"Profit sharing" is a type of compensation paid to employees by companies. Payment of a profit sharing bonus to non-management employees typically takes place at the discretion of the company and does not constitute an entitlement—although if it is paid routinely and year after year, employees may come to count on it as part of their compensation. Profit sharing bonuses are treated as income for tax purposes upon receipt unless made to deferred compensation plans.
As part of its National Compensation Survey, the U.S. Bureau of Labor Statistics (BLS) collects data on cash profit sharing bonus payments to employees. Data for 2005 indicated that 5 percent of all workers had access to such bonuses. The BLS data may actually understate the prevalence of profit sharing because it also reports "end-of-year bonus" and "holiday bonus" categories, both of which are higher, 11 and 10 percent of workers receive such bonuses respectively. Many small businesses pay such bonuses at the end of the year and without labeling them as "profit sharing"—but the bonuses are only paid in good years. This interpretation of the BLS data is borne out by the fact that bonuses labeled "profit sharing" were available to 4 percent of workers employed by small firms (under 100 employees) while 6 percent of workers in larger organizations had access to such bonuses. But 13 percent of workers in small establishments had access to end-of-year and holiday bonuses (13 percent in each category) whereas only 7 percent of workers in larger organizations had access to end-of-year bonuses and 6 percent to holiday bonuses. If all three categories are combined, it would appear that small businesses used this mechanism as a form of employee recognition more than large businesses.
BLS data also indicate that profit sharing bonuses (excluding end-of year and holiday bonuses) were more likely available to blue collar workers (7 percent versus the average of 5 percent), full timers (6 percent), unionized workers (7 percent), and higher wage workers ($15 an hour and higher, 7 percent) than other categories. Eleven percent of workers in goods producing and 3 percent of workers in services producing industries had access to such bonuses.
TYPES OF PROFIT-SHARING PLANS
Companies use any number of different formulas to calculate the distribution of profits to their employees and have a variety of rules and regulations regarding eligibility. In general, however, two types of plans prevail. The first takes the form of cash bonuses under which employees receive a profit-sharing distribution at the end of the year. The main drawback to cash distribution plans is that this income is immediately subject to income tax. This also holds if the bonus is paid out in the form of company stock.
To avoid immediate taxation, companies are permitted by the Internal Revenue Service (IRS) to set up qualified deferred profit-sharing plans. Under a deferred plan, the second type of profit sharing, profit-sharing distributions are held in individual accounts for each employee. Employees are not allowed to withdraw from their profit-sharing accounts except under certain, well-defined conditions. As long as employees do not have easy access to the funds, money in the accounts is not taxed and may earn tax-deferred interest. BLS data reported on this form of profit sharing do not show extent of corporate participation or the number of employees eligible overall.
Under qualified deferred profit-sharing plans, employees may be given a range of investment choices for their accounts, including stocks or mutual funds. Such choices are common when the accounts are managed by outside investment firms. It is becoming less common for companies to manage their own profit-sharing plans due to the fiduciary duties and liabilities associated with them. A 401(k) account is a common type of deferred profit-sharing plan, with several unique features. For example, employees are allowed to voluntarily contribute a portion of their salary, before taxes, to their 401(k) account. The company may decide to match a certain percentage of such contributions. In addition, many 401(k) accounts have provisions that enable employees to borrow money under certain conditions.
OTHER ISSUES CONCERNING PROFIT-SHARING PLANS
Deferred profit-sharing plans are a type of defined contribution plan. Such employee benefit plans provide an individual account for each employee. Individual accounts grow as contributions are made to them. Funds in the accounts are invested and may earn interest or show capital appreciation. Depending on each employee's investment choices, their account balances may be subject to increases or decreases reflecting the current value of their investments.
The amount of future benefits that employees will receive from their profit-sharing accounts depends entirely on their account balance. The amount of their account balance will include the employer's contributions from profits, any interest earned, any capital gains or losses, and possibly forfeitures from other plan participants. Forfeitures result when employees leave the company before they are vested, and the funds in their accounts are distributed to the remaining plan participants.
Employees are said to be vested when they become eligible to receive the funds in their accounts. Immediate vesting means that they have the right to funds in their account as soon as their employer makes a profit-sharing distribution. Companies may establish different time requirements before employees become fully vested. Under some deferred profit-sharing plans employees may start out partially vested, perhaps being entitled to only 25 percent of their account, then gradually become fully vested over a period of years. A company's vesting policy is written into the plan document and is designed to motivate employees and reduce employee turnover.
