Profit sharing refers to the process whereby companies distribute a portion of their profits to their employees. Profit-sharing plans are well established in American business. The annual U.S. Chamber of Commerce Employee Benefits Survey indicates that somewhere between 19 and 23 percent of U.S. companies have offered some form of profit sharing since 1963. Other estimates place the number of companies offering profit-sharing plans in the 1990s somewhere between one-fourth and one-third of all U.S. firms. For small businesses, profit sharing provides an important means of increasing employee loyalty and tying employee compensation to company performance. Profit sharing is a particularly attractive option for newer small businesses with uncertain profit levels, as it allows business owners to share the wealth during good times without obligating them to do so during lean years.
The Employee Retirement Income Security Act of 1974 (ERISA) provided a boost in the use of profits-haring plans. ERISA regulates and sets the standards for pension plans and other employee benefit plans. Many employers found that a simple profit-sharing plan avoided many of ERISA's rules and regulations that affected pension plans.
TYPES OF PROFIT-SHARING PLANS
Companies may use any number of different formulas to calculate the distribution of profits to their employees and establish a variety of rules and regulations regarding eligibility, but there are essentially two basic types of profit-sharing plans. One type is a cash or bonus plan, under which employees receive their profit-sharing distribution in cash at the end of the year. The main drawback to cash distribution plans is that employee profit-sharing bonuses are then taxed as ordinary income. Even if distributions are made in the form of company stock or some other type of current payment, they become taxable as soon as employees receive them.
To avoid immediate taxation, companies are allowed by the Internal Revenue Service (IRS) to set up qualified deferred profit-sharing plans. Under a deferred plan, 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.
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 pre-tax 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 profitsharing 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.