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Understanding Profit-Sharing Plans: Guide for Employers and Employees

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What Is a Shared-Profit Plan?

A profit-sharing plan is a qualified defined contribution plan in which you, the employer, contribute to the employee accounts. As the name suggests, employer contributions are generally (but not always) tied to the business's profits, allowing employees to "share" in those profits. Contributions to the plan may be discretionary (you are not required to contribute anything) or determined by a formula based on your annual profits.

Like other types of qualified plans, a profit-sharing plan is intended to help fund your employees' retirement. Providing such a plan may attract high-quality workers and reduce employee turnover. However, unlike other types of qualified plans, the employer typically funds a profit-sharing plan. Your employees cannot generally elect to defer a portion of their pretax compensation to the plan (although after-tax employee contributions may be permitted, as discussed below).

The term "profit-sharing plan" refers to a category encompassing several qualified retirement plans. Profit-sharing plans include employee stock ownership plans and stock bonus plans, 401(k) plans, age-weighted profit-sharing plans, and new comparability plans, although each plan has unique characteristics.

Differences Between Discretionary and Non-Discretionary Profit-Sharing Plans

A discretionary profit-sharing plan allows you to determine the annual contribution amount based on annual profits, plan maintenance fees, and other factors. You can contribute to the plan even if you have no current or accumulated profits in a given year. Similarly, you cannot contribute in a given year, even if your business has made a profit.

Even though you are generally not required to contribute yearly, the IRS requires you to make "recurring and substantial contributions." The IRS may consider your profit-sharing plan to be terminated if you have not made contributions for several consecutive years, even though it has not published any guidelines to clarify this.

Consider the following sample plan language to illustrate the operation of a discretionary profit-sharing plan.

Another option is to contribute to a profit-sharing plan using a predetermined formula. For instance, you could contribute a specified amount to the plan each year that you achieve a certain profit level. The IRS does not specify how profits are defined for this purpose so you can choose any applicable formula. Or, a nonprofit organization may adopt a profit-sharing plan with contributions based on a suitably defined "surplus account." Once you adopt a formula approach, you are required to contribute the amount specified by the formula. Consult a retirement plan expert for additional guidance on this matter.

Caution: You must state your intent to establish a profit-sharing plan in your plan document. This is particularly important if your plan requires employer contributions, as these plans resemble money-purchase pension plans governed by different rules.

Which types of businesses can utilize a profit-sharing plan?

You can establish and maintain a profit-sharing plan whether you are a large corporation, tax-exempt organization, government entity, or sole proprietor. A profit-sharing plan is most advantageous for an employer whose annual profits or financial ability to contribute to a plan fluctuates due to the flexibility of contribution options. In addition, you may find this type of plan particularly appealing if you have many relatively young employees. These employees typically have ample time to save for retirement and are frequently willing to accept some investment risk in exchange for the possibility of impressive long-term investment returns.

The type of profit-sharing plan that self-employed individuals can adopt is sometimes referred to as a Keogh plan.

The tax benefits of profit-sharing plans

Considering Taxes for Employees

When you contribute to a profit-sharing plan on behalf of your participating employees, those contributions are not currently taxable to the employees. As long as the funds remain in the plan, the employees will not owe income tax on the contributions made to their plan accounts. Similarly, the growth of funds held in the profit-sharing plan is tax-deferred. This means that any earnings from plan investments are not taxable to employees as long as they remain in the plan. This creates a greater potential for growth than if the funds were invested in identical investments outside the plan.

When a participant begins to receive distributions from the profit-sharing plan (for example, during retirement), he or she will be subject to federal (and possibly state) income tax on both plan contributions and investment earnings. The rate at which a profit-sharing plan distribution is taxed depends on the employee's federal income tax bracket in the year of receipt; however, many employees may be in a lower tax bracket by the time they begin receiving distributions. In addition to ordinary income tax, an employee who receives a distribution from the plan before age 59 1/2 years may be subject to a 10% premature distribution penalty tax (unless an exception applies).

