A profit-sharing program is exactly as it sounds: Your company gives employees a percentage of its quarterly or annual earnings. It's typically based on your organization's profit, which is your total revenue minus total expenses. Profit-sharing plans are great for companies that consistently make a profit, have a rainy day fund for operating expenses, and have low or no debt payments.
Profit sharing can involve cash bonuses or contributions to a defined contribution (DC) plan, like a tax-advantaged retirement account. Although there aren't many restrictions around contribution amounts, you must take steps to set up your program correctly. Here's how to create a profit-sharing plan.
Understand profit-sharing program requirements
Companies of any size can implement a profit-sharing plan, and you can add it to your employee benefits package, even if you already offer other retirement programs, such as a 401(k). You don't have to contribute or give everyone the same amount every year. However, the IRS requires companies to "have a set formula for determining how the contributions are divided" and show that "benefits do not discriminate in favor of the highly compensated employees."
Unlike a 401(k), only the employer contributes to a profit-sharing plan. The IRS stated, "If a salary deferral feature is added to a profit-sharing plan, it is a 401(k) plan." Additionally, when you begin a profit-sharing plan (and annually thereafter), you must file IRS Form 5500. Employers can contribute up to $66,000 or 100% of compensation, whichever amount is less for 2023 ($61,000 for 2022, and the IRS provides cost-of-living adjustments yearly).
[Read more: Employee Benefits 101: What to Offer and How to Decide]
Companies of any size can implement a profit-sharing plan, and you can add it to your employee benefits package, even if you already offer other retirement programs, such as a 401(k).
Profit-sharing plan considerations
Before drafting your initial profit-sharing program, consider how you will handle plan management, eligibility, and contributions. Companies can establish and oversee the program themselves or outsource it. A third party, such as a bank, insurance company, or mutual fund provider, handles participation, vesting, reporting, and other fiduciary responsibilities for the latter.
You'll also want to determine basic rules for participation. For example, you may require that employees be 21 years or older, be U.S. citizens, or have been with your company for 12 months. Lastly, decide how much you'll give participants during the years your company contributes. The IRS explains that the comp-to-comp method is a common formula for calculating contributions. Ramsey Solutions estimates that "most businesses participating in profit sharing probably give the people on their team who qualify up to 10%."
Steps to complete before plan implementation
The IRS provides details about profit-sharing plans for small employers. But it's a good idea to work with a professional who can answer your questions about federal regulations and tax laws. Work with your plan administrator to create documents and involve your human resource team so they are equipped to answer basic questions or refer staff to the correct person.
The Department of Labor (DOL) provides a guide for small businesses, outlining the actions required before plan implementation, such as:
- Develop a profit-sharing plan document: Employers must follow the instructions in this document, guided by 26 U.S. Code § 401 - Qualified pension, profit-sharing, and stock bonus plans. This includes the formula used to calculate contributions, vesting schedules, and how you will carry out essential functions, such as depositing contributions.
- Establish a summary plan description (SPD): This document is usually part of your profit-sharing plan information. It describes participants' rights and responsibilities according to the Employee Retirement Income Security Act (ERISA). Investopedia said the SPD must "answer specific questions such as the plan name, the plan's IRS-assigned number, the employer's name and address, and a statement of health and accountability rights."
- Set up a trust for assets: All funds for a profit-sharing program must reside in a trust for participants and their beneficiaries unless established through insurance contracts. DOL said, "The trust must have at least one trustee to handle contributions, plan investments, and distributions." The trustee is responsible for the plan's financial integrity.
- Create a recordkeeping system: Your records must document contributions, investments, earnings and losses, benefit distributions, and expenses. Your company or the third party overseeing the plan uses the records to prepare the plan's annual report required by the federal government.
- Share plan information with staff: All eligible participants must receive notification about the program's benefits, features, and rights. In addition, employers must provide an SPD to participants upon joining, beneficiaries when receiving benefits, and periodically as long as the plan exists.
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