How Does Profit Sharing Work?

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What is Profit Sharing?

Profit sharing is an incentivized compensation program that awards employees a percentage of the company’s profits. The amount awarded is based on the company’s earnings over a set period of time, usually once a year. Unlike employee bonuses, profit sharing is only applied when the company sees a profit. There are both benefits and drawbacks to utilizing a profit sharing program, but when trained human resources professionals are able to plan and execute it effectively, profit sharing can be an ideal way to both improve employee morale and boost the bottom line.

What Is Profit Sharing?

Profit sharing can work in a variety of ways. The company contributes part of its pre-tax profits into a pool that is distributed among eligible employees. Amounts distributed can be dependent on salary, and profit sharing can be used as a supplement to existing benefit plans as well. Profit sharing generally occurs after the company determines final profitability for the year.

How Does Profit Sharing Work?

Once a pool is created, either company leadership or the human resources team will create a formula for distribution. According to the Department of Labor, the following are the steps required to set up a profit sharing plan:

  • Adopt a written plan document
  • Arrange a trust for the plan’s assets
  • Develop a record keeping system
  • Provide plan information to employees eligible to participate

It is important to keep detailed records of how the plan is distributed among employees. Companies can update their plans as needed, but this should be done with proper oversight, The Balance says.

Profits can either be shared in the form of stocks and bonds or a cash amount. “Profit sharing, when distributed as a percentage of annual pay — a common practice — results in less money shared with employees in lower paying jobs and higher amounts shared with highly compensated employees,” according to The Balance.

Cash Profit Sharing Plan

There are two types of profit sharing plans: cash and deferred. In a cash profit sharing plan, “contributions are paid directly to employees in the form of cash, checks, or stock. The amount is taxed as ordinary income when distributed,” according to the Employee Benefit Research Institute (EBRI).

Deferred Profit Sharing Plan

When contributions are deferred to individual employee accounts, this is referred to as a deferred profit sharing plan. “Benefits — and any investment earnings accrued — are distributed at retirement, death, disability, and sometimes at separation from service and other events,” EBRI continues. When a company utilizes a cash plan, it is generally considered a type of employee bonus, while deferred plans are intended to supplement other benefits.

Benefits of Profit Sharing

For employers, the main benefits of profit sharing stem from employee motivation. It can help organizations secure and retain talented employees, and can be a motivating factor that can increase productivity and loyalty. And because a profit must exist before it is distributed among employees, profit sharing may be less risky than outright bonuses. Profit sharing can also increase the ownership employees feel in regard to their jobs because they are sharing in the profits they create for the company. The costs rise and fall with revenue as well, HR-Guide says, which is another benefit.

Disadvantages of Profit Sharing

There are potential disadvantages to profit sharing. For example, profit sharing could incentivize bad behavior, with employees prioritizing profitability over quality. In addition, there is usually no differentiation based on merit or performance, so employees who contribute less will receive a share in the profits regardless of their relative contribution to the company’s success.

The various advantages and disadvantages involved in profit sharing are why companies and HR teams should conduct a cost-benefit analysis before choosing to implement a plan.

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