In order for a deferred profit-sharing plan to gain qualified status from the IRS, it is important that funds in employee accounts not be readily accessible to employees. Establishing a vesting period is one way to limit access; employees have rights to the funds in their accounts only when they become partially or fully vested. Another way to limit access is to establish strict rules for making payments from employees accounts, such as upon retirement, death, permanent disability, or termination of employment. Less strict rules may allow for withdrawals under certain conditions, such as financial hardship or medical emergencies. Nevertheless, whatever rules a company may adopt for its profit-sharing plan, such rules are subject to IRS approval and must meet IRS guidelines.
The IRS also limits the amount that employers may contribute to their profit-sharing plans. The precise amount is subject to change by the IRS, but 1996 tax rules allowed companies to contribute a maximum of 15 percent of an employee's salary to his or her profit-sharing account. If a company contributed less than 15 percent in one year, it may exceed 15 percent by the difference in a subsequent year to a maximum of 25 percent of an employee's salary.
Companies may determine the amount of their profit-sharing contributions in one of two ways. One is by a set formula that is written into the plan document. Such formulas are typically based on the company's pretax net profits, earnings growth, or some other measure of profitability. Companies then plug the appropriate numbers into the formula and arrive at the amount of their contribution to the profit-sharing pool. Rather than using a set formula, companies may decide to contribute a discretionary amount each year. That is, the company's owners or directors—at their discretion—decide what an appropriate amount would be.
Once the amount of the company's contribution has been determined, different plans provide for different ways of allocating the funds among the company's employees. The employer's contribution may be translated into a percentage of the company's total payroll, with each employee receiving the same percentage of his or her annual pay. Other companies may use a sliding scale based on length of service or other factors. Profit-sharing plans also spell out precisely which employees are eligible to receive profit-sharing distributions. Some plans may require employees to reach a certain age or length of employment, for example, or to work a certain minimum number of hours during the year.
Although profit sharing offers some attractive benefits to small business owners, it also includes some potential pitfalls. It is important for small business owners who wish to share their success with employees to set up a formal profit sharing plan with the assistance of an accountant or financial advisor. Otherwise, both the employer and the employees may not receive the tax benefits they desire from the plan. Also, small business owners should avoid making mentions of profit sharing or stock ownership to motivate employees during the heat of battle. Such mentions could be construed as promises and lead to lawsuits if the employees do not receive the benefits they feel they deserved.
Blencoe, Gregory J. "Utilizing Profit Sharing to Motivate Employees: The Logic Behind Sharing a Piece of the Pie." Business Credit. September 2000.
Dietderich, Andrew. "Survey: Pay based on performance gains ground." Crain's Detroit Business. 3 April 2006.
"In Depth Profit Sharing: Share Peace of Mind." Employee Benefits. 12 January 2006.
Jones, Dan. "How Safe is Your Retirement Plan?" Paraplegia News. December 2005.
"US: Chrysler to profit-share around $650 per worker." just-auto.com . 17 February 2006.
U.S. Department of Labor. Bureau of Labor Statistics. National Compensation Survey: Employee Benefits in Private Industry in the United States, March 2005. August 2005.
Hillstrom, Northern Lights
updated by Magee, ECDI
Profit sharing is an organizational incentive plan whereby companies distribute a portion of their profits to their employees in addition to prevailing wages. Profit sharing can generate benefits to the company by fostering greater employee cooperation, reducing labor turnover, raising productivity, cutting costs, and providing retirement security. Profit sharing gives employees a direct stake in the profitability of a company, creating an atmosphere in which employees want the business to succeed as much as management does.
Profit sharing was quite common in primitive fishing and farming economies; in fact, it still persists among fisherman in many parts of the world. Albert Gallatin, Secretary of the Treasury under Presidents Jefferson and Madison, introduced profit sharing into his New Geneva, Pennsylvania, glassworks in the 1790s. Profit-sharing plans as we know them today were developed in the nineteenth century, when companies such as General Foods and Pillsbury distributed a percentage of their profits to their employees as a bonus. The first deferred profit-sharing plan was developed in 1916 by Harris Trust and Savings Bank of Chicago. Profit sharing was also instrumental during World War II, enabling wartime employers to provide additional compensation to their employees without actually raising their wages.
