In both a startup and established business, it's important for your employees to feel like they are contributing to the business's success. That's where profit sharing can play a big role. Profit sharing is a good option for attracting quality employees to your startup or existing business because it's an incentive deal where employees get part of the company's profits if they hit a certain amount of revenue.
In this lesson, we explain the pros and cons of profit sharing and how it differs from equity compensation, so you can make the right decision for your business and employees.
How It Works
Profit sharing plans can increase employee productivity – in addition to morale – because employees get a “piece” of the business’s success. As an employer, it’s up to you on how you allocate the profits, whether it’s based on an employee contribution level or employee position level.
There are two types of profit sharing plans: cash or bonus plan and registered deferred plan.
Cash Profit Plan
A cash profit plan offers employees their profit-sharing distribution in cash at the end of the year. The negative to this, however, is that the bonuses will be taxed as employee income.
Registered Deferred Plan
This plan only allows employees to collect their profit-sharing accounts upon termination or retirement. Unlike a cash profit plan, there isn't any tax. This plan is appealing for professionals looking for long-term senior level roles, as they won't achieve full ownership until a specific date.
In order to decide which plan is right for your business, consider your objective. For instance, if you’re looking to attract employees and boost production, a cash profit plan might be a better option. However, if you’re looking to increase employee retention, a registered deferred plan would be better.
Pros & Cons
Pros
- Gives everyone incentive to work harder – and for long-term success.
- Reduces costs for small businesses.
- Can give your sales team more of a personal incentive to make more sales.
Cons
- Profit sharing can be risky for employees in accounting and reporting positions because it gives them incentive to overstate earnings – AKA fraud.
- Recommended to hire a financial professional to set up and manage a good profit sharing strategy.
Profit Sharing vs Equity
In Organizing Your Management Plan, we mentioned that equity compensation was a great option for startups to pay employees. To review, equity compensation is when employers offer a share of the company's future profits in exchange for lower (or no) salaries up front.
The key difference between the two is that equity sharing is a better option for startups that need capital right away to get going. Profit sharing, however, is a better option for established businesses that are trying to attract and retain new employees.
Suggested reading on implementing a profit sharing plan:
FAQs
Profit sharing is a good option for attracting quality employees to your startup or existing business because it's an incentive deal where employees get part of the company's profits if they hit a certain amount of revenue.
How is profit sharing paid out? ›
Profit sharing works by setting aside a percentage of the company's annual profits, which is then allocated to eligible employees. This is in addition to their regular compensation.
Do I get my profit sharing if you quit? ›
Generally, no. If profit sharing is an integral part of an employee's compensation, the profit sharing partner is entitled to it, even after resignation. This applies unless the employer clearly states that continuing employment is a requirement for receiving profit sharing funds.
How does a profit share bonus work? ›
Profit sharing is an employee bonus that eligible employees receive over a set time period (quarterly or annually). The compensation paid to the employee depends on the profitability of the company over that time period and how their profit sharing plan is set up (more on this later).
How can I get my profit sharing money? ›
Regular Withdrawals
- Step 1 – Find out from your employer when you can start withdrawing funds after you turn 59 1/2. ...
- Step 2 – Calculate your tax payments. ...
- Step 3 – Start cashing out your profit-sharing plan when your employer allows or at the point when you'll get the greatest benefit.
Workers cannot see strong links between their effort and their organization's performance (profits). Profit sharing may increase compensation risks for employees by making earnings more variable. Profit sharing may incur high administrative costs.
Can I withdraw my profit-sharing? ›
If you participate in a profit-sharing plan, you may begin withdrawing funds after age 59½ without incurring a 10% federal tax penalty. Withdrawals are taxed as ordinary income.
How long does it take to get your profit sharing check? ›
For flat dollar or pro-rata formulas, processing time is generally one day. For new comparability, processing typically takes at least two weeks.
Does profit sharing count as income? ›
No, profit sharing is not taxed like a bonus. With a cash plan, employees are given either cash or stock on a regular basis, such as quarterly or annually. The payouts are quick, relative to a retirement plan, but they are also taxed as regular income.
Does profit sharing go into a 401k? ›
Profit sharing in a 401(k) plan is a pre-tax contribution employers can make to their employees' retirement accounts after the end of the year. The contributions are tax-deductible for employers for the previous tax year.
More In Retirement Plans
Profit-sharing, money purchase, 401(k), 403(b) and 457(b) plans may offer loans. To determine if a plan offers loans, check with the plan sponsor or the Summary Plan Description. IRAs and IRA-based plans (SEP, SIMPLE IRA and SARSEP plans) cannot offer participant loans.
Who receives profit sharing? ›
In a profit-sharing plan, employees receive an amount from their employer based on company profits (rather than a specific amount outlined in a match formula). All eligible employees are eligible to receive an employer discretionary profit sharing contribution.
What is the best way to do profit sharing? ›
This is up to you and what works for your company, but a good place to start is giving 10% of your profits to qualifying team members. Of course, that percentage is spread among them, so choose a percentage that's large enough that they'll feel it but also makes sense for your bottom line.
How long does it take to get your profit-sharing check? ›
For flat dollar or pro-rata formulas, processing time is generally one day. For new comparability, processing typically takes at least two weeks.
Do you have to pay taxes on profit-sharing? ›
If the employee takes it as a lump sum, it will be taxed as income at that time. If the profit-sharing money is taken out in periodic payments, it will be taxed as income each time it is paid out.
Is profit-sharing paid at the end of the year? ›
So what is it? Profit sharing in a 401(k) plan is a pre-tax contribution employers can make to their employees' retirement accounts after the end of the year. The contributions are tax-deductible for employers for the previous tax year.
Is profit-sharing immediately vested? ›
Immediate vesting: Employees receive full ownership of employer contribution benefits immediately upon enrollment. This encourages employee retention.
