Is a Profit Sharing Plan a Qualified Plan?

A profit sharing plan can be a qualified retirement plan if it adheres to government regulations. As a type of defined contribution plan, employers have the flexibility to make contributions for their employees but are not required to do so every year. To receive tax advantages, a profit sharing plan must achieve “qualified” status by meeting federal requirements. These rules ensure the plan is maintained for the benefit of employees rather than exclusively for owners and top executives.

The Definition of a Qualified Plan

A qualified plan is an employer-sponsored retirement plan that meets the requirements of the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA). These federal laws establish minimum standards for most retirement plans in private industry. Common examples of qualified plans include 401(k)s, defined benefit pensions, and profit sharing plans.

The principle of a qualified plan is a trade-off between the employer and the government. In exchange for adhering to federal rules about plan operations, participation, funding, and vesting, the employer and its employees receive tax benefits. These rules ensure the plan is operated for the exclusive benefit of employees and their beneficiaries and does not unfairly favor a company’s highest-paid employees.

Requirements for a Profit Sharing Plan to be Qualified

The plan must adhere to minimum participation standards. Under IRC section 410, a plan cannot require an employee to be older than 21 or have completed more than one year of service to participate. A year of service is defined as a 12-month period in which the employee works at least 1,000 hours. Once an employee meets these requirements, they must be allowed to enter the plan on the next semi-annual entry date, such as January 1 or July 1.

Although employer contributions are discretionary, the method for allocating them among participants must be defined in the plan document and followed consistently. A common allocation method is the “comp-to-comp” formula, where each employee receives a contribution proportional to their compensation. For 2025, total annual additions to a participant’s account, including employer contributions and allocated forfeitures, cannot exceed the lesser of 100% of their compensation or $70,000.

Participants gain ownership of employer contributions through a vesting schedule, which is the process of earning the right to those benefits. The Internal Revenue Code permits two primary vesting schedules for employer contributions. A “3-year cliff” schedule means an employee is 100% vested after three years of service. A “2-to-6 year graded” schedule gradually vests the employee, starting at 20% after two years and increasing by 20% each year until reaching 100% after six years.

A plan must pass annual non-discrimination tests. For 2025, a highly compensated employee (HCE) is defined by ownership or compensation. An HCE is any individual who owned more than 5% of the business or an employee who earned more than $160,000 in the preceding year. Employers can elect to limit the compensation-based group to only the top 20% of employees by pay. These tests analyze contribution percentages to ensure the plan provides benefits to the entire workforce.

Tax Implications of a Qualified Profit Sharing Plan

Meeting the requirements for a qualified plan provides tax advantages for the employer and employees. For the business, contributions are tax-deductible for the year they are made, reducing the company’s taxable income. This deduction is limited to 25% of the total compensation paid to all eligible participants for the year.

Employees also receive tax benefits. Employer contributions to an employee’s account are not considered taxable income for that year. Investment earnings and growth within the plan accumulate on a tax-deferred basis. Taxes are not paid on contributions or earnings until the funds are withdrawn, at which point they are taxed as ordinary income.

Establishing and Administering the Plan

Establishing a profit sharing plan begins with choosing a plan provider or custodian, such as a bank or mutual fund company. The employer must then adopt a formal written plan document that outlines all rules of operation. A trust must also be established to hold the plan’s assets for the exclusive benefit of the participants.

Ongoing administration requires the employer to follow the plan document when making any discretionary contributions. An annual task for most plans is filing Form 5500, Annual Return/Report of Employee Benefit Plan, with the Department of Labor. Plans with fewer than 100 participants file Form 5500-SF, while one-participant plans with assets over $250,000 file Form 5500-EZ.

Plans with 100 or more participants are considered large plans and must file the standard Form 5500, which includes an audit report from an independent public accountant. The plan administrator also manages participant activities, such as processing distributions and administering plan loans, according to the plan document.