What is Profit Sharing, and is it Right for My Business?

Companies are always looking for ways to motivate employees to think bigger, act faster, be stronger and stick around longer. While there are a variety of ways to do this, one attractive option is implementing a profit-sharing plan. 

In a profit-sharing plan, a company agrees to share a portion of its profits with its employees. Employees participating in the plan receive a percentage of the profits, and that cash is deposited into individual bank accounts, retirement accounts or even mutual funds. Oftentimes, businesses place restrictions on profit-sharing accounts to prevent early withdrawals; these restrictions include vesting schedules, restricted stock units, age restrictions, etc.

Profit sharing allows businesses to offer incentives to workers who contribute to the growth of the brand. It’s also a great way to give employees a sense of ownership in the business and boost employee moral.

How Profit Sharing Works

There are many ways to structure a profit-sharing plan. In general, the employer contributes a portion of its profits to an account owned by the profit-sharing group, and the employees in the plan split that contribution based on their salary, seniority, tenure and/or other factors. 

Employees typically don’t contribute their own money to a profit-sharing plan; only the employer does. The contributions are usually discretionary, however, which means companies can choose how often and how much they contribute to the plan. This is helpful if the company has a rough year and can’t afford to pay its typical contribution. Similarly, if the company has an exceptional year, it can increase its contribution. 

Employees have individual accounts in the profit-sharing plan, and they can use the cash to invest in mutual funds, savings accounts, company stock or other investments. 

The contributions to the plan and the returns employees earn are typically not taxable. Instead, the funds are taxed when employees make withdrawals. This tax-deferred system should benefit workers that make withdrawals after retirement, as they will likely be in a lower tax bracket than when they were at the height of their earning powers, and as such, they pay fewer income taxes as a retiree. 

Employees own the accounts even after leaving the company. Though this portability can be a negative for employers since it does little to limit an employee from leaving, it can also save the company a lot of administrative work associated with shutting down accounts and transferring funds every time an employee leaves. 

However, companies can implement vesting rules in profit-sharing plans, which require the employee to work for the company for a minimum length of time (e.g. two years) before the employer’s contribution to an employee’s profit-sharing account is fully owned by the worker. 

Elements of Profit-Sharing Plans 

Profit-sharing plans can vary widely, but they do have some common elements. 

First, profit-sharing plans have written rules that govern how the account is administered, with some rules required by law. Generally, the governing documents explain the plan’s daily activities and responsibilities, as well as how employers must decide to allocate any company contributions to the plan. 

Second, the company has to create a trust fund at a financial institution. This is where the plan’s assets will reside. The money in the trust fund does not commingle with the company’s other assets, which ensures that the company doesn’t raid the profit-sharing plan for cash to support other aspects of the business.

Third, the company has to create a system to keep records and create reports for the plan’s participants in order to ensure that:

  • Contributions are allocated correctly
  • The employees’ investments (and their returns) are recorded properly
  • Distributions happen correctly
  • New and old employees can access and manage their accounts

Companies must also set up systems to notify employees when they are eligible to participate in the plan, and they must provide a multitude of disclosures to various government agencies. For more info on setting up and managing a compliant profit-sharing plan, see the Department of Justice’s profit-sharing worksheet.  

Benefits of Profit Sharing 

Profit-sharing plans can help employees save for retirement, and they are a great way to motivate employees to go the extra mile. 

Of course, not all employees are motivated by retirement savings; for example, younger employees may be more motivated by current compensation or other benefits. As such, the effectiveness and participation rate of your profit-sharing plan will be largely dependent on the characteristics of your team. 

By knowing the basic steps involved in setting up a profit-sharing plan, employers can start to understand the responsibilities involved in administering them. While it’s certainly not required, a good profit-sharing plan can make employees feel like they have a stake in the business’ outcome. This breeds enthusiasm in the workplace, which is great for both office morale and your company’s bottom line.

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