Should You Start a Profit Sharing Plan for Your Small Business?

Suzanna De Baca -- Expert Business Source, 1/22/2008 6:13:00 AM

If you’re looking for a way to attract or retain employees to your small business you might consider adding a Profit Sharing Plan to your benefits roster.  

A Profit Sharing Plan is an incentive based compensation program designed to reward employees by giving them a percentage of the company’s profits.  Profit sharing is an excellent way to motivate employees to work toward a common goal, focuses employees on profitability, and recognize their efforts as a group.

In a Profit Sharing Plan, the employer contributes a portion of the company’s pre-tax profits to a fund that will be distributed among eligible employees.  Employer contributions are tax deductible for the employer and investment earnings grow tax-deferred until withdrawn.*  If there is a profit to distribute, generally it is done so on an annual basis;  however, a weighting arrangement may also be put into place so that employees with higher salaried compensation receive a slightly higher amount of the shared pool of profits.

Who is eligible?  Any business owner or self-employed individual (including sole proprietorships, partnerships, limited liability corporations (LLCs), or incorporated businesses including subchapter S corporations) may start a profit sharing plan.  All employees who worked at least 1,000 hours in past year (or who have provided services to the employer for up to two years if no vesting period is stipulated) are eligible and must be allowed to participate in the Profit Sharing Plan.  You can establish a Profit Sharing Plan in addition to other retirement plans, such as a 401(k).  From a tax preparation standpoint, you will need to file a Form 5500 on an annual basis.

Who can contribute?  Only the employer can make contributions to a profit sharing plan.  Contributions are limited to 25% of salary up to an annual limit.  Contribution amounts can vary from year to year; this flexibility can be positive for employers who may not wish to be locked into a certain percentage.  Vesting requirements are at the discretion of the employer.

In determining whether a Profit Sharing Plan is right for your business, consider the following:

Do you want to reward your employees as a group?  Profit sharing is an effective way to let your work force know that their contibutions as a group are important.  While not formal ownership, a Profit Sharing Plan conveys the message to employees that their part in achieving profitability will be recognized.  A Profit Sharing Plan does not specifically acknowledge or reward individual performance, so it may not accomplish the goal of rewarding an individual on merit.

Is profitability your current aim?  While it can be very valuable to focus on profitability, there are times in the lifecycle of a company where concentration on quality, service, expansion into new markets or other factors may be important in strengthening the company’s brand or positioning the company for further profitability.  Profit should not come at the expense of these other considerations if they are to drive the business success going forward.  While an emphasis on margins is central to achieving success, decide for yourself if this motivates your employees toward the goal you consider a priority.

Do you have dramatic shifts in earnings?  For companies with varying revenues, profit sharing should not necessarily be a major part of employee compensation. Wide fluctuations in income from year to year can be interpreted as a negative rather than a positive among an employee base, especially in companies where the employees may not be familiar with the dynamics of market cycles.

Time and expense:  Administration of a Profit Sharing Plan usually requires hiring a professional.  Consider the expense before establishing a plan.  Pre-approved profit-sharing plans are available.

For companies seeking to reward their employees for their contributions to the enterprise’s success, a Profit Sharing Plan can be a positive addition to the overall benefits package.  Consult your accountant, attorney, or benefits advisor for details and annual limitations or requirements.

* According to the IRS website, if you receive retirement benefits in the form of pension or annuity payments, the amounts you receive may be fully taxable, or partly taxable in the year received. Refer to Tax Topic 410, Pensions and Annuities, for detailed information, or Publication 575, Pension and Annuity Income.  Consult with your tax professional.

Suzanna de Baca is President of Private Capital Solutions Group.  She is a Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS), 7 Hanover Square, New York, NY 10004, (888) 600-4667.  Securities products/services and advisory services are offered through PAS, a registered broker/dealer and investment advisor. Private Capital Solutions Group is not an affiliate or subsidiary of PAS.
PAS is a member FINRA, SIPC.
Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal or investment advice. Although the information has been gathered from sources believed reliable, please note that individual situations can vary, therefore the information should be relied upon when coordinated with individual professional advice.