Profit Sharing Plan
Profit-sharing plans are one form of "defined contribution plan." A defined contribution plan provides that the employer make prescribed contributions to the plan. The amount of each employee's retirement benefit ultimately will depend on the amount of contributions and the investment performance of that particular employee's account, rather than the employer's promise to pay a specific benefit as in other types of employer retirement plans. The employer's obligation is to make the specified contributions; the employee generally bears the risk of investment performance. Many profit-sharing plans are set up so employees invest and manage their own individual accounts. A distinguishing feature of profit-sharing plans is that the employer is not obligated to make contributions each year. However, the employer must make "recurring and substantial" contributions. Employers that contribute in at least 3 of every 5 years usually will satisfy this requirement. When designing a profit-sharing plan, the employer has great flexibility in determining how and when contributions will be made. For example, contribution amounts could be (1) based on profits which exceed a certain amount, or (2) a percentage of the company's net income, or (3) determined by the board of directors each year. Employer contributions to a profit-sharing plan are deductible but limited to no more than 25% of the total compensation of participating employees. Employer contributions on behalf of an employee are often based on total compensation of that individual: regular salary, commissions, bonuses, overtime pay, etc. The maximum compensation that may be taken into account for any one employee is is $225,000 in 2007. In addition to limits on the employer's deduction, there are also limits on the annual additions that may be made to a plan participant's account. In 2007 these additions may not exceed the lesser of: - 100 percent of the employee's includable compensation, and
- $45,000.
The $40,000 amount is indexed after 2007. Profit-sharing plans enjoy the usual advantages of other types of qualified retirement plans: - Employer contributions are tax-deductible within limits.
- Employer contributions are not taxed to the employee at the time made.
- Investment earnings inside the plan accumulate on a tax-deferred basis.
- Persons born before 1936 may take special favorable tax treatment of lump-sum distributions.
Many employers prefer profit-sharing plans over other types of employer retirement plans for the following reasons: - Cost can be managed through a contribution formula that is based on profitability or the discretion of the board of directors.
- Employees are better motivated when they share in company profits.
- Employees, especially younger ones, also tend to prefer profit-sharing plans because their accounts will receive contributions over more years, and they will have longer for their retirement funds to accumulate.
Profit sharing plans are generally most attractive to companies... - with relatively young owner-employees,
- with widely fluctuating profits,
- with a desire to avoid being committed to an annual contribution, and
- with a desire to include a 401(k) feature that permits employees to make elective salary deferrals to the plan.
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