What Is A Profit Sharing Bonus?

Profit sharing is an employee bonus that eligible employees receive over a set time period (quarterly or annually). The compensation paid to the employee depends on the profitability of the company over that time period and how their profit sharing plan is set up (more on this later).

This bonus is paid out as cash, deferred for retirement, or can be company stock.

The aim of a profit sharing bonus is to motivate the employees to collaborate and work toward the company's success, giving employees a sense of ownership.

What Is Profit Sharing?

There are different types of profit sharing plans which we will discuss later, but here is a general overview of what they entail.

A company sets aside profits, before tax, into a pool. Using a set formula to determine how much each person gets, these profits are then distributed to employees as an added bonus on top of their salary.

Distributions can be at the employer's discretion when they set up the plan, but most commonly it is quarterly or annually. These distributions are then paid into a fund and employees can withdraw it (at which point they pay tax) either when they retire or before, depending on the type of plan.

The formula considers the company's profits as well as an employee's annual compensation to determine a percentage of the profits that go to each employee (but more on that later). The bonus can be either cash or company stock.

Profit sharing vs. regular bonus

A regular bonus is paid out to employees at set time periods and is most commonly in the form of cash. A bonus is taxable when paid to the employee.

Most profit sharing plans are set up to help employees save toward their retirement. Profit sharing is not taxed until employees withdraw the funds.

This helps them build up their savings and is considered more rewarding by employees. Profit sharing tends to motivate employees to remain loyal to the company.

Types of Profit Sharing

Different types of plans mean there is no set formula used to determine the bonus paid out to employees. Whatever plan an employer opts for will see a percentage or fixed-dollar amount of the company's profits be shared with employees.

To ensure transparency, employers must be upfront with how the bonus is calculated and distributed.

Here are some of the more common types of plans:

• ‍Cash profit sharing plans: This is a type of instant cash profit sharing plan. With this plan, cash or company stock is paid out as soon as it is due. This gives employees an immediate bonus, motivating them instantly. The downside of this plan is that the payout is taxable.

• Deferred profit sharing plans: With a deferred plan, the bonus is paid into a fund which is often invested in mutual funds or ETFs. The bonus is then withdrawn at retirement or termination. Contributions to the plan are tax-free; however, the tax will be paid once the fund is withdrawn.
  The benefit of this kind of plan is that it improves employee retention as employees will want to stay for the retirement benefit. It has no immediate effect on current performance.‍
• Hybrid profit sharing plans: These plans combine the two discussed above. A portion of the company's earnings is paid into a retirement plan, while a portion is instantly paid to employees. This kind of plan has the benefits of both deferred and current profit sharing plans.

Different Ways to Allocate Profit Sharing

As already mentioned, there are different ways to allocate profit sharing contributions. The employer needs to determine how profits will be distributed when setting up the plan.

Here are three of the most common profit sharing distribution methods used by companies:

Same dollar amount ‍

This method is also called the "flat" or "fixed" dollar amount method. It is the simplest method since each employee receives the exact same amount.

The way to calculate it is to take the total amount of profits allocated to the plan, divided by the number of eligible employees.

For example: If the profit pool is $50,000 and there are six eligible employees, each will get a bonus of $8,333. This will then be paid into their retirement fund or cashed out to them, depending on the plan.‍

With this plan, the exact amount paid out to each employee is the same, but the percentage of the bonus relative to the employee's compensation will differ - this might be considered unfair by some.‍

If Employee A earns $20,000 and Employee B earns $60,000, then Employee A receives 41.67% and Employee B receives 13.89% of their compensation.

Comp-to-comp method

‍This method is also called the "pro rata" method. It allocates the profits based on the same percentage of each employee's compensation.

It is calculated by adding together the total compensation of each employee's salary. Then, calculate the percentage each employee earns based on the total compensation (by dividing the employee's salary by the total salary). The profit sharing is then calculated using this percentage.

For example, say Employee A earns $20,000 and Employee B earns $60,000. There are other employees at the company as well, and in total their salaries add up to $200,000.

There is a profit pool of $50,000 to be shared among all the employees. Explpyee A and B would earn the following profit shares: 

Employee A profit = ($20,000 / $200,000) x $50,000 = $5,000

Employee B profit = ($60,000 / $200,000) x $50,000 = $15,000

New comparability

‍New comparability profit sharing is also called the "group" method as it divides employees into different groups. These groups then each receive a different percentage of the profits.

The group divisions are up to the employer's discretion, but groups are commonly age- or compensation-based. Importantly, these plans must pass discrimination tests to ensure no demographic or group is discriminated against.

This method is great for employers who want to award their older or higher-income employees more than the new starts.

ShareWillow's free Profit Sharing Plan Template is a great place to get started to determine profit sharing distributions.

Read more: Check out some profit sharing plan examples here.

Tax Implications

There are tax advantages to both employers and employees.

Firstly, the employer contribution is tax-deductible, which is a massive benefit for employers seeking to reduce the taxes paid by the company.

All contributions are made pre-tax, which means there is no income tax paid on any money that goes into the fund.

This is a benefit to employees as the bonus money will increase. Any interest or dividends earned on investments are also tax-free.

Only once the employee withdraws the money will taxes be paid. If the employee withdraws the money early (if it is a deferred profit sharing plan or retirement plan), then they might face penalties as well, on top of regular income taxes.

It should be noted that the IRS places a contribution limit on profit sharing retirement plans. For 2023, this contribution limit is set at $66,000.

The Benefits of Profit Sharing Bonuses

The main goal of profit sharing bonuses is to help employees save for the future and let them know they are valued.

Here are some benefits of this kind of bonus to employees:

• Motivation: When employees receive a part of the company's profits, they will be motivated to keep working hard to reach the company's goals.
• Ownership: By sharing in the profits, employees feel a sense of ownership of not just the company but also their own contribution to the business's success.
• Collaboration: Since employees receive a portion of the profits, they will be more willing to collaborate and communicate with colleagues to come up with innovative solutions.

Profit sharing bonuses also benefit the employer:

• Employer contributions are tax-deductible, reducing the amount of taxes paid by the company.
• It boosts the retirement savings of the owners.
• It is flexible, meaning if the company has a poor year, the employer does not have to worry about still paying big bonuses to their staff. If there are no profits, the employer contribution can be zero.
• Employees who are more motivated, as discussed above, will work harder and improve the overall success of the company.
• Satisfied employees are more likely to remain loyal to the company, reducing staff turnover.

FAQs

Can part-time employees receive profit sharing bonuses?

It will depend on the profit sharing plan the company adopted. Some companies may include part-time staff in their profit sharing bonus plan, while others might only include full-time staff. The eligibility criteria differ between businesses and it is up to the discretion of the owner.

Do some industries favor profit sharing over others?

Each employer can decide whether they want to adopt a profit sharing plan, no matter the industry. That said, these plans are more common in industries where teamwork and collaboration are prevalent and directly impact company profits. These include tech startups, law firms, and the manufacturing industry.

Do profit sharing bonuses have any disadvantages?

Although these plans benefit both employers and employees, there are some downsides. Employees may miss out on a bonus if the company doesn't do well and earn a profit. Some employers may also view the bonus as a replacement for a competitive salary, paying their staff too little according to market standards.