integrating pension plans with Social Security for more information.)2

Maximum annual contributions (employer and employee, if any) on behalf of each plan participant are limited by the defi ned contribution limits under IRC Sec. 415—the lesser of 100 percent of compensation or $49,000 (this is the dollar fi gure for 2009; for further details on contribution limits,

1 A highly compensated employee is defi ned in the chapter on pension plans.2 New methods of allocating contributions to profi t-sharing plan participants include age-weighting and cross-testing. See chapter 8 of Littell and Tacchino (2007) for additional detail.

75Chapter 7: Profi t-Sharing Plans

including future increases in the dollar amount, see chapter on retirement plans).

The total amount of contributions for all employees that an employer may deduct for federal tax purposes is limited to 25 percent of all partici-pants’ compensation. Any amount paid into the trust in any taxable year in excess of this limitation is subject to a 10 percent excise tax but will be deductible in the succeeding taxable years in order of time; however, the amount so deductible in any such succeeding taxable year, together with the amount allowable for the current year, cannot exceed 25 percent of compensation with respect to such taxable year.

For example, assume an employer pays $100,000 in compensation to all participants in 2005, 2006, and 2007. If the employer contributes $30,000 to the profi t-sharing plan in 2005, the deduction will be limited to $25,000 (25 percent of $100,000) and $5,000 ($30,000 minus $25,000) will be nondeductible and subject to an excise tax of $500 (10 percent of $5,000). If the employer contributes $23,000 in 2005, it will be able to deduct $25,000 ($23,000 plus $2,000 carried over from the previous year) and would have to pay an excise tax of $300 (10 percent on the $3,000 that still has not been deducted). If $20,000 is contributed in 2007, the deduction would be $23,000 ($20,000 plus the $3,000 carryover not previ-ously deducted). There would be no excise tax in that year.

A profi t-sharing plan is a defi ned contribution plan to which the company agrees to make “substantial and recurring” contributions;3 however, the actual amount is generally subject to employer discretion. An employer does not have to have profi ts to establish a profi t-sharing plan, and total contributions are not restricted to total profi ts. However, plan documents must specify that the plan is a profi t-sharing plan.

Employee Contributions—Pure profi t-sharing plans do not require employee contributions, but some may permit voluntary employee contribu-tions up to certain limits. The plan then generally looks more like a thrift plan. Employee contributions in the form of a salary reduction are becom-ing increasingly popular. When pretax salary reduction is allowed, the plan must follow rules for 401(k) arrangements (see chapter on 401(k) plans).

Taxation—Employer contributions to a profi t-sharing plan are deductible by the company as a business expense (up to the limits noted previously). Employees are not taxed on the deferred contributions—or any investment income accrued—until distribution. Any allocation (all or part) taken in cash is taxed on a current basis.

3 Treas. Reg. § 1.401-1(b)(2).

76 Fundamentals of Employee Benefi t Programs

InvestmentsProfi t-sharing funds may be invested in a wide variety of vehicles,

including corporate stocks, bonds, real estate, insurance products, and mutual funds. In general, retirement plans may not hold more than 10 percent of their assets in employer securities. However, an exception exists for profi t-sharing plans, stock bonus plans, thrift plans, and employee stock ownership plans, as well as money purchase plans that were in existence before ERISA’s enactment and invested primarily in employer securities at that time. Therefore, contributions are frequently invested in employer securities. This practice may give participants an increased inter-est in the fi rm’s success.

DistributionsRetirement, Disability, and Death Benefi ts—The law requires that

participants’ account balances fully vest at retirement. In addition, plans generally provide for benefi ts on death and disability. The plan’s vesting pro-visions determine whether an employee will receive full or partial benefi ts on other types of employment termination. However, if the plan is contribu-tory (i.e., employees make contributions), the employee will always receive the benefi ts that are attributable to his or her own contributions.

