Profit Sharing Plans
Chapter 17
Employee Benefit & Retirement Planning
What is it?
A profit sharing plan is a defined contribution plan
featuring a flexible employer contribution provision
– Contribution can be a purely discretionary amount or based
on some type of formula
– Employer contributions allocated to individual accounts of
participants on nondiscriminatory basis
– Plan benefits consist of the amount accumulated in each
participant’s account at retirement or termination
– Plan benefits usually distributed in a lump sum at termination
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Profit Sharing Plans
Chapter 17
Employee Benefit & Retirement Planning
When is its use indicated?
• When employer’s profits varies from year to year
• When employer wants an incentive feature
• When employee group is
– Relatively young
– Willing to accept a degree of investment risk
• When employer wants to supplement an existing
defined benefit plan
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Profit Sharing Plans
Chapter 17
Employee Benefit & Retirement Planning
Advantages
• Maximum contribution flexibility for employer
• Contributions can be made even if no profits
• Provides a tax-deferred retirement savings medium
for employees
• Participants can benefit from good investment results
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Profit Sharing Plans
Chapter 17
Employee Benefit & Retirement Planning
Disadvantages
• Retirement benefits may be inadequate for
employees entering the plan at later ages
• Relative amount of plan funding available for highly
compensated employees is more limited
• Employees bear investment risk under the plan
• Level of employer funding less predictable
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Profit Sharing Plans
Chapter 17
Employee Benefit & Retirement Planning
Design Features
• Discretionary contribution provision
– Employer can determine amount each year
– Employer can omit contribution in a given year
– But, IRS regulations require contributions to be “substantial
and recurring”
• Formula provision
– Specified amount contributed each year
– “Profits” may be defined as specified by employer
– Possibly can include a “fail-safe” provision
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Profit Sharing Plans
Chapter 17
Employee Benefit & Retirement Planning
Design Features
• All plans must have formula for allocating employer
contributions to participant accounts
– Cannot discriminate in favor of highly compensated
employees
– “Compensation” must be defined in nondiscriminatory way
– Amount of compensation taken into account is limited
– Can be based on compensation or years of service,
integrated with Social Security
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Profit Sharing Plans
Chapter 17
Employee Benefit & Retirement Planning
Design Features
• Vesting provisions
– Any vesting provision permitted by Code can be used in
general
– Special vesting requirements for “matching contributions”
– Forfeitures (non-vested amounts “forfeited” upon leaving
early) usually added to remaining participants’ accounts
– Formula for allocating forfeitures usually same as that used
for allocating employer contributions
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Profit Sharing Plans
Chapter 17
Employee Benefit & Retirement Planning
Design Features
• Distribution provisions
– Benefits usually payable at termination of employment or at
plan’s stated “normal retirement date”
– Payable in a lump sum or a series of installment payments
– Generally allow “in-service” distributions (benefits payable
before termination of service)
– Funds available for “in-service” distributions must be vested
and must have been in the plan at least 2 years
– 10% early distribution penalty may apply to distributions prior
to age 59-1/2
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Profit Sharing Plans
Chapter 17
Employee Benefit & Retirement Planning
Tax Implications
• Employer contributions deductible when made
• Maximum deductible employer contribution may not
exceed 25% of the payroll of all employees covered
under the plan
• IRC Section 415 limits the “annual additions”
(employer contributions, forfeitures form other
participant’s accounts, and employee contributions)
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Profit Sharing Plans
Chapter 17
Employee Benefit & Retirement Planning
Tax Implications
• Taxation of employees deferred until amounts
withdrawn
• Lump sum distributions may be eligible for 10-year
averaging for employees born before 1936
• Plan subject to ERISA reporting and disclosure rules
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Profit Sharing Plans
Chapter 17
Employee Benefit & Retirement Planning
Alternatives
• Money purchase pension plans (no employer
contribution flexibility)
• Cross-tested, age-weighted and target plans (more
favorable for older employees; discussed later)
• Defined benefit plans (provide more security; more
complex and costly)
• Nonqualified deferred compensation plans
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