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.
Small business profit-sharing program requirements
Profit-sharing requirements for small businesses include meeting IRS eligibility rules, creating a plan document, and complying with regulations governing program administration. Companies of any size can implement a profit-sharing plan. You can add it to your employee benefits package, even if you already offer other retirement programs, such as a 401(k).
Employer contributions are discretionary, so you don’t have to contribute each year. Amounts may change from year to year, based on your profits or another goal. 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."
However, the IRS requires companies to "have a set formula for determining how the contributions are divided." A common formula for calculating contributions is the comp-to-comp (pro rata) method. But depending on your business goals, you may want to consider age-weighted or new comparability formulas.
Before drafting your initial profit-sharing program, consider how you will handle plan management, eligibility, and contributions. The Department of Labor (DOL) provides a guide for small businesses, outlining the actions required before plan implementation.
Legal and tax implications for small businesses
Like other small-business retirement plans, profit-sharing programs must comply with IRS filing requirements and nondiscrimination rules for contributions. And once you set up a profit-sharing plan document, you are bound by what’s written in it. The IRS looks at the document, not your intentions or last-minute, unreported changes to allocations, eligibility, or timing.
Let’s go over the important factors:
- IRS nondiscrimination testing: Profit-sharing plans that inadvertently favor owners or highly compensated employees can trigger corrective contributions or disqualification.
- Fiduciary duties: Even if a third party administers the plan, business owners hold some responsibilities for plan management, including their choice of plan administrator.
- Government reporting: Plans must file IRS Form 5500 annually, which discloses information about the program and operations. This form is filed electronically through EFAST2.
- IRS contribution limits for retirement plans: In 2026, the defined contribution plan limit is $72,000 or 100% of compensation, whichever amount is less. The IRS provides cost-of-living adjustments yearly.
- Compliance and corrections: To continue benefiting from tax-deductible contributions after a late filing or other error, employers or plan sponsors can participate in guided or self-correction programs.
The IRS provides details about profit-sharing plans for small employers. But it's a good idea to work with a legal professional who can answer your questions about federal regulations and tax laws.
How to set up a profit-sharing plan (step-by-step)
Set up a profit-sharing plan by creating your plan documents, establishing a trust, developing a recordkeeping system, and distributing program information. Companies can establish and oversee the program themselves or outsource it.
A third party, such as retirement plan providers, banks, insurance companies, or mutual fund providers, handle participation, vesting, reporting, and other fiduciary responsibilities. Follow these steps when working with a retirement plan provider or setting up a profit-sharing program yourself.
1. Develop a profit-sharing plan document
The profit-sharing plan document outlines the program's essential functions. To qualify for tax-deductible contributions, it must comply with the legal requirements in 26 U.S. Code § 401 - Qualified pension, profit-sharing, and stock bonus plans.
Here are a few key items the document will list:
- Eligibility requirements: Define who is eligible to participate in the profit-sharing program. 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.
- Allocation formula: List the formula you’re using to calculate contributions and the step-by-step calculation method. The document often describes how the formula meets IRS nondiscrimination requirements.
- Vesting schedule: Explain how long employees must work to fully own their balance, whether cliff or graded vesting.
2. 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.
3. 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 (IRS Form 5500) required by the federal government.
4. Share summary plan description (SPD) with eligible staff
Employers must provide an SPD to participants upon joining, beneficiaries when receiving benefits, and periodically as long as the plan exists. 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).
In addition, all eligible participants must receive notification about the program's benefits, features, and rights. 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.
Set up a profit-sharing plan by creating your plan documents, establishing a trust, developing a recordkeeping system, and distributing program information.
4 common mistakes to avoid when setting up profit-sharing programs
Profit-sharing plans can backfire if employees don’t understand how daily work affects profits or when payouts feel inconsistent, unfair, or poorly explained. Avoiding these basic mistakes early can prevent compliance problems and frustration later. Here are four problems with profit sharing that you can fix before issues arise.
Being vague about profit-sharing goals
If employees don’t know what your business is trying to improve, then profit sharing loses its meaning. Unclear goals can erode trust and motivation. Incentive plans work best when people understand what drives profits or how success is measured. More importantly, they need to know what part they play in that overarching company goal.
- Solution: Explain in plain language what profit means for your small business, how the company goal increases it, and come up with two to four ways employees can make a difference, like upsells or on-time delivery.
Not communicating about what’s driving results
When profit-sharing discussions occur only once a year or through quarterly emails, employees—especially frontline workers—may feel it’s an abstract, out-of-reach idea. That’s compounded by Gallup’s analysis, which finds that “only one in three workers in the U.S. strongly agree that they received recognition or praise for doing good work in the past seven days.” Employees need to see a connection between their day-to-day actions and revenue, margins, or costs.
- Solution: Regardless of payout timing, keep a consistent communication schedule. Share a brief scorecard listing revenue, costs, and one or two operational drivers, and regularly talk to teams about how individual roles and team performance contribute to profitability.
Focusing only on short-term results
Profit-sharing plans that rely heavily on quarterly or annual numbers can unintentionally put too much weight on performance to the detriment of long-term sustainability. Focusing only on short-term profits can discourage improvements or investments. Even worse, it can reward bad behavior, like cutting corners or deferring maintenance.
- Solution: Balance your short-term financial metrics (profit, revenue) with at least one long-term goal (customer or employee retention, safety, or efficiency).
Making payouts feel opaque or unfair
Business owners and administrators know it’s a fair formula and that, in some cases, payouts are smaller or paused. But when profit-sharing payouts appear uneven and lack a clear explanation, people come up with their own ideas. Once that happens, it’s a lot harder to get that trust back.
- Solution: Publish the basics, explaining what’s measured and how it’s calculated for different roles across departments. Use visuals to show how different jobs impact profitability or how the allocation formula connects to business goals. Discuss when decisions happen and what can shrink the pot (slow season, unexpected costs, reinvestment, or economic downturn).
Comparing profit sharing to other incentive plans
The main difference between profit sharing, bonuses, retirement matches, and equity or stock incentives is the predictability of employer costs and the alignment of rewards with company-wide outcomes.
See how profit sharing stacks up to other retirement and incentive plans:
- Profit sharing vs. employee bonus plans: Employee bonuses reward short-term or individual performance and are taxable wages. They’re easier to administer than profit sharing, but don’t connect long-term effort to company success.
- Profit sharing vs. retirement match plans: A 401(k) match requires regular employer contributions when employees defer pay, whereas profit-sharing contributions are discretionary, and you can decide to pay or not pay annually.
- Profit sharing vs. stock or equity benefits: Equity compensation is more complex than profit sharing. It involves valuation, dilution, and regulations, ultimately affecting ownership and succession planning.
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