How to Build a Profit Sharing Strategy for a Thriving Business

One of the most significant motivators for employees is often—if not always—money.

If you were to ask me about my ideal workplace, I would say it’s somewhere I feel genuinely invested in its success—a place where my hard work and dedication are recognized and rewarded in meaningful ways.

While many businesses prioritize profitability, neglecting employee satisfaction can lead to decreased morale, increased turnover, and, ultimately, a decline in the company's bottom line. Maintaining a balance between financial goals and employee well-being is crucial for long-term success.

Traditional compensation models frequently fall short of creating a sense of ownership and shared success among team members. By aligning employee interests with the company's bottom line, organizations can cultivate a more engaged, motivated, and productive workforce.

This is where profit sharing comes into play. 

Human Resource Management Systems and Human Capital Management (HRMS & HCM) software streamlines the management of employee compensation and benefits, including profit-sharing programs. 

For example, a company, XYZ, implemented a profit-sharing plan that rewards employees with a percentage of the profits based on the company's performance. This approach not only incentivizes employees to work harder but also fosters a sense of collective ownership in the company's success, leading to increased productivity and morale.

How does profit sharing work?

Profit sharing can work in varying ways, but typically, a company contributes a portion of its pre-tax earnings to a pool that is then distributed to eligible employees. The amount distributed can depend on each employee’s salary.

Once this pool is created, it’s up to either HR professionals or C-suite leadership to create a plan for distribution as part of their benefits administration program. The US Department of Labor recommends the following:

• 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.

7 types of profit sharing plans

There are 7 main types of profit sharing plans, but at the end of the day, all are based on a similar concept. 

Benefits of profit sharing

For employees, the benefit of 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 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 other hand, profit sharing has some potential drawbacks that you should be aware of.

• Unlike merit pay, profit sharing is not directly tied to individual performance, which may reduce motivation for high achievers..
• Establishing a fair and effective profit-sharing plan can be complex and may require significant administrative effort.
• Profit sharing can be inconsistent during economic downturns, leading to uncertainty for employees.

How to set up 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 having zero contributions for years that don’t see a profit. This flexibility can be particularly beneficial during economic downturns or uncertain business climates, allowing you to retain your cash flow while still incentivizing your employees during profitable years.

You can establish such a plan regardless of the size of your business, even if you already have retirement plans in place.

If you decide to make contributions to your employees, a set formula must be in place to determine how profits are allocated. Common formulas include:

• Pro-rata basis: Distributions are based on each employee’s salary as a percentage of total salaries within the organization.
• Age-weighted contribution: Allocations are based on age and compensation, allowing for larger contributions to older employees nearing retirement.
• New comparability plan: This approach allows employers to allocate different contribution rates to different employee groups, such as executives versus regular employees.

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. This form is essential for compliance and must be filed annually.

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.

When implementing a profit-sharing plan, clear communication is vital. Employees should understand how the plan works, how contributions are calculated, and what they can expect in terms of payouts. Regular updates and educational sessions can help foster a culture of transparency and engagement, ensuring that employees feel valued and motivated to contribute to the company’s success.

Profit sharing examples

Since the most commonly used formula for a company to determine a profit-sharing allocation to its employees is the “comp-to-comp method,” let’s use that as our example.

To calculate the employer contribution, add the compensation for all your employees, typically found within a compensation statement. 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.

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.

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.

Motivate your team and boost performance through an employee bonus program.

This article was originally written in 2021. It has been updated with new information.