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Employee benefits can be powerful drivers of recruitment, retention, and performance.

Profit sharing is one such benefit. Here I’ll take you through what profit-sharing is and how to set up a profit-sharing plan.

What Is Profit Sharing?

Profit sharing is an employee benefit where employees receive a portion of the company's profits in addition to their regular salary and benefits. 

This share is typically determined by the company’s profitability, an employee's salary level, and the terms set by the employer.

Profit sharing can be implemented in various ways, such as cash payments, contributions to retirement accounts, or stock options. 

The goal of profit-sharing is to incentivize employees, align their interests with the company's financial success, and boost morale and productivity. 

It also helps companies attract and retain talent by offering a share in the financial success of the business.

Types Of Profit Sharing Plans

There are several types of profit-sharing plans that vary based on how the contributions are made and how the payouts are structured.

Here are some of the common types:

  1. Cash plans: These are the most straightforward type of profit sharing, where cash bonuses are paid directly to employees based on the company’s profitability. These payments are usually made annually and are taxable to the employee as income.
  2. Deferred plans: In deferred profit sharing plans (DPSPs), the contributions made by the employer are not given directly as cash to the employees but are instead contributed to a retirement plan on behalf of the employees. These contributions are typically tax-deferred until withdrawn by the employee, usually at retirement.
  3. Combination plans: Some companies combine profit sharing with 401(k) plans. In these plans, employers might contribute to an employee's 401(k) based both on the employee’s contributions (matching contributions) and the company’s profits. This can enhance the retirement benefits offered to employees.
  4. Stock-based plans: These plans involve awarding employees with stock options or restricted stock based on company performance. This type not only helps employees benefit from the current profits but also invests them in the future growth of the company through equity.
  5. Target allocation plans: Under this type, the profit-sharing amount each employee receives is based on a formula that might consider factors such as the employee’s salary, position, or length of service. This formula determines the percentage of the profit each employee should receive.
  6. Age-weighted plans: These plans take into account both the employee’s salary and their age. Older employees closer to retirement age might receive a larger share of the profit-sharing contributions because they have less time to save for retirement.

Benefits And Disadvantages Of Profit-Sharing

Profit-sharing plans can offer several benefits to organizations and employers but there are also some possible downsides.

Benefits of profit sharing

Increased employee motivation and productivity

When employees have a direct share in the profits, it can motivate them to work efficiently and effectively, contributing to higher overall productivity and company success.

Enhanced employee retention

Profit sharing can enhance job satisfaction and loyalty as employees feel valued and part of the company's success. This can reduce turnover and the associated costs of hiring and training new staff.

Flexible compensation strategy

For employers, profit sharing is a flexible way to manage compensation. Payments are typically linked to company performance, which can help manage payroll costs during leaner times.

Tax benefits

Contributions made by the employer are typically tax-deductible, and for employees, deferred profit-sharing contributions can grow tax-deferred until withdrawal.

Aligns employee and company goals

By tying a portion of compensation to the company’s financial success, employees' goals are aligned with company objectives, fostering a unified approach to business success.

Disadvantages of profit-sharing


Setting up and administering a profit-sharing plan can be complex. It requires careful planning, ongoing management, and adherence to regulatory requirements.

Potential for inequity

If not designed carefully, profit-sharing plans can result in perceived or real inequities among employees, particularly if distributions are not seen as fair or aligned with individual contributions.

Short-term focus

Employees might focus more on short-term gains rather than the long-term health of the company if they believe that doing so will increase their immediate profit-sharing payouts.

Tax implications for employees

For cash-based profit sharing, employees might face a higher tax burden at the time of payout, as these are treated as income. For deferred plans, while the tax is deferred, the eventual withdrawal of funds during retirement will be taxed at ordinary income rates.

Overall, while profit sharing can be a powerful tool for aligning company and employee interests and fostering a productive workplace, it needs to be well-designed and managed to mitigate potential downsides and ensure it supports the long-term strategy of the organization.

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How To Set Up A Profit-Sharing Plan

Setting up a profit-sharing plan involves several detailed steps to ensure it aligns with your business objectives and complies with legal requirements.

1. Define the purpose and goals

Before establishing a plan, clarify why you are setting it up and what you hope to achieve. This could include improving employee motivation, aligning employee goals with company performance, or enhancing your benefits package for recruitment and retention.

2. Consult with professionals

Setting up a profit-sharing plan can be complex, particularly concerning legal and tax regulations.

It's advisable to consult with a financial advisor, an attorney, and a tax professional experienced in employee benefits to ensure compliance and optimal structure.

3. Decide on the plan structure

Determine the type of profit-sharing plan that best suits your company.

4. Create a written plan document

Draft a formal plan document that includes:

  • Eligibility criteria: Who qualifies for the plan and when.
  • Formula for allocating profits: How profits will be divided among eligible employees. This could be based on salary, tenure, position, or a combination of factors.
  • Vesting schedule: If applicable, outline how long employees must remain with the company before they gain full ownership of the contributions.
  • Distribution rules: When and how the benefits will be paid out.

