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How Does Profit Sharing Work?

January 6, 2017

Business professionals sharing a currency pie

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

Organizations should keep detailed records about how the plan is distributed among employees. If updates to the plan are needed, stakeholders should be included to alter documents and communicate changes to employees accordingly.

Profits can be distributed to eligible employees in the form of cash or in stocks and bonds. Those options reflect the two types of profit sharing plans: cash and deferred.

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 an employee, typically in cash or checks, but also sometimes as stock. The amount is taxed as regular income.

Deferred Profit Sharing Plan

When contributions are deferred to individual employee accounts, this is referred to as a deferred profit sharing plan and is thought of as a retirement benefit. Earnings are distributed at retirement, upon death, after disability, or sometimes at separation from service or other events. 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

The main benefits of profit sharing for employers and employees alike stem from employee motivation. Incentivizing employees helps them increase their effort, and, as Harvard Business Review found, it results in higher levels of employee productivity and satisfaction. Feelings of ownership and loyalty can also increase.

Profit sharing may be less risky than bonuses. Because the costs of this benefit are proportional to revenue, organizations don’t have to worry about developing a bonus program that’s too large or small.

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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