What Is Profit Sharing?

Looking to offer your employees an additional benefit? Consider creating a profit-sharing plan. But before you run off and create a plan, you need to know what is profit sharing. Read on to learn all about profit sharing, including how it works and steps for creating a plan of your own.

Profit sharing is a type of pre-tax contribution plan for employees that gives workers a certain amount of a company’s profits. The profit-sharing payments depend on the:

Business’s profitability
Employee’s regular wages and bonuses
Amount set by the business

With a profit-sharing plan (PSP), employees receive an amount based on the company’s earnings over a specific period of time (e.g., a year). Generally, an employee receives a percentage or dollar amount of the business’s profits either in cash or company stock. Many businesses offer profit sharing as a retirement benefit for employees.

If an employer does not make a profit during the time period (e.g., year), they do not have to make contributions that year.

Typically, a business offers a PSP to help instill a sense of ownership in its employees. The goal of a small business profit-sharing plan is to reward employees for their contribution to the company’s success and incentivize employees to keep reaching goals.

PSP vs. 401(k)

Although a profit share agreement can be used as a retirement plan option to offer employees, it’s not the same as a 401(k) plan.

Both plans give employees additional retirement benefits. However, 401(k) plans and PSPs have different rules and structures.

With 401(k) plans, employees can make contributions to their own plans. And depending on the type of 401(k) plan, the employer might make a matching contribution.

With a PSP, an employee cannot make any contributions. Only the employer can make a contribution to the PSP. But, a company can offer other types of retirement plans, such as 401(k), along with a PSP.

What is profit sharing? Profit sharing is a type of pre-tax contribution plan for employees that gives workers a portion of a company's profits.

Types of PSPs

There are a few different types of profit-sharing plans to choose from. They all follow the same concept: an employer sharing a portion of their profits with employees.

Here are the three types of PSPs:

Pro-rata: All employees receive the same contribution amount from the employer (e.g., percentage or fixed dollar). This is the most common type of PSP.
Non-comparability / cross-testing: Employers can contribute to different groups of employees (e.g., full-time employees) at different rates.
Age-weighted: Takes age and salary into consideration. Employers can offer older employees a higher percentage than younger employees because they are closer to a retirement age. With an age-weighted plan, the longer someone stays with the business, the more their employer contribution rate increases. This type is specific to PSPs used as retirement plans.

Requirements for a PSP

Businesses of any size can create a profit-sharing plan. If you use your PSP as a retirement benefit, you can also take advantage of other retirement plan types.

A business must also follow a predetermined profit allocation formula for deciding how much employees receive in profits and which employees are eligible.

There’s no set amount that a company must contribute to its PSP each year. But, there is a maximum contribution amount that you can make per employee. According to the IRS, the contribution limit for a company sharing its profits with an employee is the lesser of 25% of that employee’s annual compensation or $69,000 (2024).

Ready to see profit sharing in action? Let’s look at an example of profit sharing so you can see it first-hand.

To calculate the employer contribution, you need to add the compensation for all employees. Divide each employee’s individual compensation for the period by the total compensation for the period. Then, multiply your profit share percentage by your profits for the period. Finally, multiply the two totals together to determine each employee’s payment amount.

Say you have three employees. Employee A makes $30,000 per year, Employee B makes $25,000, and Employee C makes $40,000. The total compensation for all three employees is $95,000 ($30,000 + $25,000 + $40,000). This year, your business had a profit of $150,000, and you share 10% of your annual profits with employees. Take a look at how much each employee would receive:

Employee A: ($150,000 X 0.10) X ($30,000 / $95,000) = $4,736.84
Employee B: ($150,000 X 0.10) X ($25,000 / $95,000) = $3,947.37
Employee C: ($150,000 X 0.10) X ($40,000 / $95,000) = $6,315.79

To figure out your company’s profit-sharing amount per employee, you can use the following formula:

Profit-sharing amount = (Profits X Profit-sharing Percentage) X (Employee Compensation / Total Employee Compensation)

To get started creating your PSP, follow the steps below:

Determine how much you want your PSP amount to be
1. Profit allocation formula
2. Percentage vs. dollar amount
Write up a plan
1. Rules
2. Eligibility requirements
3. Amount (e.g., percentage or dollar amount)
4. Frequency (e.g., annual)
Provide information to eligible employees
File IRS Form 5500 annually
1. Details your contribution plan and all participants in it
Keep records (e.g., amounts, participants, etc.)