Distributions from qualified retirement plans after an employee separates from service with the employer maintaining the plan during or after the calendar year in which the employee reaches age 55 are a significant exception to the 10% premature distribution penalty (age 50 for qualified public safety employees participating in particular state or federal governmental plans).

A participating employee who chooses a lump-sum distribution from the profit-sharing plan may be eligible for favorable tax treatment.

Generally, distributions (other than required minimum distributions, hardship distributions, and certain periodic payments and corrective distributions) may be rolled over into an IRA or other employer retirement plans.

Deduction for Employer Taxes

If you are both the employer maintaining the profit-sharing plan and a participant in the plan (for example, if you are a sole proprietor or the owner/employee of a corporation), you should be aware of the employee tax considerations discussed above. Moreover, as an employer, your contributions to the profit-sharing plan are generally tax deductible on the business's federal income tax return for the year they are made.

The maximum annual tax-deductible contribution an employer can make cannot exceed 25% of the total compensation of all covered employees. Contributions exceeding this limit are not tax deductible and are subject to a 10% federal penalty. In 2020, the maximum compensation base that can be used to calculate your maximum tax-deductible contribution will increase to $285,000 (from $280,000 in 2019).

Caution: If you maintain both a profit-sharing plan and a defined benefit plan covering some of the same employees, your annual tax-deductible contribution is limited to 25% of the total compensation of all covered employees. Contributions to the profit-sharing plan are not tax-deductible if the amount necessary to fund the defined benefit plan exceeds 25%. Consult a tax consultant for additional information.

Caution: Annual plan account contributions are limited to the lesser of $57,000 (in 2020, up from $56,000 in 2019) or 100% of the participant's compensation. Annual additions include employer and employee contributions to the participant's plan account and any reallocated forfeitures from other plan participants' accounts. To calculate the annual additions limit, you must consider all qualified defined contribution plans you maintain as a single plan.

Special Rules for Deductions for "One-Participant" Plans

If you are a sole proprietor or small business owner, you may have a "one-participant" profit-sharing plan or wish to establish one. A one-participant plan's objective is to maximize the business's tax-deductible contribution on behalf of the participant. Employers do not need to include 401(k) salary deferral contributions when calculating the maximum allowable tax deduction of 25%.

These contributions to deferred compensation are separately deductible. This allows a plan with one participant to accept a profit-sharing contribution equal to 25% of the participant's compensation (up to $285,000 in 2020) and a 401(k) employee contribution of up to $19,500 in 2020 ($26,000 for a participant who attains age 50 by the end of the year). Under the Internal Revenue Code, the entire contribution would be tax-deductible as an employer contribution (IRC).

The 401(k) elective deferral limit for 2020 is $19,500, plus a "catch-up" contribution of $6,500 for participants who reach age 50 by the end of the year.

Caution: The annual additions limitation (see above) remains in effect, so no participant's plan account can receive a total contribution that exceeds the lesser of $57,000 (in 2020) plus any age 50 catch-up contributions or 100% of the participant's pretax compensation.

Joe, age 35, has an annual salary of $30,000 in 2020 and is the sole participant in his company's 401(k) profit-sharing plan. Joe's plan account is eligible for a profit-sharing contribution of $7,500 (25% of $30,000) and a 401(k) elective deferral contribution of $19,500. This combination results in a total employer contribution of $27,000, tax deductible. This contribution falls within Joe's annual limit of $30,000 (the lesser of $57,000 or 100% of Joe's salary).

Additional Benefits of Profit-Sharing Plans

Employer contributions to a profit-sharing plan are variable on an annual basis.

Employer contributions to a typical profit-sharing plan range from 0% to 25% of an employee's compensation. As previously mentioned, however, you can set up a profit-sharing plan so that contributions are optional, allowing you to decide from year to year whether and how much to contribute. You will then only be required to make "regular and substantial" contributions to the plan. Alternatively, suppose you establish the plan so contributions are based on a formula. In that case, you can include a provision that exempts you from contributing to certain adverse financial conditions. Consult a retirement plan specialist for details.

