What Is Profit Sharing and Is It Right For Your Company?

What is Profit Sharing?

Profit sharing is a way for business owners to share a portion of their company’s profits with employees. It’s simple: when the company does well, employees get a bonus based on those profits. This bonus is usually paid out in cash, but sometimes it can be added to retirement accounts.

You might hear it called profit share, profit-sharing scheme, or profit sharing bonus. All these terms mean the same thing—employees get a cut of the company’s profits.

Profit sharing is not the same as equity ownership. With profit sharing, employees get a bonus, but they don’t own any part of the company. Equity ownership means employees actually own shares or a piece of the business. Profit sharing is about sharing success, not giving away ownership.

How Does Profit Sharing Work?

Profit sharing isn’t complicated, but it does follow a few clear steps. Here’s how the process usually works from start to finish.

Step 1: Company Makes a Profit

Profit sharing starts when your business makes a profit. This is the money left over after you pay all your bills, wages, and other expenses.

Step 2: Decide on an Allocation Formula

Next, you choose how to split those profits. Most companies use a formula. Some give everyone the same amount. Others base it on salary, role, or how long someone’s worked at the company. For example, you might decide to share 10% of annual profits with your team.

Step 3: Distribute the Profits

Once you have your formula, you pay out the bonuses. This can happen once a year, every quarter, or on another schedule you choose. Some companies pay cash. Others put the money into retirement accounts.

Who Decides and When Profits Are Shared

The business owner or leadership team decides if and when to share profits with eligible employees. They also set the rules for who qualifies and how much each person gets. Most companies share profits at the end of the year, but some do it more often.

Small Business vs. Large Corporations

Small businesses usually keep things simple. They might split profits evenly or use a basic formula. Large corporations often have more complex plans, with detailed rules and different tiers for different roles.

Example Profit Sharing Calculation

Let’s say your company made $500,000 in profit this year. You decide to share 10% with your employees. That’s $50,000. If you have 10 employees and split it evenly, each person gets a $5,000 bonus. If you use salaries to decide, higher-paid employees might get a bigger share.

Profit sharing can be as simple or as detailed as you want. The key is to pick a plan that fits your business and motivates your team.

Types of Profit Sharing Plans

There’s more than one way to share profits with your team. Here are the most common types of profit sharing plans and how they work.

Cash Profit Sharing Plans

Cash plans are the most straightforward. Employees get a bonus, usually in cash, based on the company’s profits. The payout is often made at the end of the year or quarter. It’s simple, direct, and easy for everyone to understand.

Deferred Profit Sharing Plans

With deferred profit sharing, the bonus isn’t paid out right away. Instead, the money goes into a retirement account for each employee. They can access these funds later, usually when they retire or leave the company. This plan helps employees build long-term savings.

Combination Plans

Some companies use a mix of cash and deferred plans. Part of the profit share is paid out as a bonus now, and the rest is set aside for retirement. This gives employees both immediate rewards and future security.

Phantom Stock Plans

Phantom stock is a type of profit-based compensation that feels like equity but doesn’t give away real shares. Employees receive “phantom units” whose value is tied to the company’s growth or profits. When a payout event happens—like retirement, sale of the business, or a set vesting date—they get cash based on that value.

For business owners, this makes phantom stock one of the cleanest ways to reward and retain key people. There’s no dilution, no new shareholders, and no K-1 tax headaches.

At Reins, we design and manage phantom stock plans for small and mid-sized businesses that want the benefits of equity without the risks. Our platform makes it simple to:

• Align employees with company performance
• Create flexible payout rules tied to profits, growth, or milestones
• Retain top performers without losing control of the business

Real companies are already seeing the impact. Wirenut kept their top techs from leaving by rolling out a phantom stock plan with Reins. As their owner put it: “Almost overnight, people start thinking like owners.

Benefits of implementing a small business profit sharing plan

Implementing a profit sharing plan can benefit small businesses in multiple ways—from improving retention and hiring to fostering alignment between owners and employees. Below are some of the key advantages.

Align employer and employee incentives

A profit sharing agreement indicates that employees receive a portion of a given company’s profits, which directly connects employees’ financial success to the company’s success. This shared interest in the company’s profitability is an excellent way to foster a sense of employee ownership and get employees and business owners working towards the same goals.

Boost retention and hiring

A recent Gallup poll found that a combination of pay and employee benefits is the most critically important factor when people look for a new job. A separate Gallup poll found that 40% of employees would leave their current job for an employer that offered profit sharing as a benefit – and only 20% said that their current employers did offer profit sharing. That’s a significant gap between what employees want and what they’re receiving.

