Employees Profit Sharing Plans

An Employees Profit Sharing Plan (EPSP) is a plan set up by an employer to benefit one or more of its employees . They're a tool offering benefit to both the employer and the employee.  Please contact us if you are interested in implementing an EPSP for your business.

EPSPs are set up as a special form of inter vivos trust. Typically, the trust will need three trustees, who can be the key managers of the business. There is no need to register an EPSP with CRA, although EPSPs that use a certain profit-sharing formula ("payments out of profits") must make an election with CRA to qualify the plan as an EPSP. The election requires that the EPSP be filed with CRA. A further benefit to the employer is that, beyond certain annual maintenance requirements, the EPSP trust itself does not have to prepare and file the usual federal trust income tax return with CRA. Annual maintenance requirements includes making allocations to the employees who belong to the plan and issuing T4PS Summary and Supplementary slips.

The benefits of EPSPs to employers include:

• motivating key employees through a profit-sharing arrangement;
• the ability of the employer to deduct contributions of the employer to the EPSP, so long as the contributions are made within four months of the financial year of the employer;
• a tax deferral advantage arising from the fact that contributions to EPSPs are not subject to withholdings for income tax, CPP or EI contributions;
• in a closely held corporation, the ability of the plan (if set up this way) to loan plan monies to the corporation for use until the monies need to be returned to the plan.

The benefits of EPSPs to employees include:

• a tax deferral advantage gained from the lack of a withholding requirement when the employer contributes to the plan; and
• income splitting opportunities, if there is a high-income employee and lower-income employees in the same family. Money that might otherwise have to be paid to the high-income employee can be contributed to the plan and then allocated to the lower-income employees, to take advantage of lower rates of tax.

The tax deferral benefit works best for employers whose financial years finish in September to December of the year. For example, an employer with an October 31, 2006 year end can wait until February 28, 2007 to contribute to the EPSP and still get a deduction for 2006. The trustees of the plan can then allocate the contribution among the plan members in 2007, and the plan members will not need to report that income until the following April, when they file their 2007 tax returns. The plan contribution can be put to work for those extra roughly 12 months and earn income before the government gets its portion.

For example, an employer with, say, $700,000 of pre-tax income would probably bonus down (ie, issue a bonus to certain employees) about $300,000 to get to the $400,000 small business deduction limit. With an EPSP, that $300,000 amount could be contributed to the EPSP without immediate deduction and be put to work for about 12 months before it was paid out to cover the tax bill for the employees.

Note, however, that the employer contributions must actually be money, not just a bookkeeping entry. The EPSP rules set a minimum annual contribution (for example, plans with an "out of profits" formula might use 1 percent of employee's salaries); and the amount of the contribution must be calculated only by reference to the profits of the employer and not by reference to other factors. Profits must be calculated in the ordinary way; and if the employer is profitable, the contribution must be made; deferrals or suspensions of contributions are not allowed. Conversely, if the year results in a loss, a contribution cannot be made. However, the source of funds for the contribution are not restricted: they can come from cash on hand, or borrowings, or whatever source of monies the employer can find. Subject to the minimum contribution requirement, EPSPs can achieve a certain flexibility in the amount of contribution to be made in a profitable year. Be aware, though, that some believe that the reasonableness provisions in the Income Tax Act (Canada) may limit the maximum amount that could be contributed to an EPSP. And CRA does scrutinize contributions that are made as part of plan to diminish CPP or EI contributions.

One drawback for employees who belong to the EPSP, though, is that they must report their share of the annual contribution plus any income or gains made by the EPSP trust in the year. Earnings of the trust that are eligible dividends or capital gains or losses retain their character when the employee reports them (that is, the employee can access any available dividend tax credit, and the lower rate of tax on capital gains). However, the employee will be reporting income and paying income tax for which he doesn't necessarily receive immediate cash, which could work hardship unless suitable arrangements are made with the employer and EPSP to provide the employee with the monies needed to pay the tax bill.

Those who like to look at source documents can consult: Income Tax Act (Canada), s. 144; Income Tax Regs 212 and 1500; and Interpretation Bulletins IT280R, IT379R, and IT502; which can be found through the Canada Revenue Agency (CRA) website: www.cra.gc.ca.

The tax deferral advantage and income splitting possibilities mentioned above can provide the necessary benefit to justify setting up an EPSP. If you're interested in setting up an EPSP for your business, please call or e-mail us.