In-service withdrawals may be permitted under a profit-sharing plan.

An "in-service" withdrawal from an employer-sponsored retirement plan is a distribution received while the sponsor still employs the participant. This differs from a distribution received after the participant retires or leaves the employer's employ. Profit-sharing plans may permit in-service withdrawals of employer contributions after an employee has participated in the plan for a specified number of years (typically at least five), after the employer contribution has been in the trust for a specified period of time (at least two years), or after the employee reaches a specified age (e.g., age 59 1/2).

A profit-sharing plan may also permit in-service withdrawals under certain circumstances, such as illness, disability, death, or financial hardship. A profit-sharing plan may permit participants to withdraw employee contributions after taxes at any time. Typically, other types of plans are more restrictive. For instance, defined benefit plans, money purchase pension plans, and target benefit plans typically prohibit in-service withdrawals before the average retirement age of the plan. 401(k) plans, a profit-sharing plan, are governed by special rules.

Caution: Although your profit-sharing plan may permit withdrawals during employment, it is not required to do so.

The ability to make in-service withdrawals from your profit-sharing plan may appeal to employees in financial need who participate in the plan. However, as with all plan distributions, in-service withdrawals are typically subject to federal and state income tax. Unless an exception applies, such withdrawals may also be subject to a 10% federal early withdrawal penalty tax if the participant is 59 1/2 years old. Consequently, a plan loan may be a more appealing way for participants to access plan funds (as discussed below).

A profit-sharing plan may permit loans to participants.

You can include a provision in your profit-sharing plan that allows employees to borrow money from the plan. A loan provision typically allows participants to borrow some of their vested plan benefits. However, you are not required to allow loans. Unlike plan distributions, plan loans are typically neither taxable nor subject to the early withdrawal tax penalty (assuming the loan is repaid on time and all other requirements are met). Consequently, a loan provision can be an enticing way to give participants access to their plan funds.

Plan loans cannot be made available based on discrimination. In other words, loans cannot be made available to highly compensated employees, officers, or shareholders in a more significant amount than other employees. Moreover, the loans must have a reasonable interest rate and be adequately secured. A loan must be repaid in regular installments within five years to avoid being considered a taxable distribution. (In most cases, a loan is secured by the participant's vested plan benefits) (except for loans used to purchase a principal residence).

Social Security can be "integrated" with a profit-sharing plan.

Integrating a profit-sharing plan with Social Security enables your plan to pay higher amounts to higher-paid workers. Despite the nondiscrimination requirements that typically govern profit-sharing plans and other qualified retirement plans, the IRS considers the benefits provided by a qualified plan and those provided by Social Security to be part of the same retirement program. Because Social Security benefits for lower-paid employees represent a more significant percentage of salary than for higher-paid employees, the IRS permits qualified plans to favor higher-paid employees within certain limits. This is known as "permitted disparity." For more information, consult a retirement plan specialist.

Negative aspects of profit-sharing plans

A Profit-Sharing Plan Must Satisfy Specific Requirements

The IRC imposes stringent nondiscrimination requirements on profit-sharing plans. This means that a profit-sharing plan cannot offer more advantageous benefits or contributions to highly compensated employees than to other employees. (See Questions & Answers for the definition of "highly compensated employee.") Your profit-sharing plan is generally required to undergo annual nondiscrimination testing to ensure these requirements are met. The complexity of these testing requirements exceeds the scope of this discussion. You should seek out additional resources, such as a specialist in retirement plans.

Profit-sharing plans are also subject to "top-heavy" federal requirements. A profit-sharing plan is considered top-heavy if key employees hold more than 60 percent of the plan's account balances. If your plan is top-heavy, you must make a minimum annual contribution of 3% of compensation to the accounts of all non-key employees. Typically, key employees are company owners and/or company officers.

A profit-sharing plan must comply with the reporting, disclosure, and other requirements applicable to most qualified plans under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code.

