Profit-Sharing Arrangement The Concept Profit-sharing arrangements are employer-sponsored qualified retirement arrangements. In a profit-sharing arrangement, the amount of a particular employee s retirement benefit is determined by the employer s contributions and the investment performance of the employee s account. This is one type of defined contribution arrangement. Defined benefit arrangements, on the other hand, are based essentially on the employer s promise to pay a specific retirement benefit. While not required to contribute to a profit-sharing arrangement each year, the employer must make recurring and substantial contributions. Contributing in at least three of every five years usually satisfies this requirement. Many profit-sharing arrangements allow employees to invest and manage their own accounts. The employee generally bears the risk of investment performance. The Design In a profit-sharing context, the employer has great flexibility in determining how and when to make contributions. For example, accompany may base Page 1 of 6
contributions on profits exceeding a certain amount, or the board of directors may determine the contribution each year. Deductible employer contributions cannot be more than 25% of a participating employee s total compensation. Employers often base contributions on the employee s total compensation including salary, commissions, bonuses, overtime pay, etc. The maximum compensation to be taken into account for any one employee is $255,000 in 2013. There are also limits on annual additions, which may not exceed the lesser of 100% of the employee s includable compensation, or $51,000 for 2013. The dollar amount is indexed for future years. The Tax Picture Employer contributions are tax deductible within the 25% of employee compensation limit. Employer contributions are not taxed to the employee at the time they are made. Investment earnings inside the arrangement accumulate on a tax-deferred basis. Employees born before 1936 can receive favorable tax treatment of lump-sum distributions. The Benefits Employers can manage costs based on profitability or the discretion of the board of directors. Employees may be better motivated when they share in company profits. Employees, especially younger ones, tend to prefer profit-sharing plans because they typically allow greater flexibility than defined benefit plans. Account balances can often be rolled over into a new employer s plan if the employee changes jobs. Page 2 of 6
The Bottom Line Profit-sharing arrangements are particularly attractive to companies with widely fluctuating profits and a desire to avoid an annual contribution requirement. The choice to include a 401(k) feature permits employees to make elective salary deferrals to supplement employer contributions. What Are Profit-Sharing Arrangements? Profit-sharing arrangements are a specific form of qualified retirement arrangement called a defined contribution arrangement in which the employer makes periodic contributions to the arrangement. Each employee s ultimate retirement benefit will depend on the amount of the employer s contributions, plus the investment performance of that employee s account. While the employer is obligated to make the specified contributions, the employee generally bears the risk of investment performance. They may be set up so employees can invest and manage their own individual accounts. How Do Profit-Sharing Arrangements Work? A distinguishing feature of profit-sharing arrangements is that employer contributions are not required every year. However, contributions must be recurring and substantial. Contributions in at least three out of every five years usually satisfy this requirement. The employer has great flexibility in determining how and when contributions will be made. For example, the amounts can be based on company profits which exceed a certain amount a percentage of the company s net income or determined by the board of directors each year. While contributions are deductible, they are limited to no more than 25% of the participating employees total compensation. How Are Contributions Determined? Employer contributions for each employee are often based on the individual s total compensation, which can include salary, commissions, bonuses, overtime pay, etc. The maximum compensation that can be taken into account for any one employee is Page 3 of 6
$255,000 in 2013. In addition to limits on the employer s deduction, there are also limits on the annual additions made to a participant s account. These additions can t exceed the lesser of 100% of the employee s includable compensation, or $51,000 in 2013. What Are the Benefits? Profit-sharing arrangements enjoy the usual advantages of other types of qualified retirement arrangements, including employer contributions that are tax-deductible within limits, and not taxed to the employee at the time they re made. Investment earnings also accumulate on a tax-deferred basis. Profit sharing arrangements are generally most attractive to companies with relatively young owner-employees, widely fluctuating profits, and a desire to avoid being committed to annual contributions. Another attraction is the opportunity to include a 401(k) feature that permits employees to make elective salary deferrals to the plan. Profit-sharing arrangements offer a convenient, tax-advantaged way to prepare for retirement, while still allowing contribution decisions to be based on sound business practice. Page 4 of 6
Graphic: Profit-Sharing Arrangement 1 1. The employer makes recurring and substantial contributions to the account, but not necessarily a contribution every year. 2. Employer contributions are currently deductible. 4. Distributions are made to participants at retirement and possibly other times. 2 3. Contributions are not currently taxed to participating employees, and earnings inside the account grow on a tax-deferred basis. 4 5 3 5. Distributions are generally taxed as ordinary income to participants and their beneficiaries. Page 5 of 6
Copyright 2004-2013, Pentera Group, Inc. 921 E. 86th Street, Suite 100, Indianapolis, Indiana 46240. All rights reserved. This writing is provided for informational purposes only. Neither New York Life Insurance Company, its agents, or its employees are in the business of providing tax, legal or accounting advice, and none is intended nor should be inferred from the foregoing comments and observations. Clients should be advised to seek the counsel of their own tax, accounting and legal advisors who must form their own independent opinions on these matters based upon their independent knowledge and research. This material includes a discussion of one or more tax-related topics. This tax-related discussion was prepared to assist in the promotion or marketing of the transactions or matters addressed in this material. It is not intended (and cannot be used by any taxpayer) for the purpose of avoiding any IRS penalties that may be imposed upon the taxpayer. Bates 504815 (exp. 05/16/15) Page 6 of 6