Employee profit sharing plans (EPSPs) have gained popularity in the small business environment in recent years and, in appropriate circumstances, can provide significant and immediate benefits to an organization. Key advantages include the possible reduction or elimination of Canada Pension Plan (CPP) and Employment Insurance (EI) remitting requirements, and additional tax deferral opportunities.
An EPSP is defined in subsection 144(1) of the Income Tax Act (ITA) as an arrangement whereby payments computed in reference to an employer's profits are required to be made to a trustee for the benefit of employees. Not all employees are required to participate in the EPSP, though it is recommended that a plan have at least two employees as beneficiaries.
One of several technical requirements in establishing the validity of an EPSP involves the computation of payments to the plan in accordance with a pre-determined formula that references the employer's profits. In most circumstances, an election is filed in prescribed form such that payments to the EPSP are deemed to be made "out of profits" of the employer. This election provides for considerable flexibility in the establishment of an acceptable formula and allows a plan to qualify notwithstanding payments are not computed specifically by reference to profits.
Payroll withholdings
The obligation to withhold amounts on certain employee remuneration is governed by the Income Tax Act, the Canada Pension Plan Act and the Employment Insurance Act. Despite the technical nature of the applicable provisions, the requirement to withhold and remit both CPP and EI on allocations from an EPSP is effectively eliminated, given these allocations are not deemed to be "payments" for these purposes.
The Canada Revenue Agency has provided technical interpretations1 indicating that, in cases where an employee is paid his or her total salary through an EPSP, it is a question of fact whether the arrangement would satisfy the provisions of section 144 of the ITA. However, the decision of the Tax Court of Canada in Greber Professional Corp. v. M.N.R 2 appears to have validated the acceptability of this strategy despite the Canada Revenue Agency challenging the EPSP as a conduit and attempting to subject the allocations to CPP contributions.
In the typical owner-manager scenario, assuming both spouses are compensated from the family business, the result is immediate cash savings of approximately $8,500 per year should income levels attract the maximum CPP contribution. If additional family members are involved in the business, the savings and attractiveness of the structure begin to multiply. In most cases, these savings more than offset any costs associated with establishing the structure, as well as compliance costs in the first year of operation.
Despite these potential savings, and as in any remuneration plan, the individual circumstances of the shareholder should be considered and, in most cases, individuals would be well advised to maintain some amount of salary.
The Tax Deferral
Traditional planning for the small business owner often involves some form of accrued bonus payable to individual shareholders with the remaining income taxed at the corporate level to achieve some degree of tax deferral (the amount of which varies based on the personal circumstances of the shareholder). Assuming the deferral is maximized, payroll withholdings will fall due six months following the corporation's year-end.
Should a corporation choose instead to implement an EPSP and allocate a portion of profits to the shareholder, an additional one-time deferral of up to thirteen months is made available.
The following example illustrates the effect of the tax deferral:
Corporation ABC Inc. maintains a September 30 year-end and desires to pay its sole shareholder an additional $100,000 for work performed throughout fiscal year 2010.
The bonus alternative (to be paid by March 31, 2011 to preserve the deduction at the corporate level) will result in withholding taxes due by April 2011, and include CPP of $4,300 (employee and employer portion).
Under the EPSP alternative, and as noted above, the requirement to withhold CPP and income taxes is eliminated. The EPSP payment (to be made to the plan within 120 days of year-end - January 31, 2011 in this example) will attract a tax liability due April 30, 2012, resulting in an additional thirteen-month deferral and immediate savings of $4,300.
Note that in subsequent years the EPSP participant must pay quarterly personal tax installments through EPSP allocations, and accrued bonuses may be used in alternating years to rectify this cash flow concern.
Contact your local Collins Barrow Tax Advisor to determine whether your organization might benefit from an EPSP strategy.
Jason Melo, CA, CPA, CFP, is a Senior Tax Manager in the Leamington office of Collins Barrow.
1 2000-0017, 2000-0055055
2 2007 TCC 78
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