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What is Profit Sharing?

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  • Written By: Mary McMahon
  • Edited By: O. Wallace
  • Last Modified Date: 01 December 2016
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Profit sharing is a form of compensation in which a company shares part of its pre-tax profits with employees. This type of compensation can work in a number of different ways, depending on the structure of the company and the decisions made by employees and employers. As a general rule, such plans are designed as an incentive. When employees share in the profits, they have a vested interest in increasing the profits so that they can access more money. Businesses of a wide range of sizes can engage in profit sharing arrangements.

The profits may be distributed in the form of cash, stocks, and bonds, or a mixture of these forms of compensation. In a deferred profit sharing agreement, the profits are held in trust and used to fund a retirement account. One advantage to this type of arrangement is that it is usually tax-exempt, since the employees cannot yet access the funds and they are therefore not considered income. People who receive profit sharing payouts immediately, however, will need to pay taxes on them.

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Cooperative businesses are often set up along a profit sharing model, with members of the business receiving varying shares depending on how long they have been working with the cooperative, how much they have invested in it, and so forth. Businesses which do not operate along cooperative lines can use the sharing model to incentivize hard work and innovation among employees, awarding shares of the profits on the basis of a variety of rubrics.

For pension and retirement plans, profit sharing can be highly effective. However, employees should consider enrollment in the plan carefully. If the company is growing and doing well, the pension plan will grow correspondingly large. However, if profit sharing is done in the form of stocks, employees risk having the stocks lose value, and long term employees may find that when they are ready to retire, they can't access as much money as they thought they would be able to.

Setting up a profit sharing agreement takes time. Companies and employees interested in pursuing such an agreement should do their research carefully and work with experienced lawyers to set up the terms in order to ensure that the plan operates fairly and smoothly. Sometimes it can be helpful to ask other businesses about the models they use and the pitfalls they have encountered while establishing their own plans, to generate a list of things to avoid or watch out for.

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anon221798
Post 5

i would like to inquire if you a survivor of your late spouse if you are entitled to any kind of benefits. mr. cavazos

Moldova
Post 4

@Cafe41 - I love Roth IRA’s. I just wanted to add that when I was in college, I worked for a major grocery store that offered profit sharing for all of its employees including the part time ones like me.

I started working there my senior year in high school and all through college and when I graduated from college, I was able to pay off my student loans with my profit sharing money.

It was great being out of college with no debt like that. Since I had worked for the five years that the profit sharing guidelines dictated, I was entitled to the money. It was great.

cafe41
Post 3

@SauteePan - I know what you mean. A lot of people do this because they see that they are getting a discount on the purchase price, but when the majority of your investments come from one source it does make you vulnerable not to mention if the company files for bankruptcy.

If you have a profit sharing 401K then if you qualify, you could also look into a Roth IRA. With a Roth IRA, you get to select the investments that go in there and it will give you an opportunity to diversify your holdings so that you are not so heavily invested in your company’s stock.

The nice thing about the Roth IRA is that when you are set to retire and begin withdrawing from the account, the funds are tax free at that point.

SauteePan
Post 2

@BrickBack - I agree that a profit sharing plan can keep employees from leaving a company. I know that some companies also allow a discounted stock purchase plan in which you are almost certain to earn a profit on your shares.

My husband used to work for a major package delivery company that allowed its employees to purchase up to $10,000 a year in employee stock at a discounted prices. I believe that this was a restricted stock purchase plan because they had to hold to the stock for about a year or two before they could sell.

While this benefit was popular I could see the danger in investing too much money in the company stock. They make it so easy and even offer to do automatic withdrawals from your bank account. It is definitely tempting.

BrickBack
Post 1

I think that profit sharing programs are great incentives for employees to stay with a company. I had a friend that worked for a company that had really high employee turnover and the company later introduced a profit sharing plan that allowed the employees to be vested within five years.

A lot of the employees really liked the plan and after you have a few years worth of profit sharing contributions you might think twice about leaving because my friend told me that if you leave before the five years you lose all rights to this profit sharing account.

These profit sharing plan rules were explained to the employees when the plan was first rolled out and so far their turnover rate has been significantly reduced.

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