What is Profit Sharing? How it Works, Examples, and More

What is Profit Sharing?

Profit sharing is a way for businesses to offer employees a share of the company's annual or quarterly profits based on quarterly or annual earnings. The amount paid to the employees often depends on:

• Profitability of the company
• The profit sharing calculation used

If no profit is made, then there are no contributions made to the profit sharing plan (PSP) as only the company contributes to the plan, not the employees.

There are two main types of PSPs (we will go into more detail later):

1. Deferred PSP: This is a retirement plan for employees.
2. Cash PSP: A portion of profits are paid directly to employees and taxed as if it is normal income.

The aim of profit sharing is to motivate employees and also give them a sense of ownership in the company as they benefit directly from the success of the business.

Key Takeaways:

• A profit sharing plan is an employee benefit that gives employees a share in company profits based on quarterly or annual earnings.
• The company can decide how much the employees will receive.
• Employer contributions are the only contributions to the plan, employees can't make any contributions (unlike with a 401(k) plan).

How Does Profit Sharing Work?

Employer contributions, based on the profitability of a company, are the main contributor to PSPs. Employers can decide how much of the profits will be allocated to each employee. And the plans can be adjusted based on the company's earnings.If the company had a difficult year, contributions can be zero. However, when contributions are made, a formula must be used to determine profit allocation (which will be discussed later).

Although PSPs are commonly used as retirement plans, there are also types that benefit employees while they are still working — these are called cash plans (we'll dig into those more soon). Employees don't have to do anything to contribute to the profit sharing plan. Profit sharing is, essentially, a bonus on top of any other benefits.

Some companies pay their employees in cash or contribute toward a 401(k), while others use equity-based PSPs where employees are able to receive stock in the business. Businesses can also include vesting schedules to ensure profit is only shared with employees who have contributed to the company’s success over the long term.

Get started with profit sharing

Building your own profit sharing plan can be difficult. It'll take a lot of effort from businesses owners and leadership teams — especially those in finance. To help you get started, you can try out ShareWillow's free Profit Sharing Plan template which offers an easy way to calculate profit sharing distributions. Simply fill out some basic information regarding profits and an employee's annual compensation, and the Profit Sharing Plan document will do all the difficult calculations for you.

Ways to share profits with employees

Deferred profit-sharing

A deferred profit sharing plan (DPSP) is a type of retirement benefit for employees — akin to a financial time capsule, curated over the years of service, unlocking a treasury of benefits at the golden threshold of retirement.

The employer contributes a portion of profits to the DPSP, before tax. And employees will only be taxed once they withdraw the profits. However, once employees reach the age of 59 ½ they can withdraw funds penalty-free. It is also possible for employees to take a loan against the account before they retire.

These types of retirement plans are brilliant for helping to retain employees. The employer contribution allows employees to feel the company is invested in their future and gives a feeling of employee ownership while they're working as well as the retirement benefit. The longer an employee stays, the more savings they will build up.

Let's look at Procter & Gamble as an example. All employees over the age of 21 who have been in service for a year have eligibility to be a part of the profit sharing plan. The company has a contribution limit of 15% of an employee's compensation.

Cash profit-sharing

Cash profit sharing plans mean that a portion of the company profits is paid to employees and is taxed as if it is normal income.

Cash PSPs are great for employees that would prefer to have the cash right away vs. locking it up in a retirement savings plan.

Buffer is a good example of a company offering a successful cash profit sharing plan. Based on the company's performance, they share between 8% and 15% of profit with employees each year.

Types of Profit Sharing Plans

We have already mentioned cash and deferred plans, but there are also other types of PSPs, or variations on cash and deferred PSPs, that companies can opt for. All these variations result in employees receiving profits through a profit sharing plan, but employer contributions differ based on the formula used.

1. Pro-rata plan

This is the most common type of profit-sharing plan.

With a pro-rata plan, every employee receives the exact same contribution amount (which can be either a percentage or fixed dollar amount of the company's profits).

