Profit sharing plan: What it is and how it works

A profit-sharing plan motivates employees to work and rewards them for doing so. It’s an employee benefit that keeps current employees happy and attracts high-value talent. It also gives workers a sense of ownership over their compensation.

Profit sharing shows your employees you’re counting on them. Employers who put a share of the company’s profits directly in their employee’s hands promote a trusting relationship. In this article, we’ll explain what profit sharing is and how you can use it to encourage dedication and productivity among your workforce.

What is a profit sharing in plan? 

Profit sharing is when a company shares a portion of its quarterly or annual profits with its employees. This motivates employees to work toward the company’s business objectives by linking their current rewards or retirement accounts to organizational profitability.

A profit-sharing plan is typically a pretax retirement contribution plan for employees. The amount paid depends on the company’s profitability, the employee’s salary, and the business’s reward formula. Profit-sharing plans only work if the business makes a profit—if the employer records no profit, employees usually don’t benefit. 

A profit-sharing plan differs from other employee benefits like 401(k) plans, although you can use a profit-sharing plan as a retirement savings vehicle. The main difference is that the company and the employee both contribute to a 401(k), whereas only the employer contributes to a profit-sharing plan. This size of the contribution is typically tied to organizational profits.

How does profit sharing work? 

Profit sharing is based on company contributions, calculated according to the business’s profitability. The employer determines what portion of profits they’ll allocate to employees, adjusting the plan according to company performance.

A company may use one of several formulas to calculate profit sharing, including the following:

• Pro rata plan (aka the comp-to-comp method)
• Age-weighted plan
• New comparability plan

We’ll discuss these in more detail later in this article. 

How to calculate profit sharing + Examples

Employers may use different formulas depending on the profit-sharing model they choose. Here are some common profit-sharing calculations and examples:

Pro rata plan

Also known as a comp-to-comp plan, pro rata programs are the most common type of profit-sharing plan. In this structure, employees’ profit-sharing allocations are tied to their relative compensation. Higher-earning individuals receive a greater portion of the profits.

To determine an employee’s pro rata allocation, you must first calculate the total compensation for all employees. Then, divide the individual’s compensation by the total compensation to find their profit share percentage.

A profit-sharing example using the comp-to-comp method looks something like this: 

Pearl Transport Inc. has three employees. The company shares 15% of its profits, and it made $100,000 in profits last year. This means the employer will contribute $15,000 to its workforce.

To determine each employee’s share, you must first look at their earnings:

• Employee A: $30,000
• Employee B: $35,000
• Employee C: $50,000
• Total: $115,000

Then, calculate each employee’s share based on their annual salary using the following formula:

(compensation / total compensation) x profit contribution

Here’s how much each employee will receive:

• Employee A: (30,000 / 115,000) x 15,000 = $3,913.04
• Employee B: (35,000 / 115,000) x 15,000 = $4,565.22
• Employee C: (50,000 / 115,000) x 15,000 = $6,521.74

New comparability plan

This profit-sharing type divides employees into groups that receive profits at different rates according to the employer’s criteria. Employers may allocate a greater percentage of the profits to older employees who have less time to build up their retirement plans. They may also design the plan to favor owners or highly compensated employees (HCEs).

This type of plan is subject to scrutiny to prevent discrimination between groups, and the formula must be IRS-approved.

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4 types of profit-sharing plans

Here are four of the most common profit-sharing plans:

1. Cash-based plans 

A cash-based plan directly pays workers a portion of the company’s profits, which is taxed as standard income. Some employees don’t want their share of the profits locked up in a retirement plan—this is the ideal solution for them.

2. Deferred profit-sharing plans

A DPSP is a Canadian retirement savings program. The company pays into the investment plan with pretax contributions, and recipients are only taxed once they withdraw the money. All profit sharing is taxable eventually, but deferring taxes until after retirement can yield significant tax savings.

This plan shows employees that their company is interested in their long-term well-being. It also encourages employee retention—the longer they work for the business, the larger their DSPD will be.

3. Employee stock ownership plans (ESOP)

An ESOP is a retirement plan in which the employee owns a portion of the company’s stock. The employer sets up a trust fund and either issues shares directly to the trust, contributes cash to buy company stock, or has the trust borrow money for shares. Employees each get shares of the ESOP trust relative to their base salary and tenure. This is known as a vesting schedule. 

When the employee leaves the company, they receive the fair market value of their shares.

4. Combination plans

An employer may combine cash and deferred plans. For instance, they may make profit-sharing contributions to an employee’s 401(k), which the employee can access after retirement.

Advantages and disadvantages of profit sharing

Profit sharing has many benefits, but it isn’t right for every business. Here are the major pros and cons of profit sharing:

Pros

• Boosts employee motivation and engagement: Employees are motivated to work harder when they share in the profits because they directly benefit from the company’s success. The more effort they put in, the better the outcome for the business and, therefore, their own compensation.
• Attracts and retains top talent: Talented and competitive workers seek businesses that will compensate them well. Profit-sharing plans appeal to these individuals. The plans also encourage employee loyalty—the longer people stay, the greater their share of the profits will be.
• Provides employer tax benefits: Contributions to a profit-sharing plan are tax deductible, meaning they can be subtracted from a company’s taxable income.

Cons

• Variable employer costs during profitable years: Profit-sharing plans are calculated using a formula that yields variable amounts each quarter or year. Profit-sharing expenses may be difficult to predict.
• No guaranteed payout for employees: The company isn’t obligated to pay toward a profit-sharing scheme if it doesn’t make a profit. This outcome may discourage high-performing employees, as their efforts alone can’t guarantee a payout.
• Complex administration and compliance requirements: Business owners must comply with laws governing profit-sharing plans. For example, they’re subject to nondiscrimination testing to ensure they administer the plan legally. They must also file forms, such as Internal Revenue Services Form 5500 in the United States.

Creating a profit-sharing plan

Regardless of which type of profit-sharing plan you adopt, the following universal steps will keep the system running smoothly:

1. Develop a formal plan document: Large and small businesses alike must write a formal profit-sharing plan. This document should detail the rules, eligibility requirements, shared profit amount (percentage or dollar figure), and frequency (e.g., quarterly).
2. Create a system for tracking contributions and allocations: People Ops software makes tracking contributions and payouts a breeze. 
3. Inform eligible employees about the plan details: Tell your eligible employees (current and new) about the profit-sharing plan and ensure that they understand the details. Again, software can help here. It might provide self-service options showing employees how much profit they’ve received and what they might get in the future.
4. Ensure ongoing compliance with relevant regulations: Whoever handles your profit-sharing plan (typically People Ops) must stay up to date with relevant regulations, such as ensuring there’s no discrimination in payout distribution.

Elevate your team with profit sharing made simple

Are you ready to motivate your employees and boost company performance with profit sharing? With Oyster’s global employment platform, you can track essential payroll data from a centralized hub. Oyster’s Total Rewards leverages in-house experts and deep local knowledge to ensure you offer competitive, country-specific salary, equity, and benefits that retain top global talent. Empower your workforce and drive success with Oyster’s all-in-one global employment solution.