Profit Sharing Plan

Updated on April 12, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Profit Sharing Plan?

A profit-sharing plan is a defined contribution pension plan in which the workers and employees are allowed to obtain their share in the overall profit of the organization in such a way that they are encouraged to contribute more and more to the profit of the organization and motivates to give their best efforts; thus it is an incentive plan that gives a variable benefit to the employees based on a certain percentage of profit.

What Is A Profit Sharing Plan

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This type of plan gives a win-win situation for both the employees and the employer. It encourages the employees to give their best efforts in the organization, which in turn would generate more profits and increase the wealth of the organization. Thus both the parties benefited from increased earnings.

Key Takeaways

  • Profit-sharing plans incentivize employees by offering them a share of the company’s profits. This variable benefit program aims to drive enhanced performance, encouraging employees to contribute to the organization’s success.
  • Unlike traditional Private Equity (PE) investments, which are often illiquid and long-term, investing in an ETF offers buying and selling flexibility. This feature attracts a broader range of investors and provides options for adjusting positions according to market conditions.
  • Profit-sharing plans distribute profits among employees based on a predetermined percentage. Employers have the authority to determine the allocation, and only they can contribute to the plan. 

How Does It Work?

The employee profit sharing plan specifies a certain percentage of profits for every particular employee covered under the plan. Thus, the company must decide how much profit will be shared with employees covered under a profit-sharing plan. Also, it is important to note that only employers, companies, or organizations can contribute to this plan, not the employees.

This plan provided quarterly or annual incentives to the employees of the organization based upon the quarterly and annual returns, respectively. Further, employees can get their share in the organization’s profit either in the form of cash or the company’s stock, wherein the contribution is provided to a qualified tax-deferred retirement account that allows a penalty-free distribution to the employees at a certain Pre defined age group.

Further, there are also schemes where the employee decides to leave the organization and join another one; then, in that case, the existing contribution is rolled over to another employer’s plan subject to a certain percentage of penalty on the existing contribution.

A profit-sharing plan is increasingly considered in today’s world since it provides a win-win situation for the entire company. Thus this plan helps an organization to grow and achieve heights.

Profit Sharing Plan

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Types

The various types of the employee profit sharing plan are elaborated below.

#1 – Cash Plan

The employees covered under this qualified profit sharing plan are given cash or stock of the organization or company at the end of every year or quarter, as the case may be. Thus they are given instant results of their efforts in the organization. The main disadvantage of this type of plan is that the employees are taxed on this additional income as a regular income.

#2 – Deferred Plans

The profit sharing plan for small business is directed into a specific fund known as the trust fund, which provides the rewards to the employees at a later date, often on the employees’ retirement. Accordingly, immediate taxation on the employees’ incomes is avoided under a deferred plan. Further, the qualified investment plan provides employees with various investment choices. Also, the retirement pay increases as and when the contribution increases.

#3 – Combination Plan

As the name suggests, this plan is a combination of both the plans mentioned above, which pays a part of the contribution in cash periodically, and part of the contribution is deferred into a trust fund to be paid at the time of retirement.

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Example

Let us understand the concept with the help of a suitable example.

Suppose a company, ABC corporation, earns an annual profit of $500,000. This company employs three employees, X, Y, and Z. Now, all the employees earn an income of $400,000, $200,000, and $400,000, respectively. The company has a policy of a 10%profit sharing plan.

Solution:

Hence the profit of $50,000 ( being 10% of 500,000 ) is shared among the employees as under:

  • A: $20,000 (50,000×400,000/1,000,000)
  • B: $10,000 (50,000×200,000/1,000,000)
  • C: $20,000 (50,000×400,000/1,000,000)

Thus, the above example explains the concept with proper clarity.

Rules

There are certain rules for implementing the plan in any business.

A profit sharing plan for small business or any types of entity is a way to best the interest of the organization’s employees. The simple rule of this plan is that the more the company earns profit, the more the organization’s employees earn as a reward. Thus there is a direct relationship between the efforts the employees put into the organization and the profit-sharing incentives they receive. Thus this plan helps to achieve a win-win situation in the organization for the employees and the company.

Eligibility Requirements

Typically, in this kind of organizational qualified profit sharing plan, people who are eligible can be an employee, a manager or the owner of the business. However, the arrangement may exclude people who are:

  • Below the age of 21 years.
  • Employees who have not yet completed minimum 1 year of service in the same organization (sometimes 2 years).
  • Employees who are covered under the collective bargaining agreement.
  • They are non-residents of the country.

Thus, the above are the basic requirements for being a part of the plan in an entity.  

Contribution Limits

As mentioned in the section above, in a profit sharing plan for small business or an entity of any size, the participants are the owners, managers and the employees of the organization. However, the owners can also decide how much each participant will contribute in the plan.

The document for the plan will require a set formula that will determine how each contribution made will be allocated to the participants’ account. The most simple formula clearly specifies that the contribution from the employer will be allocated in such a way so that each participant receives the same proportion as their own compensation.

However, the contribution and the forfeiture are subject to the annual limit of each participant. Such a limit is either:

  • 100% of the contribution of the participant, or
  • $61,000 as on 2022 and it is $67,500 if catch-up contributions are included, whichever is less.

Benefits

Like every other concept in the business and financial world has some benefits and limitations, so does the company profit sharing plan. Let us first find out the benefits of the same.

  • It encourages the employee to put more and more effort into the organization and increase the profitability of the organization.
  • With more effort come more profits. Thus the organization benefitted even after paying additional incentives to the employees.
  • This incentive plan includes a type where payment is deferred and payee at the time of retirement. Thus the way of saving habits in the company culture is also increased.

Limitations

However, the disadvantages of the plan are given in details below.

  • The employee’s focus is shifted from the quality of work to more and more profits.
  • This way, a false culture is motivated in the organization to ignore the qualitative aspect and only focus on the quantitative aspect of the organization.
  • This kind of culture is very disadvantageous in the long time even though it provides satisfactory results in the short term.
  • An individual’s salary goes up equally instead of based on promotions, performance, or merits. This way, some employees might not feel motivated to work and put more effort into the organization.

Profit Sharing Plan Vs 401(k) Plan

A very important difference between a 401(k) plan and a profit-sharing plan lies in those who contribute to the company profit sharing plan. Under the former plan, the employee itself contributes to the plan for the investment in the retirement plan, while in the latter, the retirement payments only compromise the contribution from the employer in contrast to the former.

Frequently Asked Questions (FAQs)

1. What is the importance of a profit-sharing plan?

Profit-sharing plans incentivize employees by linking their compensation to the company’s profitability. These plans promote a sense of ownership and motivation among employees, fostering productivity and loyalty. They also allow companies to share success with their workforce, enhancing employee engagement and overall organizational performance.

2. Is the profit-sharing plan a bonus?

While both profit-sharing plans and bonuses provide additional compensation to employees, they differ in structure and purpose. A profit-sharing plan distributes a portion of the company’s profits to employees, often annually, fostering long-term alignment with company success. Conversely, bonuses are typically one-time payments based on individual or company performance and may not necessarily be tied to profits.

3. What are the risks associated with a profit-sharing plan?

Profit-sharing plans can expose employees to certain risks. The amount distributed to employees may decrease if the company’s profits decline. Economic downturns could impact the plan’s payouts. Additionally, administrative complexities and costs might be associated with managing profit-sharing programs. Employees’ retirement savings could also become concentrated in the company’s performance, leading to a lack of diversification.

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