What is a profit-sharing plan?
A profit-sharing plan is a type of qualified defined contribution plan in which you, the employer, contribute to the accounts of participating employees. As the name implies, your employer contributions are generally (but not necessarily) tied to your business’s profits, allowing employees to “share” in those profits. Annual contributions to the plan may be discretionary (you need not contribute anything at all), or may be based on a specific formula relating to your annual profits.
Like other types of qualified plans, the purpose of a profit-sharing plan is to help fund your employees’ retirement. By offering such a plan, you may be able to attract quality employees and reduce your employee turnover rate. Unlike some other types of qualified plans, however, a pure profit-sharing plan is generally employer-funded. Your participating employees generally cannot choose to defer a portion of their pretax compensation to the plan (although after-tax employee contributions may be permitted, as discussed below).
Tip: The term “profit-sharing plan” actually describes a broad category that includes several specific types of qualified retirement plans. Employee stock ownership plans and stock bonus plans, 401(k) plans, age-weighted profit-sharing plans, and new comparability plans are all considered profit-sharing plans, although each has its own unique features.
Discretionary vs. nondiscretionary profit-sharing plans
Under a discretionary profit-sharing plan, you can determine the amount to be contributed to the plan each year based on annual profits, fees for plan maintenance, and other factors. You can make contributions to the plan even if you have no current or accumulated profits in a given year. Similarly, you can choose to contribute nothing in a given year, even if your business has generated profits for that year. However, while you are generally not required to make a contribution every year, you are required by the IRS to make “recurring and substantial” contributions. Although the IRS has not published any guidelines to clarify this, if you make no contributions for a number of consecutive years, the IRS may consider your profit-sharing plan to be terminated.
To illustrate how a discretionary profit-sharing plan might work, consider the following sample plan language:
Example(s): “The Company shall contribute each plan year during which the plan is in effect, out of its earnings for such taxable year or out of its accumulated earnings, an amount to be determined by its Board of Directors (or by the owners/partners, if not incorporated) that does not exceed 15 percent of eligible participant compensation.”
Another alternative is to contribute to a profit-sharing plan pursuant to a preset formula. For example, you might contribute a specified amount to the plan every year in which you have a certain level of profits. The IRS does not dictate how to define profits for this purpose, however, so you can specify any appropriate formula. Or a nonprofit organization might adopt a profit-sharing plan with contributions based on some appropriately defined “surplus account.” Once you have adopted a formula approach, you are obligated to contribute the amount specified under the formula. Consult a retirement plan specialist for further guidance on this issue.
Caution: You must state in your plan document your intent to establish a profit-sharing plan. This is especially important where your plan requires employer contributions– these plans look very much like money purchase pension plans, which are subject to different rules