Whether that’s giving them the afternoons off during the summer, throwing a holiday party at the end of the year, or creating a compensation and benefits program that covers all the bases, it’s important they feel appreciated.
It’s also important that your business be profitable and achieve long-term success. When you do, you can consider adding profit sharing to your employee benefit plan.
What is profit sharing?
Profit sharing is a type of compensation program that awards employees a percentage based on the company’s quarterly or annual earnings. The amount is only awarded when a company profits over that period of time.
While this may sound somewhat similar to a 401(k) or retirement plan, keep in mind that in order to be a profit sharing plan, it must accept discretionary employer contributions, meaning employees can’t make their own contributions to the total. This means a retirement plan with employee contributions, such as a 401(k), is not a profit sharing plan because of the personal contributions made by the employee.
If your company is interested in building a profit sharing plan for its employees but isn’t sure where to start, we break it all down below.
How does profit sharing work?
There are varying ways that profit sharing can work, but typically it’s when a company contributes a portion of its pre-tax earnings into a pool that is then distributed to eligible employees. The amount that is distributed can depend on each employee’s salary.
Adopt a written plan: Create a written document that establishes a foundation for profit sharing. The plan document will need to have a set formula to determine how any contributions are awarded to eligible employees, as well as a vesting schedule. Your organization may also choose to hire a plan administrator to handle this for them.
Arrange a trust for the plan’s assets: It’s required that your plan’s assets be held in a trust, that way you can be sure the assets are used exclusively to benefit the employees. It must have at least one trustee to handle all contributions and distributions.
Develop a system for record keeping: You’ll also need an accurate record-keeping system to properly track and assign earning, plan investments, and benefits. This record will also assist when it’s time to create the annual return/report required by the Federal Government.
Provide information on the plan to employees who are eligible to participate: You’ll need to notify all employees who are eligible to participate in the features and benefits within the profit sharing plan. A summary plan description (SPD) must also be shared to all plan participants.
The company’s profits are shared with employees in either the form of cash, stocks, or bonds. In a cash profit sharing plan, employees are awarded profit sharing contributions in the form of cash or checks, but sometimes also as stock. The amount is taxes as part of their regular income and is considered a type of employee bonus.
There’s also the deferred profit sharing plan, where the amount is considered a retirement benefit or bonus. Deferral earnings are awarded either when the employee retires, upon death, after a disability occurs, or when the employee leaves the company.
It’s important to keep in mind that as a qualified retirement plan, the funds can be withdrawn without penalty after the employee turns age 59 ½ from retirement accounts. If an employee chooses to withdraw retirement savings before that age, they’re subject to a 10% penalty on top of any tax-deductible they already owe.
Types of profit sharing plans
There are three main types of profit sharing plans, but at the end of the day, all three are based on the employer providing money to employees after seeing a profit.
The first type is the pro-rata plan, which means that all employees involved in the plan receive the same contribution amount from the employer, either as a fixed dollar amount or a percentage of their salary. This type of plan is the most standard choice of profit sharing options.
There’s also the age-weighted plan, which means that employers can consider how the profit sharing plan would affect the retirement plan of their employees as they take age and salary into consideration. With this plan, employers can offer older employees a higher percentage than younger employees, because they’re closer to retirement.
Lastly, there’s the non-comparability plan, which can sometimes be referred to as the cross-testing plan. With this plan, employers can contribute to different groups of employees at different rates. This allows the employee to reward different employee groups with different benefits, even if they have similar ages.
No matter which plan your organization goes with, utilizing compensation management software that not only streamlines profit sharing, but also base pay, commission, stock options, and more, makes implementing the plan easy and hassle-free.
How to make a profit sharing plan
A good first step in setting up a profit-sharing plan for your business is to decide how much to allocate to each employee. When you offer a profit-sharing plan, it can be adjusted as needed, even going as far as having zero contributions for years that don’t see a profit.
No matter the size of your business, you can establish such a plan, even if you already have retirement plans in place.
Tip: According to the IRS, as of 2021, the contribution limit for a company sharing its profits with an employee is the lesser of 25% of that employee’s annual compensation or $58,000. In addition, the amount of an employee’s salary that can be considered for a profit-sharing plan is limited, in 2020 to $290,000.
In case you do decide to make contributions to your employees, a set formula must be in place. To get started, businesses need to fill out an Internal Revenue Service 5500 Form that details all participants in the plan, as well as your defined contribution plan.
Typically, a plan will include all of a company’s employees. However, there are some exceptions, which can include:
If an employee is younger than 21 years of age
If an employee hasn’t completed a year of service at the organization
If an employee is a nonresident alien
If an employee is covered by collective bargaining agreements that don't provide for participation
Profit sharing example
Since the most commonly used formula for a company to determine a profit sharing allocation to their employees is called the “comp-to-comp method”, let’s use that as our example.
To calculate the employer contribution, add the compensation for all your employees. Divide each employee’s compensation by the total to get their percentage of the overall compensation. Then give each employee an equivalent percentage of the profit-sharing bonus.
Let’s say you have a small business and employ three employees. Your business has earned $400,000 in the fiscal year and would like to allocate 10% of annual profits to its employees.
Employee 1: If this employee earns $50,000 as their salary, their profit sharing total would be calculated by (400,000 x 0.10 ) x (50,000 / 205,000) = $9,756
Employee 2: If this employee earns $75,000 as their salary, their profit sharing total would be calculated by (400,000 x 0.10) x (75,000 / 205,000) = $14,634
Employee 3: If this employee earns $80,000 as their salary, their profit sharing total would be calculated by (400,000 x 0.10) x (80,000 / 205,000) = $15,609
So, you would multiply the fiscal year's total, 400,000 by the percent you wish to allocate to employees, which is 10%. Then, you’d divide each salary by the sum of your employee’s salary. Because you only have three employees, the total of their salaries is $205,000.
Benefits of profit sharing
For employees, the benefit to profit sharing is pretty straightforward: it allows them to save more. But, as a business owner or HR professional, there are many other advantages to profit sharing to consider.
Employees will work together toward the common goal of achieving success
Aligns employees and helps them to focus on profitability
Boosts commitment to the organization for the long-term
A profit sharing plan can entice new talent to join the company
Can help motivate the team to be productive as an incentive to achieve the reward
Challenges to profit sharing
On the flip side, there are some potential drawbacks to profit sharing that you should keep an eye out for.
As an example, profit sharing could incentivize employees to prioritize profitability over everything else, including the quality of their work. And since there isn't a difference in profit based on performance, like there is for merit pay, employees who contribute less to the success of the company will receive a share in the profits regardless.
Smells like success
No matter the size of your business, if your goal is to earn a profit this year, make sure you reward the employees who make it all possible with a profit sharing plan. While sure, you could order pizza for lunch, the chances are they’ll appreciate this just a little more.
The next step in making profit sharing a success is to incorporate it into your recruitment marketing strategy.
Mara is a Senior Content Marketing Specialist at G2. In her spare time, she's either at the gym, reading a book from her overcrowded bookshelf, enjoying the great outdoors with her rescue dog Zeke, or right in the middle of a Netflix binge. Obsessions include the Chicago Cubs, Harry Potter, and all of the Italian food imaginable. (she/her/hers)
Share the wealth
Discover more about the best compensation management software on the market.