Rev. Rul. 70-370

Advice has been requested whether a profit-sharing plan may qualify under section 401 of the Internal Revenue Code of 1954 if it permits self-employed participants to elect the percentage of employer and employee contributions that are to be allocated to the plan's variable annuity fund while no such election is available with respect to contributions on behalf of and by their common-law employees.

The trust forming part of a profit-sharing plan covering self-employed individuals and their common-law employees invests its funds in a deposit administration group annuity contract. The contract provides fixed and variable annuity benefits through (1) a guaranteed accumulation fund and (2) an equity investment accumulation fund (variable annuity fund) respectively. The plan provides for employer contributions out of profits and permits voluntary employee contributions. An investment option in the plan permits self-employed participants to elect the percentage of both the employer contributions and the voluntary employee contributions that is to be allocated to the equity fund. However, one-half of the employer contributions on behalf of common-law employees is automatically allocated to each of these funds while all their voluntary contributions must be allocated to the guaranteed fund.

Section 401(a) of the Code provides that a qualified plan must be for the exclusive benefit of the employer's employees or their beneficiaries. Section 1.401-1(b)(3) of the Income Tax Regulations provides that a plan is not for the exclusive benefit of employees in general if, by any device whatever, it discriminates either in eligibility requirements, contributions, or benefits in favor of employees who are officers, shareholders, supervisors, or highly compensated employees. A self-employed individual, by reason of the contingent nature of his compensation, is considered to be a highly compensated employee, and thus is a member of the group in whose favor discrimination is prohibited. See section 1.401-11(d)(1) of the regulations.

Where amounts to be distributed to participants under a profit-sharing trust are measured by investments that have been earmarked for their respective accounts, the trustee must invest each participant's interest proportionately unless additional provisions are included in the plan to prevent the prohibited discrimination. One acceptable provision would give all participants the right to direct the trustee to select the type of investment with respect to their individual shares. However, a plan provision that permits employees in whose favor discrimination is prohibited to select the manner in which their interests are to be invested, while denying this right to rank-and file employees, in discriminatory on its face, since the first group of employees can select the fund that is likely to provide a higher return.

Accordingly, it is held that this plan does not qualify under section 401 of the Code.