Employee Profit Sharing Plan - Explained
What is an Employee Profit Sharing Plan
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Table of ContentsWhat is an Employee Profit Sharing Plan?How Does a Profit-Sharing Plan Work?Methods of Computing Profit Sharing Comp-to-Comp method Same Dollar Amount method Rules Limiting Profit SharingFiling Requirements Other Aspects of Profit Sharing PlansExample of Employee Profit Sharing Calculation
What is an Employee Profit Sharing Plan?
Employee profit sharing plan (EPSP) or a profit share plan is when a company allocates a share of profits to its employees. An EPSP is generally based upon performance, such as annual profitability. ESPS are thought to improve employee efficiency by providing them with a sense of ownership in the company. Most ESPS have limits on when and how employees can withdraw their interests.
- Note: A profit share or profits share is different from a "profits interest", which concerns an entitlement to the proceeds from future sale of the company.
Back to:BUSINESS & PERSONAL FINANCE
How Does a Profit-Sharing Plan Work?
Profit Sharing Plans are great incentives for the employees of a company. It gives them a stake in the company and encourages them to work for profit making. Under this plan, the employees get benefit from the better performance of the company. Companies of any size can adopt a profit-sharing plan for their employees. In the private companies, the employees get a portion of profit based on the performance of the company and in publicly traded companies they get shares of stock in the company. An employee retirement plan that is financed by the employer can be termed as an employee profit sharing plan (EPSP). Defined contribution plans are not EPSPs. Usually, the profit-sharing plans are structured as a conditional contribution by the employer into an employee's retirement account. It helps them defer tax liabilities from the profit-sharing contribution. Most often the contribution is made towards the 401 (k) retirement account of the employer. The employer's contribution to the profit-sharing plan is discretionary and they decide the amount they want to contribute to each employee's account. They may adjust the plan as per the necessity and they can decide not to contribute any amount in some years. Employee participation is involuntary in this plan and contributions are not subject to social security and Medicare taxes. A company can adopt a profit-sharing plan even when there are other retirement plans are in place. Companies generally adjust profit sharing plans according to the needs and profit earnings of each financial year. In some years, when firms incur losses, it may not contribute to employee profit sharing plan.
Methods of Computing Profit Sharing
The companies need to determine a formula for allocating the contribution. It also needs to ensure that the plan does not discriminate in favor of the high salaried employees. The following methods are generally used for calculating the profit sharing.
This is the most common method used by companies to calculate profit sharing. This is a pro rata method' that allocates the profit share based on the employee's relative salary. In this method, the compensation of all the eligible employees are added up to get the sum total. Then each employee's annual compensation is divided by the sum of the total compensation. Then each employee's fraction is multiplied by the amount of the employer contribution. For example, the total compensation of all the eligible employees of a company added up to $200,000. Employee X earns $40,000 a year and employee Y earns $60,000 a year. Now if the company earns $100,000 in a fiscal year and the employer shares 10% of the annual profit, the profit share will be calculated as follows, For X it is calculated as ($40,000/$200,000) * ($100,000*0.10) = $2000 And for Y it is calculated as ($60,000/$200,000) * ($100,000*0.10) = $3,000
Same Dollar Amount method
This is a simpler method of calculating profit sharing. In this method, every employee receives an equal amount of contribution. In this method, the profit pool is divided by the total number of employees eligible for receiving the contribution.
Rules Limiting Profit Sharing
There are certain rules for ensuring fairness in profit sharing. As of 2019, the upper limit of profit sharing is lesser of 25% of the compensation or $56,000 ($62,000 for the employees who are older than 50 years of age). This figure is renewed each year depending on the cost-of-living.
The companies need to file Form 5500-series return annually in order to implement a profit sharing plan. They also need to disclose all the participants of the plan.
Other Aspects of Profit Sharing Plans
The employees are allowed to withdraw the fund while in service but this is subject to possible 10% additional tax if under age 59-1/2. The administrative cost for executing a profit share plan is often higher than more basic arrangements (SEP or SIMPLE IRA plans).
Example of Employee Profit Sharing Calculation
Under the comp-to-comp method, if employee A earns $100,000 and employee B earns $200,000 per year. The company decides to give employees 20% in the company's annual profits. The company earnings are $ $500,000. The company would calculate each employee share as following;
- Employee A = ($500,000 * 0.20) * ($100,000/$300,000) = $33,333
- Employee B = ($500,000 * 0.20) * ($200,000/$300,000) = $66,667