Please note, the material collected in this post is for informational purposes only and is not intended to be relied upon as or construed as advice regarding any specific circumstances. Consult your own financial, legal, and tax advisors.
Although the information and sources provided are believed to be accurate, EarnIn makes no guarantees regarding their accuracy or completeness and is under no obligation to update them.
Employee profit-sharing plans (PSPs) are a powerful tool to attract and motivate talent in competitive job markets. These plans help companies stand out by offering a share in the organization’s success, while recognizing employee contributions and adding flexibility to compensation. This guide explains what profit-sharing is, how it works, and how businesses can structure their plan.
What is a profit-sharing plan?
A PSP is an employer-funded compensation program that distributes a portion of the company’s profits to eligible employees.
Companies structure their PSPs in various ways. Some make regular payouts in cash or company stock. Other organizations attach profit-sharing to retirement plans, sending payouts to a 401(k) or other accounts for deferred access.
However they’re structured, profit-sharing bonuses incentivize employee performance by directly tying compensation to the company’s success. Their flexibility makes them attractive to companies of all sizes.
How does profit-sharing work?
Employers typically distribute profits from a profit-sharing pool, with individual payouts determined by factors such as
an employee’s net pay, tenure, or age. Here are several common models companies use to calculate each employee’s share:
Pro rata based on salary. Pro rata is Latin for “in proportion.” Under a pro rata PSP, eligible employees receive a percentage of the pool proportional to their annual salary. Higher salaries result in a larger share.
Years-of-service weighting. This method allocates a larger percentage of the pool to employees with longer tenures, rewarding team members’ loyal to the company.
Age-weighted plans. These plans consider age alongside salary in their calculations, generally offering older employees a higher percentage of the profit share. As team members near retirement, the employer contribution rate increases.
Flat-dollar method. Under this model, every eligible employee receives the same amount from the profit-sharing pool.
PSPs are ideal for companies that want to tie compensation to performance or those that experience cash flow variations, and are popular in technology, professional services, and healthcare industries.
Types of profit-sharing plans
Businesses configure profit-sharing plans in various ways to suit their organizational structure and needs. Here are some of the most popular profit-sharing approaches.
Cash-based plans
Cash-based profit-sharing plans directly pay employees a portion of the company’s profits, making it ideal for employees who don’t want their cash or stocks locked up in retirement accounts. In this case, profit-sharing is taxable as ordinary income.
Cash-based plans are popular with small businesses and startups looking to reward employees quickly. They’re the easiest way to allocate profits among the workforce and motivate near-term performance.
Employee stock ownership plans (ESOPs)
Combination plans
A combination plan provides short- and long-term benefits by dividing profit-sharing between cash payouts and contributions to workplace retirement accounts. ESOPs may also offer dividends to employee stockholders as an immediate reward.
Profit-sharing plans: Benefits and challenges
Profit-sharing plans have many advantages. However, there are some elements employers must consider when implementing a plan.
Pros of profit-sharing plans
Higher employee motivation and engagement. PSPs can motivate employees to work more efficiently. When they benefit from the company’s success, they’re more likely to put in more effort to increase profits and, by extension, their compensation.
Improved retention and loyalty. Profit-sharing plans give employees a sense of ownership in the business. The longer they stay with the company, the more they will share in its success.
Attractive recruitment tool. Employers that add a PSP to their
compensation and benefits package can increase their appeal to prospective employees, especially if the organization is poised for significant growth.
Potential tax benefits. The Internal Revenue Service (IRS) allows companies to deduct a portion of their PSP contributions from their taxable income.
Cons of profit-sharing plans
Variable costs year-to-year. Variations in quarterly and annual profits prevent companies from predicting exact profit-sharing payouts.
No guaranteed payouts. Depending on the agreement, companies can sometimes reduce or withhold profit-sharing allocations during slow periods. Employees might feel discouraged if their contributions don’t result in a payout.
Complex administration and compliance. Companies must follow tax rules and regulations. Complex profit-sharing plans may lead to increased administrative costs.
Minimally impact individual performance. Some hard-working employees may not like that less productive team members receive the same benefits from a profit-sharing plan. These employees often prefer salary bonuses directly connected to individual performance.