FORMS OF PROFIT SHARING
There are three basic types of profit-sharing plans: cash plans, deferred plans, and combination plans. Cash plans distribute cash or stock to employees at the end of the year. The main drawback of this plan is that employee profit-sharing bonuses are taxed as ordinary income. Even if the distribution takes the form of stock or some other payment, it becomes taxable as soon as the employee receives it.
Deferred plans direct profit shares into a trust fund on behalf of individual employees and distribute them at a later date, often at retirement. The Internal Revenue Service (IRS) allows immediate taxation to be avoided in this plan. The deferred profit-sharing plan is a type of defined-contribution plan. A separate account is established for every employee. The accounts increase as contributions are made to them, earning interest or capital gains. Qualified deferred profit-sharing plans give employees a variety of investment choices for their accounts; these choices are common when outside firms manage the accounts. These plans are often used in conjunction with a 401(k) plan, a common retirement plan for U.S. employers. Combination plans pay part of the profit share out directly in cash and defer the remainder into a trust fund.
It is becoming less common for companies to manage their own accounts, due to the fiduciary responsibilities and liabilities involved with them. Instead, companies typically contract the responsibility to financial management firms. The amount of future benefits depends on the performance of the account. The balance of the account will include the employer's contributions from profits, any interest earned, any capital gains or losses, and possibly any forfeiture from other plan participants, which may occur when participants leave the company before they are vested (that is, eligible to receive the funds in their accounts); the funds in their accounts are then distributed to the other employees' accounts.
The time required to become fully vested varies from company to company. Immediate vesting means employees are entitled to the funds in their accounts as soon as their employer makes the contribution. Some companies utilize partially vested schedules, entitling employees to, say, 20 percent of the account before gradually becoming fully vested over a period of time. Establishing a vesting schedule is one way to limit access to the account. Another way is to create strict rules as to when payments can be made from employees' accounts, such as at retirement, death, disability, or termination of employment.
The IRS limits the amount that employers may contribute to their profit-sharing plans. In 2002, the federal
government increased the maximum profit-sharing contribution from 15 percent to 25 percent, with a specific dollar-amount cap that may vary by year; as of 2008, the 25 percent contribution is capped at $46,000.
Individual companies may determine the amount of their contributions in one of two ways. One is a set formula written into the plan document. Formulas are commonly based on the company's pre-tax net profits, earnings growth, or another measure of profitability. Some companies determine a certain amount to contribute each year, settled on by the board of directors.
Many companies incorporate profit-sharing plans when economic times are hard and they are unable to provide guaranteed wage increases. Chrysler Corporation, for example, developed a profit-sharing plan for its union and non-union employees in the economic recession of 1988. The plan was incorporated into the union contract in exchange for wage concessions made by its workers. Although harsh economic times made contributions small, by 1994 (when the economy had recovered) Chrysler was paying an average bonus of $4,300 per person to 81,000 employees, for a total of about $348 million.
Many companies are also encouraged to develop profit-sharing programs because they provide significant tax advantages, which can benefit higher-paid as well as lower-paid employees. IRS regulations allow the deductibility of the employer's profit-sharing contributions as a business expense and also allow the deferral of this money into a trust without any tax liabilities until the money is received (usually at retirement, disability, death, severance of employment, or under withdrawal provisions), at which point the employee is usually in a lower tax bracket.
The Employee Retirement Income Security Act of 1974 (ERISA) is the primary legislation regulating the standards for pension plans and other employee-benefit plans. The intent of the ERISA was to protect employee rights under plans such as corporate pensions, deferred profit sharing, stock-bonus plans, and welfare. ERISA does not mandate companies to establish a profit-sharing plan, nor does it require any minimum benefit levels. ERISA did, however, establish guidelines for participation, vesting, funding, fiduciary standards, reporting/disclosing, and plan-termination insurance.
ADVANTAGES AND DISADVANTAGES
Profit sharing has become one of a new breed of incentives called total system incentives. These incentives link all of the employees of a company to the pursuit of organizational goals. A common misconception of profit sharing is that it is more suited for smaller companies where employees can more easily see the connection between their efficiency and company contributions. In actuality, profit sharing is being successfully utilized in large and small companies, labor-intensive and capital-intensive industries, mass production and job-shop situations, and industries with volatile profits as well as those with stable profits. Profit sharing can reward employee performance, seniority, and thrift, depending on the design of the plan.
