Profit Sharing Plan Rules for a Small Business

A profit sharing plan is an employer-sponsored, defined contribution retirement plan. A business makes discretionary contributions to accounts for its eligible employees, which are then invested to provide a retirement benefit. Unlike plans that mandate fixed annual payments, a profit sharing plan allows an employer to decide each year whether to contribute and how much. In a profitable year, a business can make large contributions, while in a leaner year, it can reduce or skip the contribution without penalty.

Contribution and Allocation Rules

In a traditional profit sharing plan, only the employer makes contributions. The total amount an employer can contribute and deduct is limited to 25% of the total compensation paid to all eligible employees in the plan.

There are also limits on the amount allocated to any single employee’s account. For 2025, the total contribution for one participant cannot exceed the lesser of 100% of their compensation or $70,000.

Once the total company contribution is determined, it must be allocated among employees according to a formula in the plan document. The most straightforward method is pro-rata, where each employee receives a contribution proportional to their salary. For example, if an employee’s salary represents 10% of the total eligible payroll, they would receive 10% of the company’s total contribution for that year.

Another allocation method is integrating the plan with Social Security, also called permitted disparity. This approach allows employers to contribute a higher percentage of an employee’s pay that is above the Social Security wage base. This can provide larger contributions to higher-compensated employees without violating nondiscrimination rules.

A new comparability formula is a more complex option that allows a business to divide employees into different groups, such as owners and other staff. Each group can receive a different contribution rate, which can be higher for one group than another. This design requires the plan to pass annual nondiscrimination testing to prove the formula does not unfairly favor highly compensated employees.

Employee Eligibility and Vesting

An employee must meet eligibility requirements to participate in a profit sharing plan. An employer can require an employee to complete one year of service, defined as working at least 1,000 hours in a 12-month period. An employer can also set a minimum age requirement, which cannot be higher than 21.

Vesting determines when an employee has full ownership of the employer contributions in their account. If an employee leaves the company before they are fully vested, they may forfeit some or all of the money contributed on their behalf. Forfeited funds are used to reduce future employer contributions or are reallocated among the remaining participants.

There are two primary vesting schedules. The first is a cliff vesting schedule, where an employee becomes 100% vested after a specific period, with a maximum length of three years. For example, under a three-year cliff schedule, an employee who leaves after two years and 11 months would forfeit all employer contributions, but an employee who leaves after three years would be entitled to the entire account balance.

The second option is a graded vesting schedule, which allows ownership to increase incrementally over time. A common schedule might grant 20% vesting after two years of service, with an additional 20% each year until the employee is 100% vested after six years. A graded schedule cannot be longer than six years.

Establishing the Plan

A profit sharing plan is governed by a formal written plan document that outlines all its rules. A small business can adopt a pre-approved prototype plan from a financial institution or TPA, or hire an attorney to create a custom document.

Key decisions must be made before the document is finalized, including defining eligibility requirements, selecting a vesting schedule, and choosing the contribution allocation formula.

A trust must be established to hold the plan’s assets for the exclusive benefit of employees and their beneficiaries. These assets are legally separate from the company’s business assets and are protected from its creditors. The plan administrator will handle the creation of the trust account.

To make tax-deductible contributions for a tax year, a business must adopt the plan by signing the document. A new plan can be established for a given tax year up to the due date of the employer’s tax return for that year, including extensions.

Administering the Plan

Ongoing administration is necessary to maintain a profit sharing plan’s qualified status. The employer has until its business tax filing deadline, including extensions, to deposit the contribution into the plan’s trust for the preceding tax year.

Each year, the plan must undergo compliance testing to ensure it meets federal nondiscrimination requirements. This testing verifies that the plan does not disproportionately benefit highly compensated employees. Due to the technical nature of these tests, especially for new comparability plans, this function is almost always performed by a Third-Party Administrator (TPA).

Annual government reporting is also required. Plans must file a Form 5500-series annual return with the Department of Labor, which reports information about the plan’s finances and operations. The Form 5500 is prepared by the TPA and must be filed by the end of the seventh month following the end of the plan year, with extensions available.