Deduction of Employer Contributions

Under Code Section 404(a)(3), the maximum amount that an employer can deduct for contributions to a profit-sharing plan is 15 percent of the compensation paid or accrued during the taxable year to all employees who participate in the profit-sharing plan. This is an employer deduction limit based on compensation of all covered employees; it is not a rule stating that allocations to individual participants' accounts are limited to 15 percent of their compensation. The limitation on annual additions to individual accounts, the Section 415 limit, is discussed below.

An employer can contribute to a profit-sharing or a stock bonus plan in excess of the 15 percent limit, but the excess is not deductible and is subject to a 10 percent penalty under Section 4972. The excess amount can be carried over to a future year and deducted then, but deductions in the future year for current contributions plus carryovers are still subject to the 15 percent of payroll limit.

Combined Profit-Sharing and other Plans

If an employer has both a defined-benefit plan and a profit-sharing or other defined-contribution plan covering a common group of employees, the total contribution for both plans cannot exceed 25 percent of compensation of the common group of employees. However, if a greater contribution is necessary to satisfy the minimum funding standard for the defined-benefit plan, the employer will always be able to make and deduct this contribution.

Section 415 Limits

The Section 415 limits that apply to profit-sharing plans are those applicable to all defined-contribution plans. The annual addition to any participant's account cannot exceed the lesser of 25 percent of the participant's compensation or $30,000 (as indexed for inflation). For a profit-sharing plan, the annual addition includes the participant's share of any forfeitures as well as employer and employee contributions. This means that when forfeitures are allocated to a participant's account, the amount of employer contributions that can be allocated may be reduced. The Section 415 limits usually affect only highly compensated employees covered under the plan.

Investment Earnings and Account Balances

As a defined-contribution plan, a profit-sharing plan must provide separate accounts for each participant. However, unless the plan contains a provision permitting participants to direct investments (discussed below), the plan trustee or other funding agents will generally pool all participants' accounts for investment purposes. The plan must then provide a mechanism for allocating investment gains or losses to each participant. Most methods for doing this effectively allocate such gains and losses in proportion to the participant's account balance.

IRS revenue rulings require accounts of all participants to be valued in a uniform and consistent manner at least once each year, unless all plan assets are immediately invested in individual annuity or retirement contracts meeting certain requirements. The plan usually will specify a valuation date or dates on which valuation occurs. Investment earnings, gains, and losses are allocated to participants' accounts as of this date.

Participant-Directed Investments

Under ERISA Section 404c, any "individual account" plan (such as a profit-sharing, stock bonus, or money-purchase pension plan) can include a provision allowing the participant to direct the trustee or other funding agent as to the investment of the participant's account.

If the plan administrator provides a broad range of investment choices—so that the participant's choice has real meaning—then the trustee and other plan fiduciaries are not subject to fiduciary responsibility for the investment decision.^[1] A plan can technically allow unlimited choice of investments, but this increases the plan's administrative burdens. Often, a family of mutual funds is offered as an investment option to increase the administrative feasibility of participant direction. At least three investment alternatives must be included.

Investment direction gives the participant a considerable degree of control over the funds in his or her account. It is frequently used in profit-sharing plans, particularly those for closely held businesses where the controlling employees have by far the largest accounts. On the other hand, to the extent that participant direction of investments removes the security provided by the fiduciary rules, such a provision is at odds with a plan objective of providing retirement security, and it would not be appropriate if this were a major objective of the plan for a particular employee group.

To prevent certain abuses associated with participant-directed investments, the Code provides that an investment by a participant-directed qualified plan account in a collectible will be treated as if the amount invested were distributed to the participant as taxable income to the participant. A collectible is defined in Code Section 408(m) as a work of art, rug or antique, metal or gem, stamp or coin (excluding certain federal and state-issued coins), alcoholic beverage, or any other tangible personal property designated as a collectible by the IRS.

Withdrawals during Employment and Loan Provisions

The incentive (rather than retirement security) focus of profit-sharing plans tends to dictate that participants be given the opportunity to control or benefit from their accounts even before retirement or termination of employment. There are various ways to do this. One such provision is a participant-directed account, as discussed above. Another is a special feature permitted in profit-sharing plans but not in pension plans—a provision for account withdrawals from the plan during employment.

The regulations require that employer contributions under a profit-sharing plan must be accumulated for at least two years before they can be withdrawn by participants.^[2] However, in some revenue rulings, the IRS has permitted a plan provision allowing employees with at least 60 months of participation to withdraw employer contributions, including those made within the previous two years. Also, revenue rulings have permitted a plan provision for withdrawal in the case of "hardship," including contributions made within the previous two years. Hardship must be sufficiently defined in the plan and the definitions must be consistently applied. All these limitations apply only to amounts attributable to employer contributions to the plan. If the plan permits employee contributions, the employee contributions can be withdrawn at any time without restriction.

In considering the design of withdrawal provisions, it is important to keep in mind that the taxation and early-withdrawal penalty rules act as disincentives for participants to withdraw plan funds. These rules indirectly reduce the advantages of using a qualified plan as a medium for preretirement savings.

Many plan designers prefer to have a prohibition or at least restrictions on withdrawals from the employer-contributed portion of the account. This is because favorable investment results sometimes depend on having a pool of investment money that is relatively large and not subject to the additional liquidity requirements imposed by the possibility of participant withdrawals. Some typical restrictions found in profit-sharing plans include a requirement that the participant demonstrate a need for the money coming within a list of authorized needs either set out in the plan or promulgated by the plan administrator and applied consistently. Such needs might include educational expenses for children, home purchase or remodeling, sickness or disability, and so forth. Another method of restricting plan withdrawals is to provide a penalty on a participant who withdraws amounts from the plan (in addition to the 10 percent federal penalty tax, which also applies). A plan penalty might include suspension of participation for a period of time, such as six months after the withdrawal. The plan penalty cannot, however, deprive a participant of any previously vested benefit.

Loan provisions are appropriate for profit-sharing plans. Again, however, a generous loan provision in a plan may have the effect of reducing the amount of funds available for other plan investments.

Incidental Benefits

The regulations permit profit-sharing plans to provide as an incidental benefit life, accident, or health insurance for the participant and the participant's family. Incidental life insurance is the only one that is commonly provided. If employer contributions are used to provide insurance, the incidental benefit limitations must be met.

If the plan provides incidental whole life insurance, the usual test is that aggregate premiums for each participant must be less than 50 percent of the aggregate of employer contributions allocated to the participant's account. If the plan purchases term insurance or accident and health insurance, the aggregate premiums must be less than 25 percent of the employer contributions allocated to the participant's account. The current IRS position is that universal life premiums also must meet the 25 percent limit. Note that these tests apply to the aggregate—that is, the total contributions made for all years at any given time. If either of these limits is exceeded, the plan could be disqualified. However, insurance premiums paid with employer-contributed funds that have accumulated for at least two years are not subject to these limitations.

If the employee dies before normal retirement age, the plan can provide that the face amount of the policies plus the balance credited to the participant's account in the profit-sharing plan can be distributed to the survivors without the life insurance violating the incidental benefit requirement. This can be done even though the amount of life insurance might be more than 100 times the account balance expressed as an expected monthly pension.

If life insurance is provided by the plan, the term insurance cost is currently taxable to the employee or the insurer's term insurance rates. Accident and health insurance provided by an employer under the plan might not be taxable because of the exclusion provided for employer-provided health insurance. However, there usually is no particular benefit in providing accident and health insurance under a profit-sharing plan. It is usually provided in a separate plan not connected with the profit-sharing plan.