LAST REVIEWED Jun 08 2020 8 MIN READ
By The Human Interest Team
Profit-sharing plans are an appealing benefits plan option for both employers and employees. In this article, we’ll discuss the advantages of a profit-sharing plan, how to set one up, the responsibilities of managing a profit-sharing plan, and some common considerations.
Why Use Profit-Sharing Plans?
Profit-sharing plans can encourage employees because they offer more financial security than some other retirement plans. Employers make contributions to a profit-sharing plan, and those investments grow tax-free until the funds are distributed to employees. The contribution amounts can be based on a percentage of company profits, but employers can make contributions during unprofitable years, too (though this is not required).
Employer advantages of choosing to offer a profit-sharing plan include a fair distribution of benefits, tax-advantaged contributions, and making their business appealing to applicants who want strong investment options. Employers can start a profit-sharing plan by taking these basic steps:
Creating and adopting a written plan document with specific options, features, and limits.
Choosing a trust that will hold the assets.
Implementing good recordkeeping.
Giving plan information to eligible employees.
Operating a Profit-Sharing Plan
Employers who sponsor a profit-sharing plan have certain responsibilities. They can either handle those responsibilities in-house or hire a plan administrator. Those operational tasks include:
Handling participation and contributions.
Disclosing and reporting plan details.
Acting as a fiduciary.
Investing and vesting the funds.
Almost all employees will be eligible to participate in the profit-sharing plan, including older employers. Some of the only exclusions include:
Employees younger than 21 years old.
Some nonresident individuals.
Employees who have not completed at least a year of service.
Participate in a collective bargaining agreement that prohibits participation in the plan.
Overall Limit on Contributions
In 2020, employers can only contribute amounts equal to a participant’s total compensation or $57,000 (or $63,500 for employees over 50 years old), whichever amount is less.
The profit-sharing plan document should clearly describe the formula for employer contributions. All contributions in aggregate must adhere to the contribution limits, including elective deferrals, matching and nonelective contributions, and forfeiture allocations.
Nondiscrimination testing is a common requirement for many employer-sponsored benefit plans. This assessment ensures that both highly compensated employees and general employees receive substantially fair benefits. Nondiscrimination testing is an annual requirement.
Investing Profit Sharing Plan Monies
Profit-sharing plans can be participant-managed or have the assets managed on behalf of the employees. Employers can also hire a third party to manage the funds and investment options.
Many profit-sharing plans also require someone to take on several fiduciary responsibilities. While some administrative tasks fall below the realm of fiduciary responsibility, fiduciary tasks require a higher ethical standard. Fiduciaries must act in the best interest of the plan participants, carry out tasks prudently, and adhere to the plan rules. Each plan must establish who the fiduciary is, and this is generally the plan’s trustee.
Plan sponsors can limit their liability by documenting their decision-making processes and making their prudence clear. Plan sponsors can also limit their own liability by allowing participants to manage their own investments and hiring a third-party service to act as fiduciary.
However, hiring a service provider doesn’t completely eliminate liability. Sponsors must select a service with a reasonable standard of quality and support, and the third party can’t have any conflicts of interest. Sponsors must also read through and evaluate the notices a third-party fiduciary provides, check over the fees they charge, follow up on complaints, and review their performance.
Providing Information in Participant-Direct Plans
If the participants are responsible for managing their own investments, fiduciaries must clearly communicate those responsibilities to the participants. They must also receive that information in a timely fashion.
Prohibited Transactions and Exemptions
Conflicts of interest, self-dealing, and other bad faith practices are prohibited. The Employee Benefits Security Administration outlines both restrictions and exceptions to those restrictions on their website.
Disclosing Plan Information to Participants
The main form of disclosure under a profit-sharing plan is the Summary Plan Description (SPD). In this document, the fiduciary must explain the plan’s eligibility rules, contribution and vesting specifics, how to claim benefits under the plan, and the rights and responsibilities of everyone involved. This document should also outline any administrative fees so participants can make informed decisions.
Reporting to Government Agencies
Plan sponsors are responsible for reporting specifics of the plan to the IRS and other government entities. This includes several filing requirements, such as filling out:
IRS Forms 5500, 5500-SF, and 5500-EZ.
Distributing Plan Benefits
Under most profit-sharing plan structures, eligible employees can receive their distributions in a lump sum, take periodic distributions, or roll it over into a qualified account.
Terminating a Profit-Sharing Plan
Sometimes, an employer must terminate their plan due to business needs or to replace it with a different plan type. To do so, plan administrators must amend the plan document, distribute the assets, inform participants, and report the plan’s conclusion to the government.
Treatment of Excess Deferrals
Excess deferrals, or deferrals that go over the annual deferral limit, can happen accidentally. In the event of an excess deferral, the excess amount must be distributed by April 15 of the following calendar year, and the participant must consider the excess as taxable income. However, the distribution will not be subject to the 10% early distribution penalty tax.
Partnership Profit Sharing Factors
Partnerships can also form a profit-sharing plan. Unless otherwise specified, profits and losses under the partnership are shared equally. The profit-sharing ratio that most plans establish is based on two primary factors:
Divide by Responsibility: If one organization in the partnership does more work than the other, the ratio might take this into account and split the profits accordingly.
Capital Contribution to the Partnership: If the partnership required startup capital and the two (or more) organizations didn’t contribute capital equally, the profit-sharing plan might outline the percentage of profits each organization receives based on that contribution.
In many agreements, both factors are weighed to create a final split of the partnership’s profits.
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment advising, and integration with leading payroll providers.