Rev. Rul. 71-26

Advice has been requested whether the allocation of employer contributions to the accounts of participants in accordance with the method described below adversely affects the qualification of a profit-sharing plan under section 401(a) of the Internal Revenue Code of 1954.

A corporation established a profit-sharing plan that met the requirements for qualification under section 401(a) of the Code. The plan provides for the allocation of the employer's contributions on the basis of each employee's annual compensation. Annual compensation is defined as the regular salary or commission of a participant.

The corporation's entire income is derived from manufacturers' commissions earned by its six shareholders but payable to the corporation. The net profits are distributed as dividends to the shareholders in accordance with the percentage of stock owned by each shareholder. In operation, in accordance with the taxpayer's interpretation of the plan's provisions, contributions are allocated to the accounts of the corporation's rank-and-file employees on the basis of their regular salary only; however, contributions are allocated to the accounts of the shareholders on the basis of their regular salary plus their share of the corporation's net profits.

Section 401(a)(4) of the Code provides that the contributions or benefits provided under a qualified plan cannot discriminate in favor of officers, shareholders, supervisors, or highly compensated employees.

Section 401(a)(5) of the Code provides that a plan will not be considered discriminatory merely because the contributions or benefits of or on behalf of the employees under the plan bear a uniform relationship to the total compensation, or the basic or regular rate of compensation, of such employees.

Variations in contributions or benefits may be provided so long as the plan, viewed as a whole for the benefit of the employees in general, with all its attendant circumstances, does not discriminate in favor of employees who are officers, shareholders, supervisors, or highly compensated. See section 1.401-4(a)(2)(iii) of the Income Tax Regulations. Furthermore, the law is concerned not only with the form of a plan but also with its effects in operation. Section 1.401-1(b)(3) of the regulations.

Contributions or benefits under a qualified plan may be based on compensation, whether total compensation (which may include bonuses, commissions, or overtime pay), basic compensation, or regular rate of compensation, provided that whatever is used is consistently and uniformly applicable to all participants. However, a distribution of dividends to a shareholder is not salary or commissions paid to him by the corporation for services rendered merely because it stems from commissions paid to the corporation by its manufacturer-clients. In this case, these amounts are dividends paid only to shareholders and, thus, are not uniformly and consistently available to all plan participants. Inclusion of these amounts in the shareholder's salary for plan purposes results in a disproportionate allocation of contributions to the accounts of shareholders, a group in whose favor discrimination is prohibited under section 401(a)(4) of the Code.

Accordingly, it is held that the allocation of employer contributions in accordance with the method described above adversely affects the qualification of the profit-sharing plan under section 401(a) of the Code.