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The Profit Sharing Benefits Employers Need to Know About

By:
Ryan Shank

Profit sharing isn't just a term, it's a powerful strategy that's reshaping workplaces across the US. It's a method where employees receive a portion of additional income from company profits. It's an innovative approach where everyone works toward a common business goal.

In this article, we'll dive into the power profit sharing plans (PSPs) have for you and your business; unpacking the benefits that make them a game-changer for employers and employees.

Key Takeaways:

  • PSPs distribute the company's profits amongst employees.
  • The employer contribution limit is capped by the IRS for highly compensated employees.
  • A well-structured profit sharing plan requires clear communication with all parties involved to avoid any misunderstandings or legal disputes.
  • PSPs have tax benefits for businesses.
  • Profit sharing contributions can form part of retirement plans and 401(k)s.

Top 4  Advantages of Profit Sharing

PSPs have remarkable benefits for both employers and employees. It is used to foster a collaborative workplace whereby employees are rewarded a portion of the company's profits in exchange for meeting predetermined operational benchmarks. Employer contributions are also tax-deductible to the company.

There are two forms of PSPs:

  1. Companies reward employees with a portion of their profits after a set time frame.
  2. When companies defer profits to employee retirement plans.

Either way, employer contributions form part of an employee's annual compensation and the benefits can be substantial. Let's look at a few profit sharing advantages next:

Boosting Employee Motivation and Productivity

  • Profit sharing tactics transcend financial incentives. It's a powerful motivational tool that many companies use.
  • Profit sharing is directly linked to the company's success. It creates a profound sense of investment and ownership amongst employees as they work toward the same objective.
  • It boosts morale, fosters accountability, and creates a space where employees work harder to reap the rewards at the end of the day.
  • When employees receive additional earnings that are directly linked to their efforts, it nurtures a company culture of collective success.

For instance, a retail company implements a profit sharing plan for their sales team. Employees are more likely to work harder and boost sales when they know financial incentives are linked to their hard work. By receiving a portion of their sales amount, it enhances employee motivation, engagement, and overall job satisfaction.

Enhancing Employee Retention

  • Reduced employee turnover is what most companies strive for. Employees want to feel valued, motivated, and appreciated within their line of work.
  • Profit sharing has proven successful in employee retention rates. Studies have shown that 46% of workers say salary or cash incentives are the biggest motivator for staying at their current company.
  • When employees have a stake in the company's profits and success - through profit sharing - it fosters a deeper commitment and loyalty to the company.
  • This heightened engagement increases employee retention and reduces employee turnover rates.
  • PSPs nurture long-term relationships between employers and their teams.

Attracting Top Talent

  • A profit sharing plan is like a magnet for attracting top-tier candidates.
  • It goes above and beyond offering a competitive salary. It showcases a commitment to the employees' success and company growth.
  • Top talent candidates look for working environments where they are appreciated and rewarded for their contributions.
  • Profit sharing has a direct link to attracting top-grade employers; not only do they seek financial gains but also strive for the chance to directly impact the company's trajectory.
  • Benefit distributions can differ from company to company. Some implement profit sharing strategies while others reward employees in the form of non-monetary incentives, like healthcare insurance or car allowances.

Tip: The Internal Revenue Service (IRS) limits employer contributions to eligible employees. Employees who receive under $1 million per year are subject to paying 22% tax. If profit sharing payments for highly compensated employees exceed $1 million, they pay 37% tax.

Encouraging Innovation and Creativity

  • A profit share agreement not only provides substantive benefits; it also cultivates a collaborative workforce where employee input is valued.
  • PSPs motivate employees to work hard and gives them a platform to voice their ideas. It stimulates suggestions for improved operational management and success.
  • When employees feel invested in the company, they become invested in the business - striving toward company growth and increased productivity.
  • Sharing profits acts like a catalyst for out-of-the-box thinking, fostering an entrepreneurial spirit within your teams.

For example, a furniture manufacturing startup is battling to boost sales and create awareness about their business. An employee suggests they create a website with an online store and utilize social media platforms to gain some traction.

When the business reaps the benefits from increased sales, the employee receives a share of these profits. Proft sharing has many benefits, including "two heads are better than one".

Potential Disadvantages of Profit Sharing 

While profit sharing plans have their benefits, there are a few pitfalls to consider:

Employee Discontent

A significant risk is employee dissatisfaction. If not managed properly, PSPs can lead to misconceptions of unfairness or lack of transparency. For example, if an employee doesn't know how the PSP calculations are done, they might see this as unfair.