2. Age-weighted plan

With an age-weighted plan, employers allocate a larger percentage of the profits to older employees. This is because older employees typically have less time to build up savings. Not only is the age of employees considered, but also their compensation.

3. New comparability plan

New comparability plans divide employees into two or more groups. The employer can determine the standards for each of the groups. An Internal Revenue Service (IRS)-approved formula is then used to calculate contributions to each group.

This type of plan must undergo strict discrimination tests because of its flexibility and the changes in the demographics of the workforce.

4. Comp-to-comp plan

With this type of profit sharing plan, the total profit sharing contribution to all employees is calculated first. Then, each employee's compensation is divided by the total compensation. This gives a percentage that determines each employee's share of the profits.

With this comp-to-comp method, highly compensated employees will receive a larger portion of the profits. This can discriminate against lower-earning employees.

Benefits of Profit Sharing

Profit sharing plans have become much more popular in recent years as it benefits all members of staff, including employers. Although there are several different types of profit sharing plans, most have the same advantages.

Below we will discuss the benefits of a profit sharing plan for both employers and employees.

Benefits of profit sharing for employers

Boost employee motivation and engagement

Employees are motivated to work harder once they share in the company's profits. A profit sharing plan means that an employee feels that he or she has some ownership in the company.

Workers are also more likely to engage with different aspects of the business and even take on various additional tasks, as they know they are contributing to the business's profits and, therefore, their own bonuses.

This is a benefit for the employer as there is improved employee retention and satisfaction, resulting in workers who are eager to contribute to the company's goals.

Attract and retain top talent

As mentioned, a profit sharing plan can motivate employees, which means they will want to stay at the company. Employees are no longer solely looking for a good salary; they want to feel valued, feel like they are contributing to the company's successes, and enjoy a positive workplace culture.

Through a PSP, employers will not only retain their current employees but also attract top candidates who are looking for a positive work environment where they will feel like they are working toward a common goal.

Tax advantages

Employers are able to receive tax benefits from a profit sharing plan. This is because any profit sharing contributions to a 401(k) plan are tax deductible. This means the employer's tax liability is reduced when sharing profit with employees.

Encourage a collaborative work environment

A profit sharing plan can encourage employees to work together and collaborate, as each employee now has a vested interest in the performance and success of the other team members.

Once employees work together toward a common goal, there will be improved communication, creativity, motivation, and innovation. This will benefit the company as a whole.

Enhance company performance and growth

Employees who are invested in the success of a company will be eager to collaborate with their colleagues to achieve the business's goals. This will increase the performance and growth of the company, leading to increased profits.

Since an employee's bonus or retirement plan is linked to the company's profits, they will be willing to work much harder to see the company succeed.

Successful profit sharing plans can also attract the interest and funds of investors. Investors are looking for companies with motivated and engaged employees and committed employers. A profit sharing plan is just one way in which an employer can show that they are willing to make decisions that benefit their employees and the company.

Benefits of profit sharing for employees

Increased financial rewards

The main benefit to employees is that they receive financial rewards. A profit sharing plan means that an employee will receive a financial bonus on top of their salary and other benefits.

A PSP may be a retirement plan, which is great for older employees. Alternatively, it can be a quarterly or annual cash bonus or equity through stocks in the company.

Profit sharing plans will make employees feel recognized and appreciated as their contribution to the company's success is evident in the financial reward.

Sense of ownership and responsibility

Once an employee receives a financial bonus through a profit sharing plan, they will feel a sense of responsibility for the success of the business. They will receive a tangible benefit for how they contributed to the profitability of the company, which will motivate them to keep up the hard work.

Once an employee is invested in the success of their employer, they will be more willing to collaborate with team members and increase their productivity. They will feel directly responsible for the company's success.

Improved job satisfaction and loyalty

As mentioned above, a profit sharing plan can lead to employee retention. Although this benefits the employers, it will also be a benefit to employees who enjoy higher levels of job satisfaction.