ERISA does not apply to plans maintained solely for the benefit of non-employees (such as company directors), plans that cover only partners (and their spouses), or plans that cover only a sole proprietor (and his or her spouse).

A profit-sharing plan can only accept after-tax employee contributions.

As mentioned, your participating employees cannot defer a portion of their pre-tax compensation to a profit-sharing plan. This contrasts with other types of employer-sponsored retirement plans that permit employee contributions to be made before taxes.

Generally, you must establish a 401(k) plan if you want your employees to be able to contribute on a pre-tax basis. Without a 401(k) arrangement, employees can only contribute after-tax dollars to the profit-sharing plan (consult a retirement plan specialist for more information). Before an employee's contributions could be allocated to the plan, income taxes must be withheld from his or her paycheck. Unless the plan is a 401(k), Roth after-tax contributions are not permitted.

How to Establish a Profit-Sharing Scheme

Develop a plan for your organization.

Due to the nature of the rules governing qualified retirement plans, you will likely need the assistance of a retirement plan specialist to develop a profit-sharing plan that satisfies both legal requirements and your business's needs. You must complete the following:

  • Determine the plan features most suitable for your business by analyzing your cash flow and profits, your desired tax deduction, the extent to which you and your employees will benefit from the plan, and the demographics of your employee population (including years of service, wages, salaries, and turnover rate). This will help you determine appropriate plan characteristics, such as investment vehicles, contribution levels, and employment eligibility requirements.
  • Select the plan trustee: The profit-sharing plan's assets must be held in trust by a trustee. The trustee is accountable for managing and controlling the plan's assets, preparing trust account statements, maintaining a checking account, keeping track of contributions and distributions, filing tax returns with the IRS, and withholding the appropriate taxes. You or a third party can be a plan trustee like a bank.
  • Choosing the plan administrator entails several responsibilities, including determining who is eligible to participate in the plan, determining the amount and timing of benefits, and adhering to reporting and disclosure requirements. Additionally, the plan administrator may be accountable for investing plan assets and/or providing services to plan participants. The employer may handle these responsibilities in-house, but plan sponsors typically hire a third-party firm to assist with plan administration duties. If applicable, ensure compliance with ERISA's bonding requirements.
Submit the Plan for Approval to the IRS.

Once a profit-sharing plan has been created, it must be submitted to the IRS for approval if it is not a prototype plan that the IRS has already approved. As several formal requirements must be met (such as providing formal notice to employees), you should seek assistance from a retirement plan specialist. Submission of the plan to the IRS is not required by law, but it is strongly advised.

(Please see the Questions & Answers section below for additional information.) The IRS will thoroughly review the plan to ensure it satisfies all applicable legal requirements. The IRS will issue a favorable determination letter if all requirements are met. Otherwise, the IRS will issue a letter of adverse determination detailing the deficiencies that must be addressed.

Adopt the Plan during the year it is to go into effect.

You must officially adopt your plan during the year it takes effect, so plan ahead and allow sufficient time to implement it before your company's fiscal year ends. Typically, a corporation's board of directors adopts a profit-sharing plan or another retirement plan through a formal resolution. A business that is not incorporated should adopt a written resolution that resembles a corporate resolution.

Distribute Copies of the Executive Summary of the Plan to All Eligible Employees

ERISA mandates that you provide a copy of the summary plan description (SPD) to all eligible employees within 120 days following the adoption of your profit-sharing plan. An SPD is a booklet that describes the plan's provisions and the participants' benefits, rights, and responsibilities in plain language. Continuously, you must provide new participants with a copy of the SPD within 90 days of joining the plan. In addition, you must provide employees (and, in some cases, former employees and beneficiaries) with summaries of material plan amendments. You can usually submit these documents electronically (via email or your company's intranet).

Submit the Required Annual Report to the IRS

Generally, each employer with a qualified retirement plan must file an annual report. Commonly, the annual report is known as the Form 5500 series return/report. For each plan year in which your profit-sharing plan has assets, you must file the appropriate Form 5500 series return/report. Consult a tax or retirement plan expert for additional information.

