A profit sharing plan is an employer funded incentive program where profit-based contributions are paid directly into individual employee accounts. A benefit once exclusive to only the largest companies, lucrative profit sharing plans are now offered to employees by businesses of all sizes.
The business practice of sharing profits with employees dates back to the primitive fishing and farming villages of the early 1790s. In 1900, Pillsbury Mills and General Foods introduced the first cash profit sharing plans in the form of employee year-end bonuses. Chicago’s Harris Trust and Savings Bank, in 1916, took the concept a step further and established the first deferred profit sharing plan. When federal legislation passed in 1939 allowing monies in deferred plans to remain tax exempt until disbursement, the popularity and practice of profit sharing saw a dramatic increase that has lasted through today.
There are three basic types of profit sharing plans: a deferred plan, a cash plan and a combination plan. In a deferred profit sharing plan, the employer contributions accrue over time in employee accounts and are typically disbursed upon retirement, death or however specified in the provisions of the plan. In a cash profit sharing plan, an employer may disburse cash or checks to employees whenever profits are figured. Combination profit sharing plans allow employees to defer part of the allocation and accept cash for the remaining amount. Companies can also provide employees with allocation investment options such as stocks and mutual funds.
A profit sharing plan must clearly state the formula, if any, used to figure an employee's allocation of the profit. Typically, the amount disbursed or deposited is based upon an employee’s years of employment or annual wage compensation. While employees are not required to contribute, many plans permit employees to contribute with certain restrictions.
Profit sharing plans provide many benefits to both employers and employees. For the employer, the provision of profit sharing represents a substantial tax benefit, an excellent new-hire incentive and a productivity motivator for existing employees. For the employee, a profit sharing plan provides security for retirement, investment opportunities and a way of sharing in the success of the company. Most company profit sharing plans permit partial in-service withdrawals and loan options during active employment.
For employees, the profit sharing allocations of cash plans are taxed immediately. Allocations received for deferred plans and the accruing balances are tax exempt until disbursement. In a combination profit sharing plan, only the cash portion of the allocation is taxed when disbursed. Most plans permit early, in-service withdrawals but not without a penalty tax payment. To receive contribution tax breaks, the employer must first disclose plan provisions, account information and financial statements according to the regulations governing profit sharing under the Employee Retirement Income Security Act (ERISA) of 1974. In addition, the IRS places certain restrictions on contribution levels as well as limitations on the total amount that an employer can take as a federal tax deduction.