Employees will feel like they are part of a valued team, motivating them to innovate and communicate to increase the company's profits. They are less likely to jump ship and take a different job when they feel appreciated and have a sense of ownership, as discussed earlier.

A DPSP can act as a retirement plan, and an employee will stay loyal to the company if they know their future is financially secure.

Long-term financial security

As mentioned, deferred profit sharing plans act as retirement plans that offer employees financial security once they reach retirement age. They will be able to plan for their retirement, knowing they are taken care of.

But even cash PSPs are able to offer security. This is because employees receive a financial bonus that they can use to pay off outstanding debts, invest in their future, or put toward their own retirement plans.

Profit Sharing Example

Figuring out what a company's profit sharing plan should include can be challenging. Different formulas will be used depending on the type of plan you decide to move forward with.

Here's an example using the comp-to-comp method:

Below is an example of a profit sharing plan to demonstrate how different employees can benefit from the business's profits.

Willow Coffee Inc. has four employees. The company shares 15% of their profits, and last year they made a $100,000 profit.

First, let's look at each employee's compensation:

• Employee A: $30,000
• Employee B: $35,000
• Employee C: $50,000
• Employee D: $22,000

Next, we will determine how much each employee should receive from the shared profit at 15%.

Step 1: Calculate the profit that will be shared with the employees: $100,000 x 15% = $15,000

Step 2: Determine the compensation of all the employees: $30,000 + $35,000 + $50,000 + $22,000 = $137,000

Step 3: Calculate each employee's share based on their annual compensation using the formula [(compensation/total compensation) x shared profit = profit share per employee]. Here's the breakdown:

• ‍Employee A: ($30,000 / $137,000) x $15,000 = $3,284.67‍
• Employee B: ($35,000 / $137,000) x $15,000 = $3,832.12‍
• Employee C: ($50,000 / $137,000) x $15,000 = $5,474.45‍
• Employee D: ($22,000 / $137,000) x $15,000 = $2,408.76

Real-world example: Check out how Stellantis implements its profit sharing formula here.

Profit Sharing Plan FAQs

Is profit-sharing a bonus?

Profit sharing plans act like a type of bonus but also a type of retirement plan. The profit sharing funds will only be paid out if the company made a profit over a set time period (such as a year or a quarter).

Is a profit-sharing plan the same as a 401(k)?

No, there is one key difference between a 401(k) plan and a profit sharing plan. With profit sharing plans, only employers contribute to the plan. With 401(k) plans, eligible employees are able to contribute themselves.

How do companies determine how much each employee gets?

There are different kinds of plans and formulas that can be used to determine how much eligible employees receive. Each employer can determine which type of plan and formula they wish to use, like:

• Comp-to-comp method
• Age-weighted plan
• Pro-rata plan
• New comparability plan

What happens after I leave my company?

Whether you resign, get fired, or retire, your plan's fate varies — always check with your HR team and contract before leaving to see what happens to your profit sharing plan after you leave.

Profit Sharing: The Bottom Line

Profit sharing plans hold many benefits to both employers and employees. With a profit sharing plan, employees will see how they are benefiting from the success of the company, meaning they will be willing to work harder and engage more to improve the profitability of the company.

Unlike with a 401(k), the employer contribution is the only contribution to the plan, and eligible employees can enjoy the benefits either at retirement (DPSP) or while still employed (cash PSP) eliciting a culture of shared success, profit sharing plans offer a viable pathway for CFOs and business owners to foster a motivated, collaborative, and financially invested workforce.

IRA rules can change, so it’s work always keeping an eye on contribution limits for profit sharing plans and profit sharing retirement accounts.

Disclosures: The information provided in this article is for informational purposes only. It should not be used as a substitute for specific tax, legal and/or financial advice that considers all relevant facts and circumstances. You are advised to consult a qualified financial adviser or tax professional before relying on the information provided herein.