The 25% factor applies to earned income (E) minus the profit-sharing contribution (C). The result is that the maximum employer contribution is 20% of the earned income. Doing a bit of algebra:
C = 0.25 * (E - C)
4 * C = E - C
5 * C = E
C = 0.20 * E
More generally, the calculation described in IRS Pub 560 Chapter 6 for a base percentage P is:
C =E * P / (1+ P)
So for a base percentage of 25%:
C = E * 0.25 / (1 + 0.25)
C = E * 0.25 / 1.25
C = E * 0.20
This calculation is described in Chapter 6 of IRS Pub 560.
