Should You Introduce Profit-Sharing — and How?
Your business is doing well, and you want a way to share some of your firm’s profits with the people who helped create its success. The solution might seem obvious: create a profit-sharing plan based on the performance of the company.
How will you decide on the pool of money to use for your profit-sharing plan? One CEO decided on a 10% allocation: If the company generated $1 million in profit, the pool would be $100,000. If profits rose to $3 million, the pool would grow to $300,000.
This is a simple and elegant way to create a plan that scales or shrinks depending on how well your company performs, aligning your team with profit goals. The next step is to decide how to distribute the money to your people.
You can choose either:
1. Equal distribution based on salary.
You would pay out the bonus based on a percentage of how much each worker is paid in salary. There’s a lot of research that shows that an 8% profit-sharing plan is typically enough to motivate an employee to change his or her behavior and perform better, so 10% or 20% is more than ample.
2. Distribution based on contribution level.
Compensate workers based on their role in the business. You do that by dividing up the pool into shares, with each share being worth a certain percentage of the pool. You pay based on the number of shares an employee is given — usually based on the employee’s position. You might give one share each to entry-level employees, while managers get two shares and senior execs get three.
The key is to make sure the amount you allocate in each share adds up to your total pool amount and that the potential payout motivates your workers.
You should allow yourself, as the owner of the company, to make further adjustments based on employee performance: If an employee due two shares is severely underperforming, trim the share to send a clear message. Conversely, a superstar employee might get more to reward him or her for hard work.
Profit-sharing can be part of an employee’s retirement plan. This option is called deferred profit-sharing. Depending on the retirement plan, it may be tax-deductible. Employees may be required to work for a certain period before being eligible to join a profit-sharing plan.
With profit-sharing, employees feel invested in the company. It’s a powerful incentive to work harder. The plans benefit both the business and the employees: Workers get satisfaction from getting a cut of the profits, while your business’s added productivity raises your firm’s financial performance.
Success lies in the details. Reporting should be simple and easy to understand so that both you and your workers can easily determine the amounts that will be shared. Workers start holding other employees accountable to contributing toward profitability.
The contribution limit for a company sharing profits with an employee in a deferred profit-sharing plan for 2021 is $58,000. Catch-up contributions during the year for those age 50 or over are limited to $64,500.
You have lots of flexibility in implementing a profit-sharing plan. All companies, though, have to prove that their profit-sharing plan doesn’t discriminate in favor of highly compensated employees. You must fill out an IRS Form 5500 and disclose all participants of the plan.
The goal of profit-sharing is to reward employees for their contributions to the overall success of your business — it’s not an entitlement program. It provides a clear way for your team to understand the potential bonus of a job well done.
When you create your plan, explain how it works and that the better the company performs, the more employees will profit from its success.