What is Profit Sharing?

Typically, the program grants a proportionate share of the profits of the business to employees according to a formula spelled out in the employee benefits documentation. This is a type of variable pay plan, with the leadership of the business deciding what percentage of the annual profits is shared. A profit sharing plan varies from company to company and can include actual ownership through equity sharing (stocks and bonds) or profit sharing in the form of cash. Sometimes, profit sharing is only available to those at a certain level of the company, such as managers and those above them on the organizational chart.

If the profit sharing formula distributes benefits as a percentage of annual pay, which is common, those earning less receive fewer dollars than those with higher paying positions. A highly paid executive may see large profit-sharing bonuses; up to 40 or 50 percent of the annual salary is not unusual. Employees who earn less may only receive 1 to 2 percent of salary through profit sharing.

This disparity is based on the principle that those earning higher wages are responsible for managing the company's decisions, taking risks, and providing leadership. While lower level employees receive a set annual salary and maybe a modest raise each year, employees higher up in the organization know that their compensation depends directly on the company's success.

What is Equity Sharing?

Equity sharing is a type of profit sharing that gives employees long-term ownership in the business through stock options, membership shares, and other similar vehicles. This type of plan is sometimes available only to company founders, executives, and upper management. However, it's increasingly common to offer such a plan to all employees. Technical information about equity sharing tools such as stock options, performance shares, stock appreciation, and restricted stock is readily available.

When are Profit Sharing Payments Made?

Profit sharing payments are usually made after a company has been profitable for a specified period of time, when a contract requires it, or when a leader in the company requires it. If there is no contract governing the profit sharing plan, the company can change the terms anytime.

The profit sharing calculation usually takes place once a year after the profitability of the organization for that year is finalized. However, some companies pay out profit-sharing bonuses quarterly. This places the payment as close as possible to the goal achieved in order to increase the impact of the employee recognition.

What Documents are Required?

Employers have great flexibility in setting up the profit sharing plans for their company; however, a written plan must be in place with all the relevant documentation. Careful records are required, including a strict fiduciary responsibility policy. These are legal documents, and they must be followed to the letter. The Department of Labor recommends:

  • Adopting a written plan document.
  • Setting up a trust for the plan's assets.
  • Maintaining a record keeping system.
  • Distributing this information to all eligible employees.

What are the Benefits of a Profit Sharing Plan?

Profit sharing plans convey to employees that everyone is working together on the same team. Common goals are rewarded equally to reinforce good service to customers. When employees know that monetary rewards are available if the company does well, they are more likely to do their part to make sure that happens. They have a vested interest in seeing the business do well.

For example, if the sales department pays commissions based on employee performance, that plan only incentivizes the individual and doesn't build a sense of team. Sharing the commissions with all of the department's employees through profit sharing encourages cooperation and a team effort to reach sales goals.

What are the Weaknesses of a Profit Sharing Plan?

When compensation is based on a profit sharing plan, the individual may have trouble understanding how his or her work impacts the bottom line of the company. While the employee enjoys the profit sharing distribution, that can grow into a feeling of entitlement rather than a motivating factor. Senior employees make the decisions that most directly impact profitability, so lower level employees may not understand how their day to day tasks affect the bottom line. Also, when employees receive profit-sharing checks regularly without regard to individual performance, they may see no reason to strive for improvement.

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