A profit sharing plan can be an innovative compensation strategy for business owners to motivate and reward their employees. There are 2 kinds of profit sharing plans: those that defer profits to a retirement plan and those that make profits a part of the base compensation plan. We also will talk about gainsharing here, another popular option that is separate from profit sharing, but commonly confused with it.

What Is Profit Sharing?

Profit sharing is when a company contributes a portion or percentage of its pre-tax profits to a pool that will be distributed amongst its employees. The amount distributed to each employee may be weighted by the employee’s base salary, or by their ranking, so that employees with higher base salaries receive a larger portion of the pool of profits (which, in theory, motivates management to be tied to the bottom line).

Generally, profit sharing is is done on an annual basis and has some eligibility requirement, like tenure with the company for more than 1 year.

What is a Profit Sharing Plan?

A profit sharing plan, also known as a PSP, is the document that specifies what share of profits employees will receive, eligibility requirements, and other details. PSPs are as old as taxes in the US and have become a staple in the economy once business owners realized that profit sharing could reduce their tax liabilities.

Between history, changes in the economy and business needs, profit sharing plans have evolved into 2 kinds:

Two Main Kinds of Profit Sharing

  1. Retirement Plan Deferrals
  2. Profit Sharing as Base Compensation
Plan Type/FeaturesRetirement Plan DeferralsProfit Sharing as Base Compensation
Basic PremisePercentage of profits go into a long-term retirement account like a 401KPercentage of profits are part of an employee’s compensation plan, almost like a bonus, to motivate them to perform
Where the Money GoesRetirement accountEmployee’s pocket
Employer Contributions RequiredDiscretionary and up to business owner, pending rules of the retirement policy.Employer must give out percentage promised in employment agreement.
Portability of PlanEmployee gets to take what is in their account with themEmployee does not get to take their share with them if they leave before profits are distributed

There is another type of plan that is commonly confused with profit sharing, but distinct in its own right:

Gainsharing

Similar to profit sharing, gainsharing is an incentive program where a company measures performances, likes sales, through a predetermined formula. If the company reaches it’s goal — say, sales revenue surpassing the previous year— then all employees will be rewarded, with the exact payout depending on how far they surpass the goal.

While gainsharing plans can look very similar to profit sharing plans, they’re typically more popular at a business that uses narrow operational measurements like productivity, quality, customer service, on-time delivery, and spending.

For example, let’s take ABC Lead Generation Software, which sells a web-based software as a service (SaaS) platform. In 2017, let’s say ABC account executives sell 1,000 more customers than anticipated and profits go up by an extra 30% than predicted (based on historical data and performance). If ABC has a gainsharing program, its employees would make out like bandits from a banner year that was 30% more than predicted.

How to Set Up a Profit Sharing Plan for Your Small Business

While companies can determine the exact numbers behind the setup of a profit sharing plan, they must set up an official plan document (similar to a 401K).

The Department of Labor recommends that business owners take the following steps to set up a profit sharing plan, regardless of which type they choose:

  • Adopt a written plan document,
  • Set up a trust for the plan’s assets,
  • Develop a recordkeeping system of some sort, and
  • Provide plan information to employees who are determined eligible

Businesses then decide if they want to do the administration and filing efforts on their own, or if they want to hire a 3rd party administrator (similar to commuter benefits or self-insurance). However, since companies must keep strict records and have a strict fiduciary responsibility for the plan, we recommend using a third party administrator to make sure you stay in compliance, especially since you may need to change your plan at some point. All documentation of a profit sharing plan must be airtight, so a third party truly is the best option.

Some third party administrators who do profit sharing plans include independent financial brokers or companies who also offer retirement benefit. Since these firms tend to be local, we recommend finding a TPA by using your network to ask for a referral, or to ask a local small business association or potentially your state government’s recommended providers list, to find one closest to your small business.

Let’s now look in more detail at how to set up each kind of profit sharing plan.

How to Set Up Retirement Plan Profit Sharing

Once you find a broker who can help you administer a retirement plan profit sharing plan, they will most likely want to go over your company’s financial history in depth. They will also want to make you aware of the risks.

If you then decide to move forward, the broker will counsel you on how to decide:

  1. How much of the profit pie do you want to make “up for grabs”?
  2. What employees are eligible?
  3. Should you vary the amount available by employee level?

Then, the broker will get you set up for how to start your plan and get your employees onboarded with plan documents and paperwork.

But what if you want to set up a PSP as part of base compensation?

How to Set Up Profit Sharing as Base Compensation

Companies with a strong sales component that is in the hands of its employees might consider a compensation-based profit sharing plan. A number of industries, especially those with a lot of more traditional salespeople like software, use profit sharing as a motivator to perform.

Once you find a broker who can help you, they, like above, will want to go over your company’s financial history in depth. They will also want to make you aware of the risks, so that you can make an educated decision on if profit sharing is right for your business.

Then, when you are ready to move forward, you with your broker will need to work to determine:

  1. How much do you want to use profit to incentivize performance (without eroding quality)?
  2. What employees are eligible?
  3. Should you vary the amount available?

Then, the broker will get you set up for how to start your plan and get your employees onboarded with plan documents and paperwork.

Benefits of Having a Profit Sharing Plan

There are many potential benefits to having a profit sharing plan— although, many of them will depend on a strong company culture. For example, ideally, a PSP brings people together to work as a team towards one goal. However, your company culture and employees need to have matured into a team that can work together at this level, which includes impeccable communication, project management, and performance skills towards goals.