The data shows that profit sharing serves as both a hiring and retention lever for employers who are serious about investing in their staff in order to grow their business.

The ultimate flexible benefit

The adaptability of profit sharing as a benefit plan from a business owner’s perspective should not be underestimated. Employers can design key features tailored to their specific needs and their employees’ wants. Differing amounts can be contributed to the plan every quarter or every year, and can be linked to actual company profits – or not. Companies don’t need to be profitable in order to start a profit sharing plan.

Other flexible features include profit sharing’s ability to be a standalone plan or a qualified plan (combined with other retirement plans, like a 401k); the way it can be implemented at any company regardless of size or entity type; and the option for employees to be paid out frequently in the form of a cash plan (for example, quarterly) or at retirement as part of a deferred plan.

For small businesses that want a lightweight benefits option, profit sharing plans can be formed in an ad hoc, informal manner, akin to a type of bonus. The only requirement is that eligible employees are paid out their shares while they are still employed, as opposed to after they leave the company. Done this way, profit sharing is no longer a qualified plan and there are essentially no regulations to take into account.

Both the federal government and most state governments don’t tax profit sharing contributions until they are distributed. Small business owners can take a tax deduction for profit sharing plans they implement. They can reduce their company’s income, saving tax dollars in the process. This can be hugely beneficial to younger companies, as well as companies that may have cash flow issues.

Profit Sharing Allocation Methods

How does profit sharing work? Given the malleability of profit sharing plans, it’s unsurprising that there are several different types of plans that companies can carry out.

Flat dollar plan

The simplest and most straightforward of the profit sharing plans is the flat dollar plan, which involves a fixed dollar amount being allocated to each employee, regardless of salary or position. The plan is clear, easy to execute, and showcases equality for all employees. However, the lack of customization might make the flat dollar allocation more incentivizing to lower-paid employees versus higher-paid ones.

Pro-rata profit plan

Possibly the most common profit sharing plan, the pro-rata plan means that employee participants are allocated a certain dollar amount in proportion to their annual salaries or wages. The formula used to determine pro-rata shares is often based on the ratio of an employee’s salary to the total payroll, meaning that employees with higher salaries receive a larger number of shares. However, all employees regardless of salary receive shares in proportion to their earnings.

The main advantage of a pro-rata plan is simplicity while, arguably, the main disadvantage is that the distribution of profits isn’t tied to individual performance.

Age-weighted plan

An age-weighted plan involves profit sharing allocation being higher for older employees who are closer to retirement. In this case, age is often considered along with salary, adding a bit of complexity to the profit sharing calculation. It’s not uncommon for age-weighted plans to be combined with 401ks and distributed once instead of annually.

Advantages of this plan include helping older employees catch up retirement savings, while disadvantages include being perceived as less equitable by younger employees.

Cross-testing plan

Perhaps the most complex profit sharing plan on this list, cross-testing plans divide employee participants into different groups, each of which has a specific contribution formula that determines share allocation. Groups might be formed by job title, tenure, salary, and a variety of other factors.

One benefit of a cross-testing plan is the ability for employers to favor key employees, regardless of age or salary. However, this type of plan must undergo regular nondiscrimination testing, which can add to an already complicated process.

The plans above can be further customized in various ways, including by paying out cash regularly or deferring the shares, depending on whether the owner wants to create short or long-term incentives. Employers may also want to consider adding a vesting period to a profit sharing plan; for example, requiring a minimum number of hours worked or specific tenure before employees can take part in a profit sharing plan.

How to create a profit sharing plan

There are nuances depending on the specific plan you choose but, in general, there are are five steps required of all plans:

1. Decide what percentage of the company profits you’d like to allocate to your plan – also known as the “pool.”
2. Create a formal document that outlines what type of profit sharing plan you plan to implement, along with relevant details (employee eligibility, vesting schedules if any, etc.).
3. Set up a trust. This is only required if you are treating profit sharing as a qualified plan. The Employee Retirement Income Security Act (ERISA) requires that contributions made to retirement plans (including profit sharing plans) be held in trust. Contributions to the trust are usually tax-deductible for employers and tax-deferred for employees.
4. Set up a record-keeping platform. The platform should help you keep track of everything related to your profit sharing plan.
5. Communicate to employees. This might be the most important yet also the most overlooked part of the process. Communicating the details of your profit sharing plan ensures that employees understand their new benefit.