How Does Profit Sharing Work as an Employee Benefit? (2024)

In a tight labor market, many employers are looking for ways to improve employee retention (which can help control recruiting costs). Profit-sharing plans may help strengthen employee loyalty, encourage teams to work toward shared goals, and increase productivity and efficiency.

But not all profit-sharing plans are the same, and different plans can have varying effects on employees’ earning potential, as well as tax obligations for employees and employers alike.

At the same time, profit sharing can give businesses quite a bit of flexibility with regard to contributions from year to year. That can enable a wide range of organizations to create incentive plans that can effectively align employees with the company’s mission and goals to increase loyalty and productivity.

So, what are the different types of profit-sharing plans employers can consider? How do qualified profit-sharing plans differ from employee stock ownership plans? And how can you determine which approach is right for your company?

Who Can Offer a Profit-Sharing Plan and How Does it Work?

Both nonprofit and for-profit organizations of all sizes can offer profit sharing, whether or not they offer a 401(k) or similar qualified retirement plan, or other retirement plans. Profit-sharing plans can be combined with a 401(k). When combined, the employer’s annual profit-sharing amount can be contributed directly into the employee’s retirement savings account, along with the employee’s contributions and company match (if the company provides a matching contribution).

Profit-sharing is a defined contribution (DC) benefit, like a 401(k) plan, and the contributions are discretionary. The employer can decide on an annual basis whether and how much to allocate to profit-sharing contributions, and the company has to determine an allocation formula that meets qualified plan requirements, including nondiscrimination testing, in the years it makes profit-sharing contributions.

As a qualified retirement plan, profit-sharing contributions are tax deductible up to 25% of the compensation paid during the taxable year to all employees. That means profit-sharing contributions can help lower a company’s tax obligations while increasing employees’ retirement savings — certainly a win-win.

Profit-sharing contributions that are made to an employee’s retirement savings account are also tax-deferred for the employee. Taxes are paid when the employee takes a distribution from the account.

The Internal Revenue Service (IRS) limits overall annual employer contributions paid to a participant’s account. Currently, that amount cannot exceed the lesser of:

1. 100% of the participant’s compensation, or
2. $61,000 for 2022 ($67,500 including catch-up contributions)

The maximum amount of compensation that can be considered when determining these limits is $305,000 in 2022. Limits can change annually, subject to Internal Revenue Code Section 402(g). Remember, regulatory compliance is required to ensure ongoing qualification for tax benefits. Errors are subject to the Employee Plans Compliance Resolution System (EPCRS), which allows plan sponsors to identify and fix mistakes to maintain qualified plan status.

As with other qualified plans, businesses implementing a profit-sharing plan are required to file IRS Form 5500 and disclose all plan participants.

What is a Typical Profit Share Percentage?

Contributions vary widely and there’s no specifically required percentage for employers, but most businesses end up between two percent and 10%, with the greatest majority hovering around three to five percent. That means the company decides to divide three to five percent of annual profits among participants.

Just as percentages vary, allocation formulas also vary—subject to nondiscrimination testing. Simplified profit-sharing plan documents that are pre-approved by the IRS can be purchased from consulting companies or financial institutions for those looking for an easy way to get started.

Is an ESOP Different From Profit Sharing?

An ESOP offers another very effective way to help employers align employees’ focus with business goals and encourage a shared ownership mentality and culture through beneficial employee ownership of the company itself.

An employee stock ownership plan (ESOP) is a qualified benefit plan and, like profit-sharing plans and 401(k) plans, is governed by the Employee Retirement Income Security Act of 1974 (ERISA). That means, like a profit-sharing plan, ESOP contributions are tax-deductible and subject to close scrutiny by the Department of Labor and the IRS.

All three plan types use a trust governed by a plan trustee who is a fiduciary for the plan participants. As qualified plans, eligibility and vesting rules are generally the same. Employees are taxed in the same way on distributions from 401(k) plans, profit-sharing plans, and ESOPs.

ESOP rules tend to be more complex than profit-sharing plans, but the tax advantages can also be significantly greater in many cases—and, unlike profit-sharing plans, ESOPs can borrow on company credit to purchase stock for the plan.

Learn more about how an ESOP works by downloading our free infographic, Understanding the Mechanics of an ESOP.