Start An Employee Profit-Sharing Plan (EPSP)

Introduction

The Income Tax Act provides for an employee profit-sharing plan (EPSP) to allocate profits of an employer to employees, including shareholders and family members who are employed in a corporation. An employer can include such organizations as corporations, proprietors and partnerships. They can be used to split income with family members, decrease payroll costs such as EI and CPP payments, defer income taxes, encourage key employees to stay with an employer for a certain length of time, and motivate employees to reduce costs and/or increase revenues.

How They Work

Under an EPSP, amounts are allocated and paid by the employer to a Trustee(s). Trustees can be anyone but generally three trustees are desired and they can be the employer, the employer’s lawyer, and the employer’s accountant. The amounts allocated by the employer are legally binding on the employer. The Trustee(s) hold the amounts in a Trust which invests the funds for the benefit of employees who are beneficiaries of the Plan. Not all employees must be included in the plan. An employer may pick and choose which employees benefit in the Plan.

The Trust is established through a Deed Of Settlement document and corporate resolutions are put in place to document the employer’s intentions. After the documentation is complete, a bank account for the EPSP can be set up in either the name of the Trustee(s) of the Trust or under the name of the Plan.

These plans are relatively easy to set up and maintain. There is no requirement to register a plan with the government unlike a Deferred Profit Sharing Plan (DPSP). The Trust year end is a calendar year end and the Trust does not have to file a T3 return. The only filings are T4PS summaries and supplementaries which allocate Trust profits to employees. The Trustee(s) advise the employer as to the amounts which were allocated to the beneficiaries in each particular calendar year so that the employer can complete the tax reporting requirements (T4A filing requirements), deal with changes to the beneficiaries, ensure beneficiaries are employees, and keep proper accounting records of the transactions within the EPSP.

The amount of the employer allocation must be computed by reference to profits of the employer. The allocation is computed in accordance with a set formula so long as the major variable is profit. An election, under subsection 144(10) of the Income Tax Act can be made to have the payments out of profit which adds more flexibility in determining the amounts allocated. The employer then, at it’s discretion, can add additional amounts out of profits over and above a minimum amount and overrides the formula amount in the Plan. For example $100 per employee-beneficiary as a minimum plus the variable out of profits determination. The employer contributions can be upwardly unlimited (subject to interpretation of legislation), unlike DPSP’s and Registered Pension Plans like IPP’s which have strict contribution limitations.

The allocations are tax deductible to the employer and there are no source deductions such as Income Tax, EI or CPP on the allocations by the employer. In order for the employer to deduct their contributions to the plan, the contributions must be paid to the plan during the tax year or before 120 days after the year end. Employees will be taxed on the employer contributions on their personal tax returns as regular employment income (which qualifies as RRSP eligible earnings) as well as their allocation of Trust profits. Because the employees are taxed on the employer contributions and Trust profits, there may only be a one time tax deferral at Plan inception in contrast to DPSP’s and IPP’s which have tax deferrals until funds are distributed to employees. The employee may also make contributions to the Plan which are not allowed in DPSP’s and are allowed only under certain circumstances in IPP’s. Employee contributions are not deductible to the employee, however the distribution back to the employee of their contributions are non-taxable.

In order to continue qualifying as an EPSP, the Trustee(s) must allocate each calendar year to individual employees all of the profit of the EPSP Trust and the employer contributions to the Trust. Trust profit is computed by including gross income from investments and then deducting expenses of the Trust such as professional fees. Expenses of the Trust are first offset to other income and any excess is then offset to other types of income at the discretion of the Trustee(s). The net result is Trust profit.

The types of income of a Trust can be characterized as either interest, taxable or non-taxable Canadian corporation dividends, foreign source income, and capital gains or capital losses. Any other source of income is considered other income. The employee pays tax on the allocations based on the nature of the income source of the Trust. For example, capital gains would retain their nature and only 50% is taxable to the employee.

There are no investment restrictions or government registration requirements with respect to the Trust and the Trust investments. This includes no foreign investment restrictions like those in RRSP’s, DPSP’s and IPP’s. Loans back to the employer are allowed. However, investments in treasury shares of the employer will result in a denied deduction to the employer.

Since Trust profits and the employer contributions to the Trust have been allocated and taxed to employees, the Trust does not pay any income tax on the investment income earned by the Trust or employer contributions to the Trust. Distributions to employees of capital of the Trust (for example, employer contributions, employee contributions, and accumulated investment earnings which were previously allocated to employees) are tax-free as tax has already been paid by the employee. For convenience, the Trust usually distributes enough cash for the employee to pay the tax on allocations. However, payments from the Trust to the employee are not required. Additionally, Trusts can be set up to have vesting requirements which further restricts cash distributions and allows for golden handcuffs which encourages key employees to stay with the employer for a certain length of time.

There is no requirement that all employees be included or that employees are treated equally under the plan. This provides a great deal of latitude for employers to include only those employees they desire.

Numerical Example

This is a simple example and may not reflect actual circumstances.

Dr. Adams earns income through a Professional Corporation (PC). His wife and child are employed by the PC but draw nominal but regular salaries for their services. Dr. Adams must withdraw $150,000 cash from PC to live on. The salary to Dr. Adams for $150,000 net cash is approximately $228,500 with tax of $78,213 and CPP of approximately $1,800.

With an EPSP the $150,000 cash requirements could be allocated among family members through the Plan say as follows: