Technological innovations and ever-shifting economic trends are changing how we do business. In turn, the relationships between employers and employees have entered a more dynamic state of flux.
To that end, many organizations—from small business owners to multinational groups—have adapted how they attract talent by incorporating benefits that incentivize their hard work with profit sharing plans. Profit sharing plans are a novel retirement program that employers and employees each appreciate. The potential boost to their retirement plan attracts new talent, while organizations benefit from increased retention.
Explore the potential profit-sharing plans present for organizations: What they are, the different types, and the benefits they have for all parties involved.
What is a profit-sharing plan and how does a profit-sharing plan work?
Profit-sharing plans are retirement programs where an organization’s profits fund an employee’s retirement package to reward employees for their contributions to an organization’s success and align their financial well-being with the organization’s well-being.
While there are several variations of profit-sharing plans, they each work similarly: At the end of the year, employers allocate a contractually determined percentage of the organization’s profits—usually 25 percent of payroll—into their employees’ retirement accounts.
Contributions do not necessarily depend on whether an organization makes a profit, although all eligible employees receive money based on an organization’s profits. Rather, the employer makes a contribution amount at their discretion based on several factors, like rollover payments or contractual obligations of their profit-sharing plan document.
Because an organization’s annual profits and the employee’s annual compensation inform profit sharing plans, allocations fluctuate yearly.
4 types of profit-sharing plans
There are different types of profit-sharing plans organizations choose from, including the following:
1. Cash-based plans
Cash-based profit-sharing plans are the most straightforward: Employers make direct cash payments to an employee’s account as part of their profit-sharing bonus. Because they are direct payments, payments don’t always include a tax deferral.
2. Deferred plans
A deferred profit-sharing plan functions like a defined contribution plan for retirement savings. Employers contribute to an employee’s retirement account, usually for additional tax benefits, but employees only access it when they retire or leave the organization.
3. Combination plans
Combination plans typically refer to a mix between cash plans and deferred plans. Employers sometimes make direct payments to an employee’s retirement account and contributions to a deferred plan for long-term tax-advantaged retirement savings.
4. Employee Stock Ownership Plans (ESOPs)
In ESOPs2, employers benefit from an organization’s profits by giving their employees shares of stock instead of cash.
Profit sharing plan vs 401k: Are they the same?
Like 401ks, profit sharing plans provide employees with additional income to build a robust retirement program. Their roles are similar, but they have clear differences.
Employees are the people who make contributions to their 401k program. Employers then offer a set percentage they are willing to match with their contribution. Profit sharing plans are managed almost exclusively on the employer’s end; employees are typically unable to contribute.
Additionally, each plan has a different set of abiding requirements. For starters, 401ks have different filing forms than profit sharing plans. Because they require disbursement amongst many employees, profit sharing plans must stand to higher degrees of scrutiny that profits are distributed indiscriminately to income level; 401ks have no such requirement.
This difference means that these funds aren’t mutually exclusive. Companies offer one or both for added allure when hiring new talent.
How are benefits shared with employees?
There are a few ways that employers share the benefits of these plans with employees, including:
Pro-rata plan
Pro-rata profit sharing plans distribute profits based on their earnings. Disbursement corresponds to earnings per year, meaning high-earning employees stand to earn a larger percentage of the profit share.
Fixed percentage plan
Alternatively, a fixed percentage profit sharing plan disburses profits at a set percentage, regardless of external factors.
Age-weight plan
For age-weighted plans, organizations give employees larger percentages of the profit share based on their age or length of time spent with the organization; more senior employees get a larger percentage.
New comparability plan
New comparability plans use several factors when distributing profit shares to employees, like hours worked, time with the organization, and age.
What are the advantages of a profit-sharing plan?
The advantages of a profit-sharing plan include productivity incentives, tax-deductible contributions, and beyond:
Productivity incentives
With a profit-sharing plan, employees profit when organizations do. When employees have more incentive to be productive, both the organization and the employees benefit.
Contributions are tax-deductible
An employer’s contributions to a profit-sharing plan are tax-deductible, meaning that organizations can write off a large amount of taxes while appeasing their employees.
Boost employees’ commitment to the business
When employees’ bonuses have financial gain from the organization’s performance, they feel a deeper commitment to fulfilling organization goals. Deferred profit-sharing plans put an even greater stake in the organization’s long-term health.
Attract and retain top talent
Top talent in any field will be more competitive; higher demand for them means organizations must make them the best possible offer. Including profit sharing plans in employee contracts is sometimes the incentive that lures talented people away from competitors.
Are there any disadvantages?
As with any plan, there are disadvantages to profit sharing plans, including set-up time, the lack of ability for employees to contribute, and nondiscrimination testing requirements.
Takes time to set up
Profit-sharing plans are complex. Employers consider several types of profit-sharing plans to find the best fit. Between tailoring the plan to the organization, filing for the program with the IRS, bringing employees on board, and getting assistance from a financial advisor, setting up a profit-sharing plan takes longer than expected.
Employees can’t contribute
Unlike similar plans, employees cannot contribute to a profit-sharing program and must rely on the employer to do it on their behalf. While employees stand to benefit greatly from a profit-sharing plan, their lack of autonomy sometimes dissuades them.
Employer is subject to nondiscrimination testing
Profit sharing plans come with higher degrees of scrutiny than other employee benefit programs. Rigorous testing must regularly demonstrate that the disbursement of annual profits is non-discriminatory, and employers sometimes feel overwhelmed by the high levels of regulation.
5 steps for business owners to create a profit-sharing plan
Profit-sharing plans present an exciting opportunity for employers and employees but implementing them is a serious undertaking.
Employers must ensure they’ve found the right plan for their organization and the right financial institution or professional to manage it. Questions such as whether profit-sharing will reduce employer or employee tax bills, whether they need flexibility in determining how much money they pay out each year, and whether they have a written plan with the features they want to offer are all important for employers to answer before making a final decision.
Other important questions include:
- Do you know the fiduciary responsibilities?
- Can you monitor the plan’s service providers?
- Do you have a trust for plan assets?
In addition to answering the above questions and beyond, here are a few key steps organizations should follow when implementing a profit-sharing plan.
1. Determine profitability
Organizations need to be sure that they are capable of implementing a profit-sharing plan to begin with. The first step is an organization-wide audit to determine profitability to establish what kind of profit-sharing plan employers should choose.
2. Choose a recordkeeping system
Profit-sharing plans hinge on a comprehensive recordkeeping system. By selecting an effective system, organizations can better distribute profits among participants and generate data demonstrating their nondiscriminatory practices.
3. Choose a trustee
The assets in a profit-sharing plan must be held in a trust and therefore require at least one trustee to manage the fund. Employers need to choose a trustee or fiduciary who can handle contributions, investments, and distributions as the plan develops.
4. Provide information to eligible employees
A profit-sharing plan exists to benefit employees. Employers need to get the word out about their plan to their employees to start making contributions on their behalf.
5. File IRS Form 5500 annually
Employers must legally fill out IRS Form 5500 to qualify for their profit-sharing plan. From then on, Form 5500 must be filed annually to prove to the IRS that the plan abides by its requirements.
Wage-sharing discretionary options that employers may want to consider
Because employers are the primary handlers of a profit-sharing plan, they have the leeway to handle the fund at their discretion in a few key ways. Here are some discretionary options employers have over how they handle their plan:
Employee eligibility
Employers set limitations on employee eligibility for profit-sharing plans. For instance, employees must have at least 12 months’ tenure at the organization, and employees are required to have worked at least 1,200 hours with the organization. Citizenship status, union affiliation, and under-21 age limits also preclude employee eligibility.
Contribution timing
Employers decide when to contribute to the profit-sharing plan. Typically, trustees make a one-time contribution at the end of the year. Provided that the contribution is made before the corporate tax filing deadline for tax purposes, employers make their profit-sharing contribution at their discretion.
Loans
Employers have the ability to make loan distributions drawn from the plan, like withdrawals for hardships. Their ability to make these kinds of distributions depends on the legal specifics of the plan. Some employers leave room for loans, while others prefer to keep distributions locked so that money is available for retirement.
Distribution
Employers have many options for how and when they make distributions from a profit-sharing plan. For one, employers set the requirement for when employees are eligible to start receiving distributions, usually depending on the employee’s age and years spent with the organization.
Additionally, employers decide how they distribute funds: in a lump-sum distribution, periodic distributions, ad-hoc distributions, or annuities.
A profit-sharing plan example
The many technicalities of a profit-sharing plan make it difficult to envision. Let’s run through a clear example so that you see what they look like.
Clark, Stephanie, and Gil enroll in a profit-sharing plan. Each employee’s salary is $35,000, $50,000, and $75,000 annually. The first step to determining how a profit-sharing plan works for these three employees is to determine the total dollar amount of their annual compensation: $160,000.
Next, establish the year’s profits and the profit share percentage in the plan: $175,000 and 12 percent. The profit sharing total for the plan is 12 percent of $175,000: $21,000 is the amount that will be distributed amongst the employees.
In a compensation-based profit-sharing plan, the disbursement of that $21,000 follows a set formula based on each employee’s yearly compensation as a percentage of the total compensation: 20 percent for Clark, 28 percent for Stephanie, and 42 percent for Gil.
Clark’s profit share is $4,200, Stephanie’s is $5,880, and Gil’s is $8,820.
Profit sharing plan distribution rules and limits
Profit sharing plans are handled by the employer, not by the employee, so the legal responsibilities fall upon the former party. To meet the legal requirements for a profit-sharing plan, employers must:
- File a Form 5500 every year and list all participants in the plan
- Prove their plan does not favor highly compensated employees
- Do not exceed the maximum payment: $66,000 for 2023
- Employer contributions are tax-deferred
- Employee contributions are not allowed
- An employee’s compensation must start by the April of the year they turn 73
- Employees who leave the organization have the option to take their money or leave it in the plan
While there is no legally set minimum for annual contributions outside of the specifics of an employer’s plan, there are set ceilings on maximum contributions: Profit-sharing plan contribution limits reach up to the lesser of 100 percent of the employee’s total compensation or $66,000 for 2023.
Maximizing benefits for both employees and employers
Organizations want to increase profitability; employees want a fair share. Profit-sharing plans synthesize this dynamic into a system that uplifts both parties. Under a profit-sharing plan, employees are incentivized to work harder, boosting profits for their employer. The bigger the profits, the better off an employee’s retirement benefits.
One of the strongest benefits of a profit-sharing plan is that it will attract top talent: Novel compensation plans make all the difference in drawing in quality candidates. When top talent works their hardest, profitability is bound to go through the roof, all thanks to a little more equity in a profit-sharing plan.
Properly implemented incentive-based compensation programs like profit sharing plans unleash your organization’s potential—learn how to implement a program that fits your enterprise with Payscale today.
