Recently I met with a client who owned a business. For the last ten years he had been paying significant bonuses to his employees based on the profits of the company. As nice as bonuses are, the employees lost a significant portion of the bonus to taxes Is there another way to structure this bonus program in a more tax efficient way.
A Deferred Profit Sharing Plan (DPSP)
DPSPs are one of the most powerful employee benefit tools available today that an employer can include in their arsenal to attract and retain top notch personal. In a nut shell, employers and employees appreciate the DPSP because it rewards employees for helping a company earn profits. A Deferred Profit Sharing Plan is a simple and flexible arrangement, a company/plan sponsor distributes a portion of the company's pre-tax profits. DPSPs are arrangements where an employer may share with either all or a designated group of employees the profits from the employer's business.
Contributions and administration fees are tax deductible for the employer and accumulate tax-sheltered in the plan for the benefit of the employees, until paid out of the DPSP. In years that a DPSP sponsor is not profitable the employer only needs to contribute 1% of an employee's income.
Traditionally, the amounts payable by the employer under a DPSP can be calculated as:
- a portion of profits (e.g., 10% of profits as defined in the plan),
- a fixed dollar amount per plan member or (e.g. up to a maximum of $1000 per employee)
- a fixed percentage of payroll.(e.g. 3% of employee's base income)
A Group RRSP / DPSP Combo plan
In today's world, the DPSP is most commonly used in conjunction with a Group RRSP plan where employees will contribute a percentage of pay to the Group RRSP and the employers will contribute their matching contributions to a DPSP.
Related article: Group RRSP / DPSP Combo Plan
Important Features of a DPSP
- A connected person (an individual who owns directly or indirectly more than 10% of a company) is not eligible to participate in a DPSP.
- Employer contributions into a DPSP are limited to the lesser of 18% of the employee's compensation for the year or a dollar limit equal to one half of the defined contribution pension plan limit. (See New planning Data for current and past DPSP limits)
- Contributions are not added to members' earnings and are not subject to payroll taxes such as EI & CPP.
- Unlike a Group RRSP or pension plan, only employer contributions are allowed under a DPSP. Most employers use a DPSP as a complement to a Group RRSP
- DPSP contribution reduces the employee's RRSP room for the following year (allows full RRSP contribution for the current year). The reduction shows up as a Pension Adjustment (PA) amount on the employee's T4.
- Vesting periods for employer contributions can be set up to a maximum of two years and are not locked-in. Employers can place withdrawal restrictions on the contributions for as long as the employee is employed.
- Terminated employees can withdraw the full vested amount subject to taxation.
- The DPSPs requires trustees with at least one trustee being fully independent of the employer and plan member(s) and all trustees must be residents of Canada.
- All DPSPs must comply with the rules laid out by Canada Revenue Agency
DPSPs require specialties in areas as diverse as pension legislation, employment law, and employee benefit plan construction. Many employers and their accounting professionals who think they would benefit from implementing a DPSP should seek financial education services to aid them in its set-up and maintenance stages.