When done correctly and with the right team, the following benefits can happen in profit sharing:

  • Company performance and the bottom line improves as employees are motivated for the promise of shared profits;
  • Employees are encouraged to work together towards the success of the company and have a focus on the company’s profitability;
  • The costs of implementing the plan rise and fall with the company’s profitability, which can be nice versus a traditional 401K or other benefit plan that you have a set cost for, regardless of company health.

As Bob Shoyhet, the CFO of Melillo Consulting, who has implemented over a dozen profit sharing plans, elaborates that:

“You will find that employees become engaged in your company’s performance immediately. They will ask questions, they will ask how they can help. In a very real sense it becomes their company too.”

However, there are some risks and downsides of profit sharing as well.

Risks of Profit Sharing Plans

Profit sharing also has its risks and disadvantages:

  • The pay for employees moves up or down all together. In general, with profit sharing, there are no individual differences for merit or performance and discretionary bonuses are removed from compensation plans.
  • You have to share your company finances with your employees constantly. There is no privacy around your financials, and this can be a bit distressing for many business owners.
  • Profit sharing only focuses on the goal of profitability. This can lead to cutting corners, a downgrade in quality, or working the line people far harder than necessary.
  • Plans can result in drastic swings in earnings for employees which the employees may find difficult to cope with, leading to increased employee turnover during the “down” years— which is exactly when you don’t have time or money to spend on recruiting.
  • You start to swim in murky waters with FLSA and overtime laws, and you’ll need a strong way to recalculate employees’ pay. With that in mind, many companies only make “exempt” employeesavailable for the profit sharing plan, which can cause some conflict amongst the employees and management.
  • In the end, people are happy when they get a bonus and are upset when they don’t. You’ll swing constantly between them feeling like they “earned it,” versus a down year being just “the company’s fault”, which can be tough on morale.

Let’s now look at an example of what a small business is currently doing for their profit sharing plan, and their insights.

What Other Small Businesses Are Doing

The story of Be The Machine’s profit sharing plan has a number of great insights.

Patrick West, Owner and Founder of Be The Machine, explained to me that the company’s profit sharing plan was created on day 1 when he founded his marketing firm in NYC and Florida. He implemented it from the get-go because he feels it is important for employees to feel invested in the company and also for them to feel that the company is invested in them.

Be The Machine has a year-end profit sharing plan that is a part of compensation (not the retirement kind). The profit sharing plan is based on percentages; participating employees are granted a certain percentage of the company’s year-end profits. Profits are defined as revenues after all direct project costs (production, shipping, etc.) and indirect operational costs (salaries, rent, etc.) have been factored.

Patrick notes that it takes until March to calculate the previous year’s finances and the payments made to employees are defined as bonuses. So far, the system has gone incredibly smoothly over the past 2 years. However, Patrick notes that that might not always be the case as the company grows and changes over the coming years.

When asked why he chose this kind of profit sharing plan, instead of retirement contributions, Patrick shared that he wanted a plan for his business that was much more transparent and simple than at companies he previously worked at, and noted that modern employees, especially millennials, crave tangible benefits, which a compensation-tied PSP provides.

While he realized the white-knuckle nature of sharing company financials with all employees is apparent, he also felt it also gives them a reality check on actual entrepreneurship and how a business really works (versus how people maybe think it works).

Patrick elaborated that:

“Without a doubt, employees appreciate the money when it hits their account but I truly believe they value the plan’s existence and company’s transparency even more.”

However, if profit sharing still is not for you, let’s check out some alternatives.

Alternative Incentives to Profit Sharing

Profit sharing, with all of its documentation and potential risks, might seem like a bit too much for your company. However, you may still look for a way to connect your employees to your company’s bottom line and to the company’s mission in general.

Here are 4 alternative motivation and incentive ideas for your small business:

Idea 1: Monetary Bonuses based on Company Goals

A client I had on the West Coast has a very interesting bonus platform. They had 3 different revenue goals that were evenly paced throughout the year. If the company met those goals, everyone got a bonus. If the company didn’t, no one did (even the C suite). It was that simple.

This simple kind of philosophy could also work for your small business. Having something available more than annually is advised so that everyone stays motivated. Perhaps bi-annually, quarterly, or on the trimester like my client.

Idea 2: Monetary Bonuses based on Individual Goals

Maybe company goals don’t make sense for your business. If you make widgets (aka physical products) or have a strong sales component to your company base, like a restaurant where waitstaff can upsell, having individual revenue goals would make more sense to motivate your team. These goals should be fairly frequent (i.e. monthly for a restaurant) or at least bi-annual, quarterly, or on the trimester if you have sales commissions or sales revenue percentages available.

This is somewhat different from traditional performance management and discretionary performance bonuses; this is a distinct goal based on revenue, almost like a quota, that you are asking people to meet in order to then reward them on it. For example, you might give a 5% bonus to each staff member who sells more than $1000 in services.

Idea 3: Traditional Performance Management

That’s not to say that discretionary, performance-driven goals and reviews couldn’t also be the answer to motivate your team. Having performance reviews where the high performers are rewarded with bonuses and promotions and the low performers are not is an easy solution to implement. Traditional reviews can hopefully motivate your team to perform at a high level and reach goals.

Idea 4: Fringe Benefits

If having bonuses like the first 3 ideas doesn’t make sense for your small business, you could also consider implementing fringe benefits that are linked to goals. Maybe your whole team really wants a fancy cappuccino machine and snacks in the break room. Well, link that kind of benefit to company performance or the team’s performance and you can motivate them to get there and get their fancy coffees on the company then.

The Bottom Line

Profit sharing, when done correctly, can be a unique way to create a company culture that is based around the success of the company. It also can be an incredible headache that involves a fluctuating employee morale, potential recruitment or employee retainment issues, and a good bit of paperwork. You’ll want to carefully consider your options before enacting a profit sharing plan of any kind.