Employers are always looking for new ways to incentivize their workforce. Those who have established businesses with a solid revenue stream might consider offering a profit sharing plan. It ties employee performance to the pursuit of business objectives, helping spur further growth. And because it’s a compensatory benefit, profit sharing can be an effective tool in attracting and retaining talent.
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What is a profit sharing plan (PSP)?
Profit sharing is most commonly a retirement savings plan funded entirely by employers. Participating employees receive a portion of the business’s quarterly or annual revenue. The exact amount is subject to the employer’s discretion, though the IRS imposes annual contribution limits per employee.
How does profit sharing work?
Profit sharing plans lend themselves to flexibility. Employers can choose how much profit to share with employees up to the annual limit. Additionally, there is no obligation to make minimum contributions, so employers can choose not to fund the plan when revenue is lean. If they do share profits, however, they must have a set formula for calculating and dividing the contributions amongst the workforce.
Who can offer a profit sharing plan?
Businesses of all sizes can sponsor profit-sharing benefits, but it may not be right for every organization. Generally, companies wait until they’ve recorded revenue for a specific time before sharing it with employees.
Profit sharing plan vs. 401(k)
Profit sharing plans and 401(k) plans are both tax-deferred investments that can help employees save for retirement. The primary difference between the two is how they are funded. Only employers may contribute to profit sharing plans, whereas a 401(k) permits contributions from both employers and employees.
Benefits of profit sharing
Profit sharing plans offer advantages for employers and employees alike. Here are some of the substantive benefits:
- Tax-deferred savings
Profit sharing helps boost employees’ retirement savings without increasing their taxable income. - Flexibility
Employers can wait until the end of the year to decide whether they can afford to share profits with employees. - Customizable vesting
Employers can choose a contribution vesting schedule that works for them and their employees. - Portability
Employees may be able to take their vested account balance with them if they leave the company, easing administrative responsibilities.
Disadvantages of profit sharing
The administrative costs of managing a profit sharing plan may be higher than other types of retirement savings plans, like the simplified employee pension (SEP) or the SIMPLE individual retirement account (IRA). Profit sharing plans are also subject to nondiscrimination testing to ensure they don’t favor highly compensated employees.
How to calculate profit sharing
Employers commonly distribute company profits amongst plan participants using the “comp-to-comp” method. It proceeds as follows:
- Calculate the sum of all employee compensation
- Divide each employee’s salary by the total compensation
- Multiply the result by the amount of the employers’ contribution
Alternatives to the comp-to-comp method include age-weighted allocations, integrations with Social Security, flat dollar calculations and new comparability plans.
Profit sharing example
A business earns $400,000 profit. At the end of the year, company leadership decides to share 10% of that sum with the employees. If the total workforce compensation is $200,000, how much profit will an employee earning $80,000 receive?
($80,000/$200,000) x ($400,000 x 0.10) = $16,000
How to create a profit sharing plan
Employers interested in profit sharing must first decide if they will set up and manage the plan themselves or seek help from a financial institution. After that, there are four main steps:
- Writing the plan document
- Setting up a trust for plan assets
- Selecting a plan recordkeeper
- Notifying eligible employees
1. Writing the profit sharing plan document
The plan document outlines the day-to-day management of the profit sharing program. Provisions include, but are not limited to:
- Formulas for calculating contributions
- Vesting schedules
- Nondiscrimination testing
- Employee eligibility
The plan document may need to describe other features and processes as required by law.
2. Setting up a trust for plan assets
Holding the plan’s assets in trust helps ensure they are used solely for the benefit of the plan participants and their beneficiaries. As such, choosing a person or firm for this role is one of the most important decisions when creating a profit sharing plan. At least one trustee is necessary to manage contributions, plan investments and benefit distributions.
3. Recordkeeping
Profit sharing plans require a method of accurately tracking contributions, earnings, losses, investments, expenses and distributions. These records are essential when filing the plan’s annual report with the federal government. If a financial institution manages the plan, it typically handles recordkeeping responsibilities on the employer’s behalf.
Notifying eligible employees
All eligible employees must be notified about certain benefits, rights and features specific to the profit sharing plan. They must also receive a summary plan description (SPD), which provides information about the retirement savings program and how it operates. This material is usually created in tandem with the plan document.
ADP delivers what you need to effectively manage retirement benefits and help employees meet their saving goals.
Learn MoreProfit sharing plans combined with a 401(k) plan
Businesses may offer a profit-sharing plan alongside a 401(k) or other retirement plan, giving their employees multiple saving options. However, if employers add a salary deferral feature to their profit-sharing program, the IRS will treat it as a 401(k).
Reporting profit sharing plans
Employers must report information about their profit sharing plans to the federal government. The correct form to use depends on the number and type of plan participants. Options include:
- Form 5500, Annual Return/Report of Employee Benefit Plan
- Form 5500-SF, Short Form Annual Return/Report of Small Employee Benefit Plan
- Form 5500-EZ, Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan
These forms can be filed electronically using EFAST2.
Frequently asked questions about profit sharing plans
How can I start a profit-sharing plan?
To start a profit sharing plan, employers must write a plan document, arrange a trust for plan assets, select a plan recordkeeper and notify eligible employees about the benefit. They can manage these tasks themselves, if so inclined, or seek professional assistance, e.g. insurance company, mutual fund provider, etc.
Is profit sharing taxable?
Profit sharing plans are generally tax deferred investments. In other words, employees don’t pay tax on the income until it is withdrawn from the account, usually at retirement age. Withdrawals prior to retirement may result in penalties.
How is profit sharing paid out?
Employers commonly share profits amongst eligible plan participants using the comp-to-comp method. This calculation ensures that each employee receives a contribution proportionate to their base compensation. Alternative methods include age-weighted allocations, integrations with Social Security, flat dollar calculations and new comparability plans.
Do employees get profit sharing if they quit?
Depending on the design of the profit sharing plan, employees may be able to take their savings with them if they leave the company. However, employers sometimes implement vesting schedules, which require employees to work with the company for a specific time before they have full access to the money saved.
Do all employees get a profit share?
Profit sharing plans must not disproportionately favor highly compensated employees, like senior leaders. As long as the plan passes nondiscrimination tests, employers may freely choose which types of employees are eligible for participation, e.g., full-time, part-time, etc.
What is a small business profit sharing agreement?
In a small business profit sharing plan, the employer shares a portion of the business’s quarterly or annual profits with eligible employees. The money is generally deposited into a tax deferred retirement savings account. Additionally, employers may choose to share or not share profits at their discretion. This provision makes profit sharing plans ideal for small businesses with inconsistent cash flow.
This article is intended to be used as a starting point in analyzing the profit sharing definition and is not a comprehensive resource requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services.
M-694983-2025-02-26