5. Establish a trust for plan assets

If the plan involves deferred contributions, set up a trust to hold and manage the plan's assets. This trust must be managed by a trustee who acts as a fiduciary.

6. Implement record-keeping procedures

Accurate record-keeping is essential for tracking contributions, earnings, and distributions. This is crucial for regulatory compliance and for providing information to participants about their benefits.

7. Provide information to employees

Communicate the details of the profit-sharing plan to your employees. This should include how the plan works and how it fits into their overall compensation and benefits package.

8. File the plan with the IRS

Depending on the structure of your profit-sharing plan, you may need to file the plan with the IRS to ensure it qualifies for tax advantages. This typically involves completing Form 5500 annually.

9. Regular review and adjustments

Regularly review the plan to ensure it continues to meet the needs of both the business and its employees. Changes in the company's financial situation, tax laws, or employee feedback may require adjustments to the plan.

10. Ensure compliance with regulations

Stay informed about changes in employment and tax laws that impact profit-sharing plans. Regular audits and checks can help ensure ongoing compliance and avoid penalties.

By carefully designing and managing a profit-sharing plan, you can create a valuable tool for enhancing your company’s competitiveness and employee satisfaction.

Profit Sharing Plan Requirements

While not the most complicated process, there are several requirements and considerations that companies must follow when implementing a profit-sharing plan.

These help ensure fairness, compliance with regulations, and effective administration of the plan.

Documentation and formal plan structure

Companies must establish a written plan that details the formula used for allocating contributions among participants, the eligibility criteria, the vesting schedule, and the distribution rules.

Nondiscrimination testing

Profit-sharing plans are subject to nondiscrimination testing to ensure that the benefits do not disproportionately favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). This helps maintain the plan’s qualified status under IRS rules.

Coverage and participation rules

The plan must meet certain minimum coverage requirements, meaning it must benefit a certain percentage of all employees, not just select groups. Typically, employees over age 21 who have worked for the company for at least 1,000 hours in a year must be included.

Contribution limits

The IRS sets annual limits on how much can be contributed to each employee's account. For 2023, the total contributions to a participant’s account (including employer contributions and employee deferrals) cannot exceed the lesser of 100% of the employee’s compensation or $66,000.

Vesting schedule

Profit-sharing plans often have vesting schedules that determine how long an employee must work at the company before they own the employer’s contributions. The schedule can be immediate or it could extend several years.

Fiduciary responsibilities

The plan administrators are considered fiduciaries and must act in the best interests of the plan participants. This includes managing the plan prudently, selecting appropriate investments (if applicable), and ensuring the plan's fees are reasonable.

Annual reporting

Profit-sharing plans typically require the annual filing of IRS Form 5500 to report on the plan’s financial condition, investments, and operations.

Distributions and withdrawals

The plan must specify when distributions can be made, such as at retirement, upon termination of employment, or under other specific conditions. These distributions may also be subject to rules about rollovers and taxation.

Profit Sharing Plan Example

Nothing brings a concept to life quite like an example, so here’s a profit-sharing plan example for a creatively named tech company.

Company profile:

  • Name: TechSolutions Inc.
  • Industry: Technology
  • Number of Employees: 150
  • Annual Profits: $5 million (variable)

1. Purpose of the plan

  • To enhance employee retention and motivation.
  • To align employee interests with company profitability and performance.

2. Eligibility

  • All permanent employees who work more than 30 hours per week and have completed at least one year of service are eligible.
  • Part-time and contract employees are not eligible for the profit-sharing plan.

3. Contribution formula

  • The company allocates 10% of its annual pre-tax profits to the profit-sharing plan.
  • The contribution for each employee is based on a combination of their salary level and length of service.
  • Allocation example: 70% of the contribution amount is divided equally among all eligible employees; the remaining 30% is allocated based on each employee's annual salary as a percentage of the total payroll of all eligible employees.

4. Vesting schedule

  • Employees vest in the profit-sharing contributions over a 4-year graded schedule:
  • 25% vested after the second year of participation.
  • 50% vested after the third year.
  • 75% vested after the fourth year.
  • 100% vested after the fifth year.

5. Distribution rules

  • Distributions are made annually, directly into the employees' designated bank accounts.
  • Employees may choose to defer their distribution into their individual 401(k) plans, subject to annual contribution limits.
  • Distributions are subject to applicable federal and state income taxes unless rolled over into a 401(k) or similar plan.

6. Plan administration

  • The plan is administered by a committee of three, including the CFO, an HR representative, and an external financial advisor.
  • The committee is responsible for calculating contributions, managing distributions, and ensuring compliance with all legal and regulatory requirements.

7. Communication

  • Employees are informed about the details of the plan upon becoming eligible and receive annual statements showing their accumulated benefits and the total contributions made by the company.

8. Annual review and adjustments

  • The plan is reviewed annually by the administrative committee, which may propose adjustments based on company performance, employee feedback, and changes in tax or employment law.

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By Finn Bartram

Finn is an editor at People Managing People. He's passionate about growing organizations where people are empowered to continuously improve and genuinely enjoy coming to work. If not at his desk, you can find him playing sports or enjoying the great outdoors.