Profit sharing is a type of employee benefits plan that lets employers share company profits with their staff. Despite the word “profit” being prominently featured, profit sharing plans are very flexible; in fact, employers can choose to profit share even during an unprofitable year. They can customize payouts on any sort of schedule they want, or not at all some years. There are several types of profit sharing plans, several of which are outlined below. But first, why should small businesses consider profit sharing?
Benefits of implementing a small business profit sharing plan
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 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.
Types of profit sharing plans
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:
- Decide what percentage of the company profits you’d like to allocate to your plan – also known as the “pool.”
- 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.).
- 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.
- Set up a record-keeping platform. The platform should help you keep track of everything related to your profit sharing plan.
- 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.