Tips to avoid these common pitfalls:

  • Use clear language when explaining PSPs to employees. This mitigates the risk of any misunderstandings.
  • Use an equitable distribution formula when calculating profit sharing payments. Ensure fairness amongst all employees. Factors to consider include employee role, duties, and performance.
  • Engage with employees regularly so they stay informed and up-to-date with PSPs.

Financial Risk

Profit sharing also carries certain financial risks to the business. The variability in profit levels can make budgeting for PSP contributions challenging.

Additionally, the administrative costs for managing profit sharing plans can be higher when compared to other retirement plans like SIMPLE IRAs.

Tips to mitigate financial risk:

  1. Budget a fixed percentage of profits for sharing in high-profit years.
  2. Explore cost-effective ways to administrate PSPs, such as using automated platforms and systems.
  3. Periodically review the plan's impact on the company's finances and adjust accordingly.

Employees Can't Contribute

In stand-alone PSPs, only employers can contribute to the fund, which means employees cannot add additional savings to it. This limitation can be a drawback for employees who wish to have more control over their retirement savings.

Tips for addressing this issue include:

  • Consider offering hybrid programs, which are a combination of profit sharing and 401(k) plans.
  • Provide other saving or investment options where employees can contribute, such as company stock purchase plans.
  • Offer financial education resources to help employees understand and maximize their PSP benefits.

How is Profit Sharing Different from Revenue Sharing

Profit sharing and revenue sharing are often used interchangeably but differ in purpose and functionality. Both aim to align employees' interests with company success. But here is the difference:

Profit Sharing

  • Profit sharing contributions are when a portion of the company's profits are split amongst employees, stakeholders, and other profit sharing partners.
  • It is a performance-based incentive tied to the company's overall financial success.
  • Employees receive a share of profits based on predetermined criteria or key performance indicator (KPI) benchmarks. This is usually linked to the company's net profit (money after tax and expenses have been paid).
  • This employer contribution strategy motivates employees to work toward increasing the company's bottom line (i.e. profitability) as their employee contributions are directly tied to operational success.

Revenue Sharing

  • On the other hand, revenue sharing focuses on allocating a percentage of the company's overall revenue generation (i.e. gross income).
  • It involves dividing the revenue pie amongst employees and stakeholders - income that is generated from sales or services.
  • It does not take company expenses or other financial obligations into consideration.

Understanding the difference between profit sharing vs. revenue sharing is crucial for business owners looking to implement incentive programs.

Get the Benefits of Profit Sharing with Our Profit Sharing Template

Discover the ease and efficiency of profit sharing plan management with ShareWillow. Our platform streamlines the complexities of traditional profit sharing processes, offering a transparent, automated, and efficient solution for business owners.

Our profit sharing template is designed to simplify the creation and management of your PSPs. ShareWillow offers a user-friendly interface, empowering you to design and oversee employer contributions, retirement plans, contribution limits, annual profits, and more.

FAQs on Profit Sharing

What is profit sharing?

PSPs are a way businesses offer their employees a share of the company's annual profits based on the total profit earnings. This is based on predetermined benchmarks. If there is no profit, then there are no profit sharing contributions to pay out.

What types of profit sharing are there?

There are various types of profit sharing contribution plans:

  • Deferred profit sharing plans - in the form of a retirement plan whereby employer contributions translate to retirement savings. This is often used as a retirement benefit for younger employees (but not limited to older employees).
  • Cash profit sharing plans - in the form of cash incentives paid directly to the employee over and above the employer's salary. This is typically paid as bonuses when predetermined benchmarks have been met. They are taxed as if it were normal pay.
  • Stock profit sharing plans - offering employees a share of company stock. Often used in startup companies where company stock is offered to employees at a reduced price.
  • 401(k) profit sharing plans - employers contribute a portion of their profits to an employee's 401(k) retirement plan. These can be subjected to vesting schedules but are a retirement benefit for employees.

Who can offer a profit sharing plan?

Any business, regardless of its size or industry, can offer a profit sharing plan to eligible employees. Ensure you set clear benchmark objectives and use reliable calculations for effective management.

Which is better, 401(k) or profit sharing?

When it comes to 401(k) vs. profit sharing plans, the best one for your business will depend on your specific needs and objectives.

Profit sharing contributions have tax benefits for employers as they are tax deductible. However, employees cannot contribute to these savings as they directly come from the employer. On the other hand, 401(k) retirement plan participants can add to their retirement savings as they wish.

ABOUT THE AUTHOR

Ryan is the founder of ShareWillow. He's passionate about helping businesses create incentive plans that motivate and reward employees. He previously built and sold PhoneWagon.

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