Profit Sharing Plan: No Company Profits Required

You determine the annual contribution to a profit sharing plan, a qualified retirement plan, and the amount is entirely up to you, and you may choose to make no contributions in any year. Although this plan is called a "profit sharing" plan, there is no requirement that your business earn a profit before you make an annual contribution.

Many owners are initially misled by the term "profit sharing," as they think it means that employees receive a portion of company profits, and this is how many older companies have traditionally paid their workers in cash. Modern retirement plans maintain this flexibility while eliminating the need for any company profits.

What is a profit sharing plan?

A profit sharing program is an optional use of discretionary employer dollars placed into a qualified retirement savings vehicle. A profit sharing plan is a type of defined-contribution plan which houses these contributions. The company-sponsored plan document will outline how the aggregate annual profit sharing amounts are allocated to participants. As such, this money grows tax-deferred until distribution at retirement. The profit sharing plan is the oldest form of defined contribution plans, and remains as such due to low operational costs and because it asks nothing of you in a bad year. Any corporation, partnership or self-employed individual may establish a profit sharing plan. The trade-off lies with the employee in terms of not knowing what their account balance will be at the end of the year based upon management decisions made by the employer.

A Profit Sharing Plan is also an Employer Funded option that has a similar "Family" to the other employer-funded options in the small-business retirement plans Overview. The Discretion of a Profit Sharing Plan however provides for the flexibility of allowing employers to either increase or decrease their contributions, or even elect to contribute nothing at all to the plan. Under a SEP, each participant must receive the same percentage of salary contribution from their employer. Since participants are allocated shares based upon formulas established by the Employer, this creates another level of opportunity for employers to favor selected employees within these plans.

Does a profit sharing plan require actual profits?

No, and this is by far the most common myth. Many business owners think the plan will only work if their company has been profitable, and therefore they don't take advantage of it when things are bad. The IRS clearly states that you do not have to make profits on your business in order to fund the plan, nor does it state what amount of contribution is required under the law. ^[1] A good year financially (profitable) is a "practical" rule not a legal requirement. There is one guardrail: the IRS expects substantial and recurring contributions to your plan from year-to-year, and if you fail to do so for an extended period of time (years), the IRS may treat your plan as "terminated", and all participants will be fully vested.

How are profit sharing contributions allocated?

In addition to determining the total contribution, the plan's written formula splits that total among employees as well. The most commonly used method of doing this is comp-to-comp (or pro-rata). With comp-to-comp, each employee's share is determined by taking his/her compensation divided by the total compensation of all participants, multiplied by the total contribution. ^[1]

In addition to comp-to-comp, you can steer your plan in favor of owners or older workers while staying inside the nondiscrimination rules. The integrated formula incorporates an additional allocation that applies to salary above the Social Security wage base. An age-weighted design converts employer contributions into projected retirement benefit amounts. A cross-tested (new comparability) design does the same. That is why it is possible for an older owner to have five figures in their profit sharing account while younger employees are allocated only a few percent of their compensation. These designs will only work if the demographics of the owner(s) align with those of the workforce. If the owner(s) are younger than most employees, then an age-weighted formula would essentially be funding all employee accounts rather than the owner's.

What are the profit sharing plan contribution limits?

There are two different ceilings for a profit sharing plan. Owners have a tendency to get these confused with each other. The first ceiling is the deduction limit on employer contributions, as stated by the IRS (Publication 560). This states that an employer can deduct no more than 25% of the compensation paid to participants.^[2] The second ceiling is the annual additions limit as set forth in Internal Revenue Code Section 415(c). These limits state that when adding money to one employee's account, it cannot exceed the lesser of 100% of his/her pay or $72,000 in 2026.^[3] A plan will need to meet both tests, a company-wide payroll test (the 25%) and a per-person account test (the $72,000), and only the first $360,000 of any individual's pay will be used for either test. The 25% payroll limitation (W-2) will scale with pay until it reaches the annual cap:

Self-employed owners are eligible for a 25% deduction based on net earnings from self-employment instead of a W-2 salary. This produces an approximate effective rate of about 20% once the self-deduction is calculated as part of that. This peculiarity causes confusion for those who own and operate their business solely as a sole proprietorship and expect a full quarter of their draw. Once a top-heavy plan benefits the owner(s), each non-key employee in such plans must receive at least 3% of compensation.

Vesting is another lever under Section 411. A vesting schedule in a profit sharing plan may be either a three year cliff, or a graded schedule reaching 100% over six years. Money forfeited by employees who depart before their vesting date can cut your next contribution. ^[4] That's an actual difference with respect to plans run through our platform: a SIMPLE IRA vests all employer dollars immediately.

Profit sharing plan vs. a SIMPLE IRA: which should a small employer choose?

In most cases for small businesses, an honest answer is a SIMPLE IRA. The Standalone Profit Sharing Plan rarely makes sense today. That shows up as the Employer Contribution Feature added to a 401(k) (which means Form 5500 Filings, Nondiscrimination Testing and Administration Costs) which a SIMPLE IRA does not have. You go with profit sharing when you want your Owner Contributions pushed towards the $72,000 annual additions cap, and the Cost of the Allocation Formula across the rest of payroll still has you ahead of a SIMPLE's flat 3%.

In addition to being an affordable option for companies that have a state mandate and are looking to maintain their required cost close to 3% of payroll, a SIMPLE IRA wins, and it also provides a very basic, no-frills plan that will meet this purpose. The full comparison lives in our SIMPLE IRA vs. 401(k) breakdown. If your objective is to shelter as much owner income as possible, then a Profit Sharing 401(k) has earned its way.

The Bottom Line

A Profit Sharing Plan is a Qualified Plan that you fund with discretionary employer contributions. The Employer does not have to be profitable to make such contributions. The Profit Sharing Plans offer high contribution ceilings and formulas that can favor Owners, however they typically come as an additional 401(k) plan add-on requiring paperwork and administrative burden. If you desire this level of reach, then a Profit Sharing Plan will fit. However if you wish for simplicity and low cost, price a SIMPLE IRA first.

This guide is educational and summarizes IRS rules for profit sharing plans. It is not investment, legal, or tax advice. Your plan documents and current IRS limits control. Talk to your tax advisor about your business's circumstances.