The Employee Profit Sharing Plan has become an increasingly popular structure for owner-mangers in recent years. An Employee Profit Sharing Plan is defined as a plan under which an employer sets aside a portion of its annual profits in trust for employees.
It is not necessary that all employees receive allocations from an Employee Profit Sharing Plan, or even that they all be beneficiaries. In a small business context, it is common for only the owner-manger to receive allocations, although employed family members are often also included, and sometimes key employees are as well.
Rules and Regulations
The EPSP requires a binding agreement requiring the employer make payments on the basis of profits earned, with a minimum of 1% of profits. Alternatively, the Income Tax Act permits an employer to elect that an arrangement which provides that payments to a Trustee shall be made “out of profits”, and be an arrangement under which payments are made by reference to the employer’s profits. This election is commonly used to avoid a strict formula for annual contributions, preserving flexibility.
There is no requirement that the EPSP be registered with the Canada Revenue Agency. Multiple related employers may participate in a single EPSP, permitting a single plan to be established for a corporate group.
Payments to an EPSP are income tax deductible to the employer if they are made during the year, or up to 120 days following the end of the employer’s taxation year. While this allows payment after year end, the timeframe is shorter than the 179 day period permitted for bonuses to employees.
The EPSP itself is exempt from taxation. However, it must designate all income, including employer contributions, received in the calendar year to be payable to employee beneficiaries. The employees are taxable on this income in the year of allocation. Most allocations are taxed as employment income; however some types of income, such as capital gains and dividends, retain their character for purposes of taxes payable by the employees.
Allocations can be contingent. For example, payment could be contingent on the employee remaining with the business for at least ten years, creating a “golden handcuff”. Reversed allocations are deductible to the employee in the year they cease to be payable to the employee, and must be reallocated to, and taxed to, other beneficiaries in that year.
Allocations to the employees are required to be reported on T4PS slips annually, for the calendar year.
Employee Profit Sharing Plans also have become very popular over the past number of years. The major advantages are:
- The Canada Revenue Agency has concluded that source deductions are not required on EPSP payments. As such, there can be a tax deferral advantage, although this can also leave taxes payable at filing time, and result in installment requirements.
- EPSP allocations are not pensionable earnings for CPP, or insurable earnings for EI purposes, so EPSP’s are sometimes used to “opt out” of these programs.
- These are unregistered plans, and can therefore be unrestricted in their investment choices.
- Because income flows out as employment income, participants still generate RRSP deduction room, and can deduct such expenses as child care and moving expenses which require employment income to be deducted against.
- The EPSP can provide an added layer of confidentiality. They can be administered separate from the payroll system, and thus be kept confidential from payroll staff.
Employee Profit Sharing Plans also have some minor disadvantages but these are far outweighed by the above advantages.
If you have any questions about an Employee Profit Sharing Plan for your employees or any other income tax questions, do not hesitate in contacting Joseph A. Truscott, Chartered Accountant at (905) 528-0234 or e-mail Joe Truscott at email@example.com.