Digest of Benefit Entitlement Principles Chapter 5 - Section 15
5.15.0 Profit sharing plans
Employers use profit sharing plans as a way of rewarding the good performance of their employees. These plans may also instill a sense of partnership between the employer and each participating employee, in the pursuit of maximum profits.
There are 4 types of profit sharing plans:
- Cash or current distribution profit sharing plans (Digest 5.15.1)
- Employee's profit sharing plans (Digest 5.15.2)
- Deferred profit sharing plans (Digest 5.15.3), and
- Registered profit sharing pension plans (Digest 5.15.4)
These plans vary from immediate compensation and taxation, to having both compensation and taxation deferred until the moneys are withdrawn from the plan. Knowing which section of the Income Tax Act these plans are registered under is essential to identifying the type of profit sharing plan that the employer has established.
5.15.1 Cash or current distribution profit sharing plans
Cash or current distribution profit sharing plans are designed to provide periodic cash distribution to plan members, based on the profits of the employer. Occasionally company stock may be distributed, rather than cash and the employer determines the distribution schedule. As the distribution is made periodically, rather than being held until the participant leaves employment, this plan is a form of direct compensation.
This is the simplest form of profit sharing plans. It does not require registration with the CRA as all profit sharing payments are made directly to the employee in cash or stock certificates. Taxation is not deferred, and occurs in the year that these moneys are paid. Any cash, or the value of any stock distributed to the employees, is earnings arising out of employment (EIR 35(2)). Like all profit sharing plans, the payment of these moneys is linked to the services provided by the employees in their daily work, that assist the company in earning profits. As the share in the profits arises from the performance of services, these earnings are allocated to the week or weeks in which the services were performed (EIR 36(6)).
5.15.2 Employee's profit sharing plans
In an employee's profit sharing plan, a share of the company’s yearly profits is placed in a trust fund and is allocated to participating employees, along with their share of the fund’s accumulated interest for that year. The allocation may be in proportion to the employee's earnings, length of service, or another formula.
Generally, these moneys remain in the trust account until the participant's employment is terminated. However, some plans may allow cash withdrawals by the employee, while still employed. Employees may also contribute to this fund, although these contributions are not tax deductible.
Vesting (full ownership rights) of the employer's profit sharing contributions can vary from immediate, to vesting only on death, termination of employment, or retirement. In cases where vesting is not immediate, cash withdrawals cannot be made while employed, as the employee has no right to these payments.
Although a participant may not normally receive a distribution from this trust fund until retirement or until employment is terminated, the employee is taxed each year on their share of the profits, the interest accruing in the trust, and any realized capital gains, as though they were in immediate receipt of the moneys. There is no income tax payable on any employee contributions made to this fund, as these moneys come from the employee's after-tax income. This type of profit sharing plan is registered under section 144 of the Income Tax Act.
These moneys are earnings that arise out of employment (EIR 35(2)). However, they are not considered as payable until their actual distribution to the employee. Like all profit sharing plans, the payment of these earnings is linked to the services provided by the employees in their daily work, that assist the employer in earning profits. These earnings are allocated to the week or weeks in which the services were performed, because the share in the profits arose from the performance of services (EIR 36(6)). If the amount of interest is known, this amount is deducted.
5.15.3 Deferred profit sharing plans (DPSP)
In a deferred profit sharing plan (DPSP), the employer allocates a share of the profits to all participating employees each year, and places it in a trust account. These moneys remain in this trust account until the participant's employment is terminated. Employees cannot contribute into this plan, except for direct transfers from other registered tax-assisted plans.
Income tax is not deducted from the employee's share of the profits and the interest accrued in the trust fund, until the employee receives these moneys. These plans are registered under section 147 of the Income Tax Act, and are subject to greater regulation and control than an employee's profit sharing plans (Digest 5.15.2).
Although a DPSP may have some of the same characteristics of a pension plan, it does have some important differences. A DPSP may allow for withdrawal of all or part of an employee's account (including the vested employer share) while still in active employment. This is not the case under a pension plan. The entire withdrawal above the employee's own contributions is taxed as income. At termination or retirement, lump-sum payments out of a DPSP are similarly taxed as income, but may be tax-sheltered if an annuity is purchased, or all or some of the payment is transferred to an individual RRSP. Unlike a DPSP, a pension plan does not normally make payment available as a lump sum at termination or retirement (Digest 5.13.0).
These moneys are earnings that arise out of employment (EIR 35(2)), however, they are not considered payable until their actual distribution to the employee. Like all profit sharing plans, the payment of these earnings is linked to the services provided by the employees through their work, which assists the company in earning these profits. As the share in the profits arose from the performance of services, these earnings are allocated to the week in which the services were performed (EIR 36(6)).
5.15.4 Registered profit sharing pension plans
A registered profit sharing pension plan is a pension plan in which employer contributions are linked to profits. The provisions of these plans are the same as other pension plans, and they are subject to the same pension legislation as all other plans. The profit sharing aspect of the pension plan is solely a method of funding. Any moneys placed in the fund must remain there until retirement or termination of employment.
As with all other pension plans, profit sharing pension plans are registered under section 147.1 of the Income Tax Act. Employee and employer contributions are tax deductible (to a maximum amount that is the same as for other pension plans.) but the interest income of the trust fund is not. That being said, all benefits are taxable when paid out.
Because they are most often locked-in, these benefits are normally only paid in the form of annuities at retirement. In exceptional circumstances, lump-sum payments may be made provided the following conditions are met:
- the contributions have not been locked-in
- the annuity amount due is below a set limit
- there is a shorter than normal life expectancy
- partial commutation is allowed by legislation
- Additional Voluntary Contributions (AVCs) are being returned, and
- contributions are being refunded under the maximum funding by employee provisions
Payments made from a registered profit sharing pension plan are earnings because they have all the characteristics of a pension that arises out of employment (EIR 35(1); EIR 35(2)(e)). Payment from these plans is treated in the same manner as any payment out of a pension fund: as a periodic pension (Digest 5.13.5), as a lump-sum pension benefit (Digest 5.13.6), or as a return of contributions (Digest 5.13.8, Digest 5.13.9). If the employee terminates their employment prior to retirement age, any locked-in pension credits transferred directly into a locked-in vehicle are not considered payable until they are paid to the claimant (Digest 5.13.7).
5.15.5 Profit sharing plan comparison
|Cash or current distribution plan||Cash or shares in the stock of the company are periodically distributed||Taxed with wages and other benefits when paid||Not registered under the Income Tax Act||Immediately as paid out to employee||EIR 35(2)||EIR 36(6)|
|Employee’s profit sharing plan||Accumulates in a trust fund along with interest||Taxed each year on share of profits and accumulated interest in the trust fund||Registered under section 144 of the Income Tax Act||On termination or retirement, or sometimes during employment||EIR 35(2)||EIR 36(6)|
|Deferred profit sharing plan||Accumulates in a trust fund along with interest||Taxed only when money is paid out||Registered under section 147 of the Income Tax Act||On termination or retirement, or sometimes during employment||EIR 35(2)||EIR 36(6)|
|Registered profit sharing pension plan||Accumulates in a trust fund along with interest||Taxed only when money is paid out||Registered under section 147.1 of the Income Tax Act||Only on termination or retirement as there is no access while employed||EIR 35(2)(e)||EIR 36(14)
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