Questions & Answers

Which Workers Must Be Included in Your Profit-Sharing Plan?

You must include all employees with at least one year of service and a minimum age of 21. Two years of service may be required for participation if the employee is immediately 100% vested. If desired, you can impose less (but not more) restrictive requirements.

When must participate in the Plan begin?

An employee who meets the minimum age and service requirements of the plan must be permitted to participate no later than:

  • The first day of the plan year begins after the date the employee met the age and service requirements or the date of separation from service.
  • Six months after these conditions are satisfied
How Is Remuneration Definable?

Compensation may be defined differently depending on the plan's objectives. Compensation generally includes all taxable personal services income, such as wages, salaries, fees, commissions, bonuses, and tips, for calculating the annual additions limitation. It excludes pension-related income, such as payments from qualified plans and non-qualified pensions, and taxable compensation resulting from participation in various stock and stock option plans. In addition, compensation comprises 401(k) and cafeteria plan salary deferrals. This definition applies when determining which employees are highly compensated.

What Is an Extremely Well-Compensated Employee?

A highly compensated employee in 2020 is a person who:

  • Was a 5% owner (i.e., an employee who owns more than 5% of the business) during 2019 or 2020, or
  • In 2019, earned over $125,000 and, at the employer's discretion, ranked among the top 20% of employees in terms of compensation for that year. In 2020, this $125,000 limit will increase to $130,000.
When do employees have partial or complete ownership of their account funds?

Vesting is the process by which employees acquire partial or complete ownership of their plan benefits. Contributions made by employees must vest immediately. Employer contributions typically vest at 100% after three years of service ("cliff" vesting) or gradually with 20% after two years of service, followed by 20% per year until 100% vesting is achieved after six years ("graded" or "graduated" vesting).

Plans requiring two years of service before employees are eligible to participate must provide full vesting after two years.

A plan may have a vesting schedule faster than the law requires but not slower.

What Happens to an Employee's Account Upon Termination of Employment Before Completion of Vesting?

If a participant leaves employment before fully vested in the plan, the employee forfeits the unvested portion. The forfeited amount can then be used to reduce future employer contributions or reallocated among the account balances of the remaining plan participants. The IRS mandates that forfeitures be redistributed without discrimination. This typically necessitates reallocating forfeiture in proportion to participants' compensation instead of their existing account balances.

Do You Need a Letter of Approval from the IRS for Your Plan to Be Acceptable?

No, an IRS determination letter is not required for a plan to qualify. If the plan's provisions meet the requirements of the Internal Revenue Code, the plan is considered qualified and is eligible for the associated tax benefits. However, without a letter of determination, the issue of plan eligibility for a given year does not arise until the IRS audits your tax returns for that year.

It may be too late to amend your plan to remove any ineligible provisions. If you have a favorable determination letter, auditing agents will generally not raise the issue of plan qualification concerning the "form" of the plan (as opposed to its "operation") if this problem arises (or if a preapproved prototype plan is used).

What Happens If the IRS Determines Your Plan No Longer Meets the Requirements for a Qualified Plan?

The IRS has established corrective programs for plan sponsors. These programs permit correction through sanctions less severe than complete disqualification. If necessary, your tax professional can assist you in utilizing these programs. However, it may be disqualified if you cannot make the necessary corrections to your plan. Loss of qualified status for a plan has the following repercussions:

  • Employees could be taxed on employer contributions when contributions vest rather than when benefits are paid.
  • Your employer contribution deduction may be deferred.
  • The plan trust's earnings are subject to taxation.
  • The distributions are no longer eligible for favorable tax treatment and cannot be rolled over tax-free.
Do You Have a Fiduciary Obligation Regarding Employee Accounts?

