3749 / What is a profit sharing plan?

A profit sharing plan is a plan for sharing company profits with employees. A profit sharing plan need not provide a definite, predetermined formula for determining the amount of profits to be shared. In the absence of a definite formula, there must be recurring and substantial contributions, and contributions must not be made at such times and in such amounts that the plan in operation discriminates in favor of highly compensated employees.¹ A profit sharing plan may explicitly provide for investment primarily in qualifying employer securities ( Q 3818).²

For an explanation of specific qualification requirements applicable to profit sharing plans, see Q 3751.There are qualification requirements that apply to 401(k) plans ( Q 3752 to Q 3808) and an employer deduction limit for profit sharing contributions ( Q 3750).

A profit sharing plan must provide a definite, predetermined formula for allocating contributions among participants and for distributing accumulated funds to the employees after a fixed number of years (at least two), the attainment of a stated age, or on prior occurrence of some event such as layoff, illness, disability, retirement, death, or severance of employment. The allocation formula generally is related to compensation, although age, service, and other factors may be given consideration ( Q 3862). A profit sharing plan cannot provide for allocations or distributions based on predetermined benefits, because such a plan would be a pension plan. Although a profit sharing plan is primarily a plan of deferred compensation, the plan may use funds in an employee’s account to provide incidental life or health insurance for the employee or the employee’s family ( Q 3830).³

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Planning Point: In a private letter ruling,⁴ the IRS blessed amendment to a profit sharing plan covering collectively bargained employees to allow participants to allocate contributions between HRAs and the plan based on an annual election (a default would apply in the absence of an election). The IRS found that the proposed amendment would not cause the plan to be treated as a 401(k), because it would not create an opportunity for participants to elect cash or to use the contributions to pay for taxable benefits. Therefore, the profit sharing plan would not offer a cash or deferred arrangement under IRC Section 401. The IRS also found that the arrangement would not violate the HRA rules.

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A tax-exempt “non-profit” charitable organization may maintain a profit sharing plan, including a 401(k) plan.⁵