Questions & Answers
What employees do you have to include in your profit-sharing plan?
You must include all employees who are at least 21 years old and have at least one year of service. Two years of service may be required for participation as long as the employee will be 100 percent vested immediately. If desired, you can impose less (but not more) restrictive requirements.
When must plan participation begin?
An employee who meets the plan’s minimum age and service requirements must be allowed to participate no later than the earlier of:
Example(s): Marcus, age 48, was hired by City Hospital on December 1, 2021. City Hospital has a profit-sharing plan, and the plan year begins on January 1 of each year. Marcus will have one year of service as of December 1, 2022. He must be allowed to participate in the profit-sharing plan by January 1, 2022.
How is compensation defined?
Compensation may be defined differently for different plan purposes. For determining the annual additions limitation, compensation generally includes all taxable personal services income, such as wages, salaries, fees, commissions, bonuses, and tips. It does not include pension-type income, such as payments from qualified plans, non-qualified pensions, and taxable compensation due to participation in various types of stock and stock option plans. In addition, compensation includes voluntary salary deferrals to 401(k) plans and cafeteria plans. (Employers have some flexibility to include or exclude certain items of compensation.) This definition also applies when determining which employees are highly compensated.
What is a highly compensated employee?
For 2022, a highly compensated employee is an individual who:
When do employees have part or full ownership of the funds in their accounts?
The process by which employees acquire part or full ownership of their plan benefits is called vesting. Employee contributions must vest immediately. In general, employer contributions either must vest 100 percent after three years of service (“cliff” vesting), or must gradually vest with 20 percent after two years of service, followed by 20 percent per year until 100 percent vesting is achieved after six years (“graded” or “graduated” vesting).
Caution: Plans that require two years of service before employees are eligible to participate must vest 100 percent after two years of service.
Tip: A plan can have a faster vesting schedule than the law requires, but not a slower one.
What happens to an employee’s account if the employee terminates employment before he or she is 100 percent vested?
If a participant separates from service before being 100 percent vested in the plan, the employee will forfeit the amount that is not vested. The amount forfeited can then be used to reduce future employer contributions under the plan, or can be reallocated among the remaining plan participants’ account balances. The IRS requires that forfeitures be reallocated in a non-discriminatory manner. This usually requires forfeiture reallocation in proportion to participants’ compensation, rather than in proportion to their existing account balances.
Do you need to receive a favorable determination letter from the IRS in order for your plan to be qualified?
No, a plan does not need to receive a favorable IRS determination letter in order to be qualified. If the plan provisions meet IRC requirements, the plan is considered qualified and is entitled to the accompanying tax benefits. However, without a determination letter, the issue of plan qualification for a given year does not arise until the IRS audits your tax returns for that year. By that time, it may be too late for you to amend your plan to correct any disqualifying provisions. A determination letter helps to avoid this problem because auditing agents generally will not raise the issue of plan qualification with respect to the “form” of the plan (as opposed to its “operation”) if you have a favorable determination letter (or if a pre-approved prototype plan is used).
What happens if the IRS determines that your plan no longer meets the qualified plan requirements?
The IRS has established programs for plan sponsors to correct defects. These programs are designed to allow correction with sanctions that are less severe than outright disqualification. Your tax professional will be able to assist you in utilizing these programs should the need arise. However, if you are unable to correct the defects in your plan as required, the plan may be disqualified. Loss of a plan’s qualified status results in the following consequences:
Do you have fiduciary responsibility for your employees’ accounts?
You have a fiduciary responsibility to exercise care and prudence in the selection and appropriate diversification of plan investments. Your liability for investment returns, however, is generally significantly reduced if you allow participants to “direct the investments” of their own accounts. A plan is considered “participant-directed” if, among other requirements, it:
Caution: If you sponsor a participant-directed plan, you may assume some responsibility for investment education of your participating employees. The challenge is to provide the appropriate level of investment education without becoming legally responsible for your employees’ investment decisions. This is an issue to consider carefully when implementing a profit-sharing plan or other qualified retirement plan.
Tip: The Pension Protection Act of 2006 creates a new prohibited transaction exemption under ERISA that allows related parties (“fiduciary advisers”) to provide investment advice (including, for example, recommendation of the advisor’s own funds) to profit-sharing (and other defined contribution) plan participants if either (a) the advisor’s fees don’t vary based on the investment selected by the participant, or (b) the advice is based on a computer model certified by an independent expert, and certain other requirements, including detailed disclosure requirements, are satisfied. The Act also provides protection to retirement plan fiduciaries where an employee’s account is placed in a default investment in accordance with DOL regulations because the participant failed to make an affirmative investment election. These provisions are generally effective January 1, 2007.