Although the concept has experienced a tremendous growth rate, profit-sharing plans do not always work. Roughly 2 percent of deferred plans are terminated annually—some as a result of mergers, others because companies are liquidated or sold. The majority of terminations tend to occur after consecutive years of losses, when investment performance is poor, or when ineffective communication has resulted in lack of employee understanding, appreciation, or interest. Profit sharing may also entail some disadvantages for a company. Such plans may limit the company's ability to reward the performance of individual employees, for example, since the pay for all employees moves up or down according to a formula. At smaller companies, tying employee compensation to often uncertain profits may result in drastic income swings from one year to the next. Finally, some critics claim that profit sharing may encourage employees to focus only on increasing profitability, perhaps at the expense of quality or other goals.
Allen, Everett T. Jr., et al. Pension Planning: Pensions, Profit Sharing, and Other Deferred Compensation Plans. 9th ed. New York: McGraw Hill/Irwin, 2002.
Blencoe, Gregory J. “Utilizing Profit Sharing to MotivateEmployees: The Logic Behind Sharing a Piece of the Pie.” Business Credit. September 2000.
Girard, Bryan. “Is There an ESOP in Your Company's Future? An Employee Stock Ownership Plan Could Enhance Your Company's Bottom Line.” Strategic Finance May 2002.
Metzger, Bert L. How to Motivate with Profit Sharing. Evanston, IL: Profit Sharing Research Foundation, 1978.
Profit Sharing/401(k) Council of America. “50th Annual Survey of Profit Sharing and 401(k) Plans.” PSCA.org, 4 September 2007. Available from: http://guest.cvent.com/EVENTS/Info/Summary.aspx?e=4a234333-4fa7-4c57-bf3f-604c19d62ddf.
PROFIT SHARING. The U.S. Department of Labor defines a profit-sharing plan as a "defined contribution plan under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution."
Annual cash bonuses, particularly to white-collar or administrative workers, have a long history in Europe. Plans to distribute a percentage of profits to all workers appeared in the United States shortly after the Civil War. These plans were largely confined to medium-sized family or paternalistic companies and never became widespread before their general abandonment during the Great Depression. The difficulties encountered in such plans were formidable: many employers feared the effect on prices and competitors from a public disclosure of large profits; it was hard for managers to see how a share in profits could raise the productivity of many types of labor; workers feared that a promise of a bonus based on profits was in fact an excuse for a low wage, antiunion policy; and most working-class families preferred a reliable to a fluctuating income. As a consequence, when unions became strong in the manufacturing field after 1940, their leaders proposed fixed fringe benefits such as group insurance, pensions, or guaranteed annual wages, rather than profit sharing.
An allied movement, particularly popular in the prosperous 1920s, was the purchase of stock in the company by employees. Management offered easy payments and often a per-share price lower than the current market figure. It was hoped, as in the case of profit sharing, that such plans would reduce labor turnover and give workers a stronger interest in company welfare. The decline in value of common stocks in the Great Depression to much less than the workers had paid for them, especially when installment payments were still due, ended the popularity of employee stock-purchase plans.
Annual bonuses in stock, cash, or both continued in many companies as an incentive to employees in management positions. Especially when managerial talent has been scarce, as in the booms of the mid-1950s or 1960s, options to buy large amounts of stock over a span of years at a set price were used to attract and keep executives.
In the 1960s, the Supreme Court ruled that professionals could incorporate, which meant that they could also take advantage of retirement benefits that paralleled plans available to people working in corporations. In 1963, Harry V. Lamon, Jr. drafted the first master Keogh plan, a tax-deferred retirement program for self-employed people and unincorporated businesses.
The Employment Retirement Income Security Act was passed in 1974 to protect retirement plan participants. This act established numerous reporting and disclosure rules and provided additional incentives for Keogh plan participants. Another important element of the act was the establishment of employee stock-ownership plans.
Retirement plans were simplified by the Revenue Act of 1978, which, among other changes, established the 401(k) retirement plans. A contributor to a 401(k) plan is not taxed on the income deposited in the year it was earned; the money is taxed at the time of withdrawal.
While each of the legislative changes over the last third of the twentieth century addressed different elements of profit sharing plans, the overall focus has shifted from a clearly defined benefit to defined contribution.
Allen, Everett T. Jr., et. al. Pension Planning: Pensions, Profit Sharing, and Other Deferred Compensation Plans. 8th ed. New York: McGraw Hill/Irwin, 1997.
See alsoEmployment Retirement Income Security Act, Retirement Plans .