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:

Dr. Adams has reduced the cash withdrawn from the PC from $228,500 to $204,000 resulting in more cash left behind in the PC of $24,500 which is approximately the tax and CPP savings on using the EPSP.

Taking this example further, Dr. Adams may be able to use an EPSP to tax effectively save for a child's post-secondary education costs. Instead of limiting the allocations to actual cash requirements, Dr. Adams could allocate more than the $28,000 to his child and accumulate the surplus in the EPSP Trust. The tax rate for the child on the allocations will still be less than Dr. Adams tax rate. The Trust could invest the funds and over the years accumulate sufficient amounts to fund the child's education.

Costs

A tax lawyer and accountant would be engaged to prepare the EPSP Plan documents, prepare EPSP Trust documents, prepare corporate resolutions and Trustee(s) resolutions. Typically these fees are approximately $3,000 for legal services and $1,500 for accounting services. These fees are a one-time cost and ongoing costs to file the T4PS documents are approximately $500 per year.

Tax Planning

1. A tax deferral is possible at plan inception. For example, if an employer has a September 30 2003 year end, an expense can be claimed for an allocation payable which is paid 120 days later on January 28, 2004. That payment will then be allocated by the Trust on December 31, 2004 and the employee pays tax by April 30, 2005. This results in over one year of tax deferral.

2. One of the drawbacks of EPSP's is that the employer allocation may result in the employee having to make income tax instalments for the subsequent calendar year, negating any further tax deferral advantage. To avoid this, one tax planning alternative is to alternate paying EPSP payments and salary each year. For example, in Year 1, the employer would make large EPSP payments which the employee includes in income with a small regular salary. The tax on that income is not due until April 30 of the year following the payment. For the employee, this will create a large tax instalment base after he files his personal income tax return. However, payment of the instalment base may be avoided by paying a larger regular salary with regular monthly tax remittances in Year 2 with a smaller EPSP payment. Then you start the process again in Year 3.

3. Employee Profit-Sharing Programs may provide a technique to allocate income to employees, including family members, without the employer concerning themselves whether the amounts allocated are reasonable in the eyes of CRA. CRA will deny unreasonable regular salaries paid to family members. Therefore, an EPSP may allow for easier income splitting with family members - including minor children. Caution is warranted as CRA may challenge this tax planning technique.

Pros

1. Reduce payroll costs such as employer contributions to EI and CPP.

2. Possible deferral of tax on initial employer allocation for over one year.

3. No limitations on investments such as foreign property in contrast to RRSP's, IPP's, and DPSP's.

4. Employer allocations are "earned income" for RRSP purposes and increases RRSP contribution room.

5. Employees can contribute to the Plan to pool investment funds in the EPSP Trust.

6. Income splitting with family members including minor children. Becoming more important since the "kiddie tax" has eliminated the income splitting with minor children using Family Trusts.

7. Easily maintained with minimal reporting to CRA.

8. No registration required with CRA.

9. Motivation for employees to keep costs down and increase revenues.

10. Motivation for employees to stay with employer.

11. Employer can control the Trust.

12. No legally defined upper limits on employer contributions unlike IPP's and DPSP's.

13. Does not reduce RRSP limits like an IPP, or DPSP does.

Cons

1. Not for everyone. Initial costs can be prohibitive for small organizations. Determining whether to have an EPSP requires an analysis of tax savings and tax deferrals compared to initial costs and ongoing fees.

2. Other tax planning techniques may already be used which accomplishes much the same thing. For example, aggressive salaries to family members or the use of Family Trusts.

3. Employee contributions are not deductible.

4. Employees may become aware of the profitability of the employer.

5. Employees not involved in Plan may be less motivated.

6. Employer allocations are legally binding on the employer.

7. The widespread adoption of EPSP's is a recent phenomena, mostly due to the "kiddie tax" income splitting legislation on family trusts. CRA is aware of the increased use and are now auditing heavily and issuing unfavourable reassessments. Employers are now appealing to the courts, but no court decisions have been issued. Uncertainty of the Plan limitations therefore exists.

8. If CRA becomes aware of a Plan, they will most likely audit it. Currently, the filing of 144(10) elections and T4PS forms have not been tracked by CRA and are therefore not factors in whether an audit will be triggered. This may change.

9. CRA has looked at several factors during their audit process. The first is whether the employee has significant and regular monthly salaries to justify "employee" status. CRA will scrutinize family member employees looking for irregular and/or low salaries. Even if CRA finds that the family members are "employees", CRA  will also challenge the EPSP payments on the basis that the salary reasonability test should also apply on EPSP payments. Second is whether profit is determined before payment to the Plan and not after. Third is whether the profit element in the formula is in reference to prior year's taxable profits, not accounting profits. Some employers have been issuing Plan contributions in accounting and tax unprofitable years and current legal advice is mixed on whether this is allowed under the legislation. Fourth is whether a separate bank account is kept. Fifth is whether there is more than one employee in the Plan. The legislation allows "Employees" Profit Sharing Plans which indicates more than one employee in the Plan is required.

10. Even if the courts ultimately rule favourably to the employer, CRA may push for revisions to the legislation removing some of the "offending" outcomes. If legislation is revised, it is uncertain if any grandfathering provisions would be implemented.

Careful planning with a Chartered Accountant is warranted. Contact Keith Anderson CA at (780) 447-5830 if you need advice. 

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