Discrimination test. The IRS requires that companies test certain types of profit-sharing plans to ensure they don’t disproportionately benefit highly paid employees. These tests present an additional administrative burden.
PSPs provide numerous long-term financial benefits, but they come with paperwork and organizational burdens. Fortunately, not all
employee benefits add administrative complexity. EarnIn’s
financial wellness solutions can be offered alongside profit-sharing plans to support employees’ day-to-day financial well-being at no cost to employers.
Tax treatment of profit-sharing plans
Profit-sharing plans can yield tax advantages for employers and employees. Employers may be eligible to deduct their contributions from taxable income. If eligible, employees may be able to defer taxes on qualified plans until they take distributions.
Some companies institute PSPs in addition to other types of retirement plans.
The IRS says companies can make profit-sharing plans “as simple or as complex” as they’d like and suggests purchasing “a pre-approved profit-sharing plan document from a benefits professional or financial institution to cut down on administrative headaches.” The IRS does set contribution limits for PSPs. In 2024, contributions were capped at
$69,000 or 100% of an employee’s compensation — whichever was less.
How to create a profit-sharing plan
Although profit-sharing plans vary widely, every employer must address a few common elements. Here is a general framework for setting up a profit-sharing plan.
First, the employer must create a written document that includes the eligibility requirements, rules, shared profit formula (e.g. percentage or dollar figure), and distribution frequency (e.g., annual or quarterly). Companies can work with a finance or retirement plan specialist to build a solid foundation for their profit-sharing plan.
2. Establish a trust
Profit-sharing assets must be held in a trust separate from general funds. A trustee is assigned to ensure the company responsibly manages contributions, investments, and distributions.
3. Notify employees about the plan
Businesses must inform employees about profit-sharing plans, outlining their rights and the plan’s features and benefits. PSP participants must receive a Summary Plan Description (SPD), which is typically created alongside the formal plan document and details how the plan works.
4. Maintain compliance with nondiscrimination and tax rules
Businesses should keep meticulous records on profit-sharing plans. They’re required to submit an annual report to the federal government and abide by all tax and nondiscrimination rules.
FAQs
Does profit-sharing count as income?
Profit-sharing generally counts as income, but it depends on how a company structures its profit-sharing plan. If employees receive profit-sharing income immediately as a salary bonus, the IRS taxes it as ordinary income in the tax year it was paid out. If the employer distributes profits into workplace retirement plans, taxes may be deferred, depending on the type of plan and IRS rules.
When is profit-sharing fully vested?
Vesting of profit-sharing income depends on the plan. Some companies provide immediate vesting to recipients, whereas others distribute it in parts through a vesting schedule. Employees might need to stay with a company for a specific period or work a set number of hours before they’re entitled to the full value of their profit-sharing funds. This is often the case for profit-sharing plans that double as retirement plans.
The IRS requires all employees to be 100% vested when they reach retirement age or when the company ends the PSP.
Motivate employees with profit-sharing and financial wellness
PSPs can motivate employees by connecting their compensation to company performance. They can also drive loyalty and retention when integrated into a broader employee well-being strategy that includes benefits like bonuses, workplace retirement plans, and modern financial wellness tools.
EarnIn complements benefits like profit-sharing and retirement plans by helping your team build better financial habits today. With
Earned Wage Access, employees can access their pay the same day they work — up to $150 per day, with a max of $750 between paydays
— starting at $2.99 per transfer.
Additional tools like Bill Reminders
help them stay on top of due dates and avoid late fees, while Balance Shield
helps protect them against overdrafts.
Please note, the material collected in this post is for informational purposes only and is not intended to be relied upon as or construed as advice regarding any specific circumstances. Consult your own financial, legal, and tax advisors.
Although the information and sources provided are believed to be accurate, EarnIn makes no guarantees regarding their accuracy or completeness and is under no obligation to update them.
EarnIn is a financial technology company not a bank. Banking Services are provided by Evolve Bank & Trust, Member FDIC. The FDIC provides deposit insurance to protect your money in the event of a bank failure. More details about deposit insurance
here.
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