Profi t-sharing plans typically give retiring participants and benefi ciaries of deceased participants a choice between a lump-sum payment and install-ments. Usually, those who terminate employment for reasons other than retirement, death, or disability receive lump-sum distributions, although if the benefi t exceeds $5,000, the participant cannot be forced to take an imme-diate benefi t. Distributions from profi t-sharing accounts must follow the distribution rules for all qualifi ed retirement plans. As a result of tax penal-ties, distributions will generally begin by the year following the attainment of age 70½, unless the individual has not retired. (For a complete description of pension plan distributions, see chapter on pension plans.)

In-Service Withdrawals—Some profi t-sharing plans provide for partial account withdrawals during active employment. Plans allowing participants to elect account withdrawals impose certain conditions, which vary widely. But generally the funds must be held in the plan for two years before a withdrawal is allowed.4

Loans—Some plans permit employees to borrow a portion of their vested benefi ts. In general, the employee must repay the loan according to a level amortization schedule, with payments made at least quarterly. If loans

4 A 10 percent additional income tax applies to most early distributions made before age 59½. See chapter on planning for retirement for more detail.

77Chapter 7: Profi t-Sharing Plans

are permitted, they must be available to all participants on a comparable basis and must bear a reasonable interest rate. (For a detailed explanation of loan requirements, see chapter on pension plans.)

ConclusionProfi t sharing offers employees a chance to share in their company’s

success. The level of company success is directly related to profi ts, which often defi ne the amount of profi t-sharing allocation. So the greater the profi ts of the company, the larger the potential allocation. However, profi t-sharing plans can serve several goals. If the plan is cash only, it is generally viewed as a form of bonus. If profi ts are good, benefi ts are paid. However, these can become viewed as certain, and employees may spend anticipated benefi ts before they materialize. Deferred plans are generally intended to supplement other pension plans and thus are generally more appropriate for retirement purposes.

Because of their advantages to both employees and employers, profi t-sharing plans will probably continue to play an important role in employee benefi ts planning.

BibliographyAllen, Everett T., Jr. et al. Pension Planning: Pension, Profi t-Sharing,

and Other Deferred Compensation Plans. Ninth edition. Boston, MA: McGraw-Hill/Irwin, 2003.

Buckley, John F., IV. ERISA Law Answer Book. Sixth edition. New York: Aspen Publishers, 2008.

Employee Benefi t Research Institute. EBRI Databook on Employee Benefi ts. Online at www.ebri.org/publications/books/index.cfm?fa=databook

Ferrera, Tess J. ERISA Fiduciary Answer Book. Fifth edition. New York: Aspen Publishers, 2006.

Krass, Stephen J. The 2008 Pension Answer Book. New York: Aspen Publishers, 2008.

Littell, David A., and Kenn Beam Tacchino. Planning for Retirement Needs. Ninth edition. Bryn Mawr, PA: The American College Press, 2007.

McGill, Dan M. et al. Fundamentals of Private Pensions. Eighth edition. New York: Oxford University Press, 2005.

78 Fundamentals of Employee Benefi t Programs

Palmer, Bruce A. “Profi t-Sharing Plans.” In Jerry S. Rosenbloom, ed., The Handbook of Employee Benefi ts: Design, Funding and Administration. Sixth edition. New York: McGraw-Hill, 2005.

Profi t Sharing/401(k) Council of America. 51st Annual Survey of Profi t Sharing and 401(k) Plans: Refl ecting 2007 Plan Year Experience. Chicago: Profi t Sharing/401(k) Council of America, 2008.

U.S. Department of Labor. Bureau of Labor Statistics. National Compensation Survey: Employee Benefi ts in Private Industry in the United States, March 2007. Washington, DC: U.S. Department of Labor, 2007.

Additional InformationPension Research CouncilThe Wharton School of the University of Pennsylvania3620 Locust Walk, 3000 Steinberg Hall – Dietrich HallPhiladelphia, PA 19104(215) 898-7620www.prc.wharton.upenn.edu/prc/prc.html

Profi t Sharing/401(k) Council of America20 N. Wacker Drive, Suite 3700Chicago, IL 60606(312) 419-1863www.psca.org