You are obligated as a fiduciary to select and diversify plan investments with care and prudence. However, if you allow participants to "direct the investments" of their own accounts, your liability for investment returns is typically significantly reduced. A plan is deemed "participant-directed" if, among other conditions, it meets the following:

  • Offers participants a diverse selection of investments with varying risk and return characteristics.
  • Permits participants to provide investment instructions at least every three months.
  • Enables participants to diversify their investments globally and within specific investment categories.
  • Provides sufficient information for participants to make informed investment decisions.
Caution: if you sponsor a participant-directed plan, you may be accountable for the investment education of your employees. The challenge is to provide adequate investment education without becoming legally liable for the investment decisions of your employees. This issue should be considered when implementing a profit-sharing plan or other qualified retirement plans.

The Pension Protection Act of 2006 created a new prohibited transaction exemption under ERISA that permits related parties ("fiduciary advisers") to provide investment advice (including, for example, the recommendation of the advisor's own funds) to profit-sharing (and other defined contribution) plan participants if (a) the advisor's fees do not vary based on the investment selected by the participant, or (b) the advice is based on a computer model certified by an independent third party. The Act also protects retirement plan fiduciaries when an employee's account is placed in default investments under DOL regulations because the participant failed to make an affirmative investment election. Generally, these provisions became effective on January 1, 2007.

The Lynch Retirement Investment Group has prepared some of the following materials. The material is considered reliable, but Raymond James Financial Services, Inc. does not guarantee that the foregoing is accurate or complete. This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. The investments mentioned may not be suitable for all investors. The material is general in nature. Past performance may not be indicative of future results. Raymond James Financial Services, Inc. does not provide advice on tax, legal, or mortgage issues. These matters should be discussed with the appropriate professional. 401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken before age 59 1/2, may be subject to a 10% federal tax penalty. Matching contributions from your employer may be subject to a vesting schedule. Please consult with your financial advisor for more information.

UntitledddewqeLynch Retirement Investment Group
2016, 2017, 2018, and 2019
forbes 2021John M. Lynch, CIMA®, CPWA®

John M. Lynch, CIMA®, CPWA® Managing Director – LRIG
Financial Advisor– RJFS
, of The Lynch Retirement Investment Group, LLC.
Was named on the 2021 Forbes Best-In-State Wealth Advisor List.

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John M. Lynch, CIMA®, CPWA®
Managing Director – LRIG,
Financial Advisor – RJFS

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Andrew Fentress, CFP®
Financial Advisor

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Adam Tobin, CFP®, CRPC
Customer Relationship Manager


Barron's "Top 1,200 Financial Advisors," March 2022. Barron's is a registered trademark of Dow Jones & Company, L.P. All rights reserved. The rankings are based on data provided by 6,186 individual advisors and their firms and include qualitative and quantitative criteria. Factors included in the rankings: assets under management, revenue produced for the firm, regulatory record, quality of practice, and philanthropic work. Investment performance is not an explicit component because not all advisors have audited results and because performance figures often are influenced more by a client's risk tolerance than by an advisor's investment picking abilities. The ranking may not be representative of any one client's experience, is not an endorsement, and is not indicative of the advisor's future performance. Neither Raymond James nor any of its Financial Advisors pay a fee in exchange for this award/rating. Barron's is not affiliated with Raymond James. The Forbes ranking of Best-In-State Wealth Advisors, developed by SHOOK Research, is based on an algorithm of qualitative criteria, mostly gained through telephone and in-person due diligence interviews, and quantitative data. Those advisors that are considered have a minimum of seven years of experience, and the algorithm weights factors like revenue trends, assets under management, compliance records, industry experience, and those that encompass best practices in their practices and approach to working with clients. Portfolio performance is not a criterion due to varying client objectives and a lack of audited data. Out of approximately 32,725 nominations, more than 5,000 advisors received the award. This ranking is not indicative of an advisor's future performance, is not an endorsement, and may not be representative of (individual clients' experience. Neither Raymond James nor any of its Financial Advisors or RIA firms pay a fee in exchange for this award/rating. Raymond James is not affiliated with Forbes or Shook Research, LLC. Please visit https://www.forbes.com/best-in-state-wealth-advisors for more info

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