What Is Profit Sharing? Pros and Cons

Two businessmen divide in parts the profit between themselve

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Profit sharing helps employees prepare for retirement by offering them a portion of the company’s profits. Who wouldn’t want that? While it does offer both employees and employers definite advantages, profit sharing also comes with some less obvious drawbacks. 

Key Takeaways: Profit Sharing

  • Profit sharing is a workplace compensation benefit that helps employees save for retirement by paying them a portion of the company’s profits if any.
  • In profit sharing, the company contributes a part of its profits into a pool of funds to be distributed among eligible employees.
  • Profit sharing plans may be offered in lieu of or in addition to traditional retirement benefits, like a 401(k) plan.

Profit Sharing Definition

“Profit sharing” refers to variable pay workplace compensation systems under which employees receive a percentage of the company’s profits in addition to their regular salary, bonuses, and benefits. In an effort to help its employees save for retirement, the company contributes a part of its profits into a pool of funds to be distributed among employees. Profit sharing plans may be offered in lieu of or in addition to traditional retirement benefits, and the company is free to make contributions even if it fails to make a profit. 

What Is a Profit Sharing Plan?

Company-funded profit sharing retirement plans differ from employee-funded profit sharing plans like 401(k) plans, in which participating employees make their own contributions. However, the company may combine a profit sharing plan with a 401(k) plan as a part of its overall retirement benefits package. 

Under company-funded profit sharing plans, the company decides from year to year how much—if anything—it contributes to its employees. However, the company has to prove that its profit sharing plan does not unfairly favor its highest-paid employees or officers. The company’s profit sharing contributions may be made in the form of cash or stocks and bonds. 

How Profit Sharing Plans Work

Most companies make their profit sharing contributions to qualified tax-deferred retirement accounts. Employees can begin taking penalty-free distributions from these accounts after age 59 1/2. If taken before age 59 1/2, distributions may be subject to a 10% penalty. Employees who leave the company are free to move their profit-sharing funds into a Rollover IRA. In addition, employees may be able to borrow money from the profit sharing pool as long as they are employed by the company. 

How Individual Contributions Are Determined

Many companies determine how much they will contribute to each employee’s profit sharing plan using the “comp-to-comp” or “pro-rata” method, which allocates a share of the profit based on the employee’s relative salaries. 

Each employee’s allocation is calculated by dividing the employee’s compensation by the company’s total compensation. The resulting fraction is then multiplied by the percentage of profit the company has decided to contribute to profit sharing to determine each employee’s share of the total company contribution.

For example, a company with total annual compensation of $200,000 to all of its plan-eligible employees decides to contribute $10,000—or 5.0%—of its net profit to the profit sharing plan. In this case, the contribution to three different employees might look like this:

Employee Salary Calculation Contribution (%)
A $50,000 $50,000*($10,000 / $200,000) = $2,500 (5.0%)
B $80,000 $80,000*($10,000 / $200,000) = $4,000 (5.0%)
C $150,000 $150,000*($10,000 / $200,000) = $7,500 (5.0%)

Under current U.S. tax laws, there is a maximum amount a company can contribute to each employee’s profit sharing account. This amount changes depending on the inflation rate. For example, in 2019, the law allowed for a maximum contribution of the lesser of 25% of the employee’s total compensation or $56,000, with a limit of $280,000.

Distributions from profit sharing plans are taxed as ordinary income and must be reported as such on the employee’s tax return. 

The Pros of Profit Sharing 

Besides helping employees build toward a comfortable retirement, profit sharing makes them feel that they are working as part of a team helping the company achieve its goals. The assurance that they will be rewarded above and beyond their base salaries for helping the company prosper motivates employees to perform above and beyond minimal expectations. 

For example, in a company that only pays its salespersons commissions based on their individual sales, such a team spirit rarely exists, as each employee acts in his or her own best interest. However, when a portion the total commissions earned is shared among all of the salespersons, the more likely they are to function as a cohesive team.

The offer of profit sharing can also be a valuable tool in helping companies recruit and keep talented, enthusiastic employees. In addition, the fact that company contributions are contingent on the existence of a profit, profit sharing is generally less risky than outright bonuses.

The Cons of Profit Sharing

Some of the main strengths of profit sharing actually contribute to its potential weaknesses. While employees benefit from their profit sharing money, the assurance of its payment can make them appreciate less as a motivational tool and more as an annual entitlement. Since they receive their profit sharing contribution regardless of their job performance, individual employees see little need to improve. 

Unlike director-level employees who make decisions that can directly affect revenue, lower-level, and front line employees tend to be less aware of how their daily interactions with customers and the public can help—or harm—the company’s profitability.

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