Rev. Rul. 56-497

Advice has been requested whether an employee's profit-sharing arrangement, which provides for cash payments to some participants and deferment by funding through a trust of contributions on behalf of other participants, will qualify under section 401(a) of the Internal Revenue Code of 1954.

In this respect, the plans of two employers, the M company and the N company have been submitted for consideration. The M company established a profit-sharing arrangement under which all employees with three years of service are eligible to participate in the company's annual profits. The portion of the company's profits to be shared in allocated among employees in proportion to their basic annual salaries. Prior to the close of the calendar year, each eligible employee is required to make an irrevocable election whether to take his distributive share of the current year's profits (1) in cash, (2) have it deferred for distribution at a future date, or (3) one-half in cash and one-half deferred. After the close of the year, a cash payment is made to all employees who elected to receive cash, either in full or to the extent of the one-half, and the balance is contributed to the trust for the benefit of employees who have their shares deferred.

The following tabulation shows, by respective compensation classes, the manner and extent of participation under the plan and trust of the M company:

                                           Number         Number

In the case of a profit-sharing arrangement which grants to each eligible employee an election to receive his allocable share of the profits by current cash payment to him or by payment to a deferred trust for his benefit, qualification of the plan as non- discriminatory must be judged by reference only to those employees who elect to participate in the deferred trust. A determination is made both with respect to the coverage requirements and also as to nondiscrimination in contributions or benefits. See sections 1.401- 3(c) and 1.401-4(a)(1)(ii), of the Income Tax Regulations, T. D. 6203, page 219, this Bulletin.

In order for the plan to meet the coverage requirements, there must be sufficient participation by the lower paid employees to demonstrate that in practice the plan does not discriminate in favor of the higher paid employees. In the case of the M company, it is first observed that the proportion of the more highly compensated employees who participate in the trust is greater than the proportion of the lower compensated employees who participate. The terms "highly compensated" and "lower compensated" are relative, and the distinction between them must be based upon the circumstances of each case. In this case, not only are all employees with at least three years of service nominally eligible to participate, but also it is observed that over one-half of the participants in the trust are among the lowest paid two-thirds of all eligible employees, giving half weight to those who participate to the extent of half shares. Moreover, the employer contributions to the trust are allocated in proportion to the basic annual salaries of the participants for those who participate for their full shares, and similarly appropriate allocations of trust contributions are made to those who participate to the extent of half shares.

It is accordingly held that, for any year during which the lower compensated employees participate to the extent illustrated, the coverage requirements of section 401(a)(3)(B) of the Code and the requirements as to nondiscrimination in contributions or benefits under section 401(a)(4) of the Code are met.

The profit-sharing plan of the N company provides for participation of all employees with two years of service. The company contributions are equal to ten percent of its annual profits and are allocated among participants in proportion to compensation. Each employee is required to make an irrevocable election annually whether to take his distributive portion in cash or have it placed in trust for subsequent distribution on retirement, disability, death or severance of employment for other reasons. The following tabulation shows the manner and extent of participation under the plan and trust of the N company:

                              Number of       Number elect-

It is possible that the applicable requirements may be met in some subsequent year when substantial participation in the trust takes place. However, no advance determination letter will be issued with respect to such possibility. If the taxpayer feels that in a particular year the applicable requirements are met, he may submit the facts and figures for such year for an appropriate determination.