How Does Profit Sharing Work?

by Luke Arthur; Updated September 26, 2017

When a company wants to make sure that its employees are motivated, giving them a share of the profit is a good place to start. With a profit sharing plan, the company shares a portion of the money that it makes with each employee. This can be set up as a retirement plan or as a cash profit sharing plan.

Retirement Plan

Many companies have profit-sharing retirement plans. With this type of plan, the company sets up a trust -- each year it puts a portion of the profit that it generates in each person's retirement account. In most cases, employees cannot get access to the retirement money until they have worked for the company for a certain number of years. This gives the company a way to retain talented employees as they will not want to leave retirement money behind.

Cash Profit Sharing Plan

Another type of profit sharing plan involves cash profit sharing. With this type of plan, the company simply takes the profit that is generated for the year and then divides it between the employees that participate in the plan. With this approach, the money is simply added to the employee's salary for the year and is taxed at their regular marginal tax rates. This is a type of bonus that comes with working for the company.

Rules

A profit sharing plan can be set up with several different rules, depending on the employer. If the company sets up the plan as a retirement benefit, it is subject to some rules that are set forth by the IRS. For example, 70 percent of your employees with at least one year of service have to participate in the plan. You also cannot contribute more than the annual maximum of $49,000 per employee, as of 2010. Each employee can only have a maximum of 25 percent of their income put into the plan.

Distributions

When a company sets up a profit sharing plan, it can distribute the profits to employees in any way that it chooses. In many cases, the company will simply distribute the profits once a year to the employees. In other cases, the company will distribute the money once per quarter so that the employees can gain access to it quicker. If a company does not have a profitable year, it can also elect to skip contributions for the year.

About the Author

Luke Arthur has been writing professionally since 2004 on a number of different subjects. In addition to writing informative articles, he published a book, "Modern Day Parables," in 2008. Arthur holds a Bachelor of Science in business from Missouri State University.