What Is a Profit-Sharing Plan?

A profit-sharing plan is a company benefit that involves distributing a portion of the company's profits to its employees in the form of cash or stock. This can be offered in the form of a company retirement plan known as a deferred profit-sharing plan (DPSP).

The Internal Revenue Service (IRS) limits the amounts that can be awarded annually through a deferred profit-sharing plan. Unlike other retirement plans such as the 401(k), a profit-sharing plan is funded only by the employer, not by the employee.

Understanding Profit-Sharing Plans

A profit-sharing plan, in general, is a company policy to reserve a portion of its profits for distribution among its employees. A retirement plan based on profit-sharing invests the company contributions in long-term accounts to be collected by꧑ the employee after retirement.

If the plan is retirement-based it comes with certain regulations imposed by t𓂃he IRS.

Em🦄ployers control how much of the profit to share in each period, and may decide to share none in a bad quarter or year.

In the years that it opts to make contributions, the company must come up with a set formula for profit allocation. This is meant to ensure that profits are not unequally awarded to the company's highly-compensated employees.

The most common way for a business to determine the allocation of a profit-sharing plan is through the comp-to-comp method. The formula calculates each employee's share percentage based on the individual's annual compensation.

Example of a Profit-Sharing Plan

The IRS has attempted to make profit-sharing plans appealing to small businesses in particular.

Let’s assume a business with only two employees uses a comp-to-comp method for profit sharing. In this case, employee A earns $50,000 a year, and 🦩employee B earns $100,000 a year. If the business owner shares 10% of the annual profits and the business earns $100,000 in a fiscal year, the company would allocate profit share as foll⛦ows:

• Employee A = ($100,000 X 0.10) X ($50,000 / $150,000), or $3,333.33
• Employee B = ($100,000 X 0.10) X ($100,000 / $150,000), or $6,666.67

Requirements for a Profit-Sharing Plan

A profit-sharing plan can be created by a business of any size, and a company can establish one even if it has other retirement plans.

Companies have a great deal of flexibility in implementing a profit-sharing plan. As with a 401(k) plan, an employer has full discretion over how and when it makes contributions. However, all companies have to prove to the IRS that its profit-sharing plan does not discriminate in favor of highly compensated employees.

There are annual contribution limits. For the 2024 tax year, the maximum is the lesser of 100% of compensation or $69,000 per year, or a total of $76,500 if the employee is eligible for a catch-up contribution. The limits rise to $70,000, or $77,500 including the catch-up contribution.

To implement a profit-sharing plan, all businesses must fill out an Internal Revenue Service Form 5500 and disclose all participants of the plan.

Early withdrawals, just as with other retirement plans, are subject to penalties with certain exceptions.

The Bottom Line

A profit-sharing plan is a way for employers to provide employees with a portion of the business's profits, based on quarterly or annual earnings. Contributions are awarded quarterly or annually, or are deposited into a fund that is handed over when the employee retires.

Profit-sharing plans are generally seen as a meaningful way to motivate employees by directly connecting the company's success to the employees' efforts.