Definition · Compensation and benefits
Profit Sharing
Definition
Profit sharing is a compensation arrangement in which an employer shares a portion of company profits with employees, either as cash or as contributions to a retirement plan. The pool usually depends on company results, then is split among eligible employees by a formula, often in proportion to pay.
Also called: Profit sharing plan, Profit-sharing bonus, Gain sharing (related)
Formula
Employee share = Profit sharing pool × (Employee's eligible pay ÷ Total eligible pay of all participants)
- Profit sharing pool
- The amount set aside for sharing, often a percentage of pre-tax profit above a threshold, or a discretionary amount.
- Eligible pay
- Compensation counted under the plan, typically base pay, sometimes including overtime and bonuses.
- Total eligible pay
- Sum of eligible pay for everyone participating.
Worked example
A company sets aside $600,000. Total eligible pay is $20 million. An employee earning $50,000 receives 600,000 × (50,000 ÷ 20,000,000) = $1,500, equal to 3% of pay.
Types of profit sharing plans
- Cash profit sharing: paid out in cash, usually once a year after results are final. Taxed as ordinary wages.
- Deferred profit sharing plan: a qualified retirement plan where the employer contributes to employee accounts, governed in the US by the Internal Revenue Code and ERISA. Many 401(k) plans include a profit sharing feature that lets the employer make discretionary contributions on top of any match. Employer contributions usually follow a vesting schedule.
- Combination plans: part paid in cash, part deferred.
Qualified plans must meet nondiscrimination testing so they do not favor highly compensated employees. Allocation methods such as pro rata, integrated with Social Security, or new comparability affect who gets what and need a plan administrator's help.
Profit sharing vs bonus
A bonus is usually tied to individual or team goals and paid regardless of whether the whole company made a profit. Profit sharing depends on company profit, so everyone gains or loses together and an individual has little direct influence over the result. That makes profit sharing better for building a sense of shared ownership and weaker as a motivator for specific behaviors. Many employers use both: variable pay for individual or team targets, profit sharing for company-wide results.
Gain sharing is a related idea that shares savings from productivity or cost improvements in a specific unit, which gives employees a clearer line of sight than company profit.
Design choices and pitfalls
- Eligibility: many plans require a minimum service period, such as one year, and employment on the payout date. Long waiting periods exclude much of a high-turnover hourly workforce, which defeats the purpose if retention is the goal.
- Communication: a plan that pays 2% in a good year and nothing in a bad one feels like a broken promise if expectations were not set clearly.
- Overtime: in the US, cash profit sharing that is promised or formula-based may need to be included in the regular rate for non-exempt employees, while contributions to a bona fide qualified plan generally are excluded. Confirm with payroll counsel.
- Visibility: share the formula and the pool calculation. Employees trust a plan they can follow.
Frequently asked questions
What is a profit sharing plan?
A profit sharing plan is an arrangement where the employer contributes part of its profits to employees, either in cash or into retirement accounts. In the US, the term often refers specifically to a qualified defined contribution retirement plan.
How is profit sharing calculated?
The company decides the pool, often a percentage of profit, then allocates it by formula. The most common method is in proportion to each employee's eligible pay.
Is profit sharing better than a bonus?
They do different jobs. Bonuses reward individual or team performance. Profit sharing ties employees to company results and builds shared ownership. Many employers offer both.
Do employers have to contribute to profit sharing every year?
For most qualified profit sharing plans, contributions are discretionary and can vary or be zero in a given year, subject to plan terms and IRS rules.