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Employee Profit Sharing Plan Explained

Employee Profit Sharing Plan (EPSP)

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.

A Little More on Profit-Sharing Plans

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.

Comp-to-Comp method

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.

Filing requirements

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

References for Employee Profit Sharing Plan


https://www.investopedia.com/terms/p/profitsharingplan.asp

https://www.businessdictionary.com/definition/employee-profit-sharing-plan-EPSP.html

https://www.getsmarteraboutmoney.ca/plan-manage/retirement-planning/pension-savings-plans/employee-profit-sharing-plans-epsps/

References for Profit Sharing Plan

Academic Research on Profit Sharing Plan

Qualified Pension and ProfitSharing Plan Vesting: Revolution Not Reform, Osgood, R. K. (1979). BUL Rev., 59, 452. This paper argues that a qualified pension and profit-sharing plan is a revolution and not a reform. It discusses the regulations of pension and profit-sharing plan mandated by the Internal Revenue Code and similar provisions of the labor laws.

Wife’s Community Interest in Her Husband’s Qualified Pension or ProfitSharing Plan, Dutton, D. (1971). Tex. L. Rev., 50, 334. This paper discusses the complexity of the interest of the nonemployee spouse in the qualified pension or profit-sharing plans in community property states. The benefits of such a plan can be received only after the retirement or the death of the employee. If an employee dies before receiving the actual benefit, then how to treat this benefit, is it a community property or a separate property? This paper seeks an answer to this question. It also tries to determine the estate tax treatment of the benefit in such scenarios.

ProfitSharing Plan, Bruton, J. C. (1952). SCLQ, 5, 201. This paper discusses the Profit-Sharing Plan and analyzes its tax advantages.

A Long-term ProfitSharing Plan to stimulate Motivation and Innovation among R&D Personnel, Schroeder IV, E. A., Sherman, J. D., & Elmore, R. C. (1987). Personnel Review, 16(3), 34-38. This paper argues technological innovation is one of the most important tools for economic growth and it is also necessary for maintaining competitiveness in international trade. The paper discusses how a long-term Profit-Sharing Plan can be useful in motivating the employees working in Research and Development. The paper says this motivation will lead to innovation and thus will be helpful in the overall growth of the economy.

A ProfitSharing Plan for Restaurants, Garcia, M. (1988). Cornell Hotel and Restaurant Administration Quarterly, 29(1), 13-17. This paper argues the adoption of profit-sharing plan or similar employee incentive programs is slow in the restaurant industry. It describes the method of designing a profit-sharing program for the restaurant industry.

Designing a Deferred Compensation Profit Sharing Plan for a Small Company, Lubick, D. C. (1953). Buff. L. Rev., 3, 222. This paper proposes the method of designing a deferred compensation profit sharing plan for small businesses.

Earnings persistence and profit sharing plan adoption, Daneshfar, A. (2001). (Doctoral dissertation, Concordia University). This study examines the hypothesis that assumes the level of permanence of current earnings changes positive affects the adoption of profit-sharing plans. It collects profit-sharing data from the U.S. Internal Revenue Service’s 5500 Form and financial data are retrieved from Compustat. The sample size in 298 firms and in this sample, there are equal numbers of profit sharing and non-profit sharing firms. It uses two alternative time-series models: IMA (1,1) and ARIMA (2,2,0) to calculate the level of earnings persistence. This is used for measuring the earning changes. The result confirms that information about the persistence of earnings innovations plays a significant role in determining profit-sharing plan adoption. It shows a positive association exists between earning persistence and the probability of profit-sharing plan adoption. Introduction of control variables and the use of an alternative measure of earning persistence gave a robust result.

Proposed Legislation to Exempt from Inheritance Taxation the Non-Employee Spouse’s Interest under a Qualified Pension or Profit Sharing Plan, Massman, R. A. (1977). This article analyzes the proposed legislation that exempts from inheritance taxation the Non-Employee Spouse’s interest under a qualified pension or profit-sharing plan.

What Is A New Comparability Profit Sharing Plan?, Plan, T. P. S., & New, A. A. N. (2006). Policy, 281, 334-2469. It provides the definition of the new comparability profit sharing plan and discusses its provisions.

Study on Employee Profit Sharing Plan in Western Enterprises, Ying, L. (2009). Study on Employee Profit Sharing Plan in Western Enterprises. Labor Economic Review, 2009-00. This paper studies the employee profit-sharing plan adopted by businesses in Western countries.

Conversion of a pension plan to a profitsharing plan, Shaw, T. T. (1962). Journal of Accountancy (pre-1986), 113(000001), 74. This paper discusses how the companies can terminate the existing pension plan and introduce a profit-sharing plan as a substitution. It describes the benefits and the procedure. It also discusses the reverse conversion where a profit sharing plan is to other pension plans.

The incidence and nature of employee profit sharing and share ownership in Canada, Long, R. (1992). Relations industrielles/Industrial Relations47(3), 463-488. The paper outlines the regular attributes of employee profit sharing and share ownership in Canada. The data analyzed to achieve these were the interviews conducted in 1989/1990. Chief executive officers of 626 Canadian firms were interviewed. The result revealed that both have grown dramatically in the past decade and will likely continue to do so despite the absence of legislative support.

Profit sharing: Does it make a difference?: The productivity and stability effects of employee profitsharing plans, Kruse, D. (1993).  Kruse employed the productivity and the stability theories, which are the two salient theories related to profit sharing in the study. The study detailed the reasons why the systematic factors within firms influence the success of profit sharing plans upon execution. The evidence presented was based on a particular database developed from 500 public U.S. firms over the period of 1979-1991.

Why do firms adopt profitsharing and employee ownership plans?, Kruse, D. L. (1996). British Journal of Industrial Relations34(4), 515-538. This study seeks to provide answers to why firms adopt profit-sharing and employee ownership plans by examining the factors predicting the adoption of profit-sharing and employee stock ownership plans (ESOPs) in the 1975–91 period. Data from a survey of 500 US public companies were employed. Findings depict that some companies adopt for productivity related reasons while others for flexibility related reasons.

Employee profit sharing: Consequences and moderators, Long, R. (2000). Relations industrielles/Industrial Relations55(3), 477-504. This study employs a data set from 108 Canadian profit sharing firms to objectively examine the feasible ramifications and facilitators of profit sharing. The result revealed that almost all the predicted ramifications emanated, although in varying degrees. It was further revealed that firms that allocated the profit –sharing bonus based on individual employee performance are at an advantage over other firms.

Using profit sharing to enhance employee attitudes: A longitudinal examination of the effects on trust and commitment, Coyle‐Shapiro, J. A. M., Morrow, P. C., Richardson, R., & Dunn, S. R. (2002). Human Resource Management: Published in Cooperation with the School of Business Administration, The University of Michigan and in alliance with the Society of Human Resources Management41(4), 423-439. This study employs a principal agent, expectancy, and organizational justice theories to investigate the effects of the positive changes in employees’ attitudes as a result of the profit-sharing plan, on organizational trust and commitment. The result indicated that profit sharing increases organizational commitment while only organizational reciprocity projects organizational trust.

Introduction to” Shared Capitalism at Work: Employee Ownership, Profit and Gain Sharing, and Broad-based Stock Options”, Freeman, R. B., Blasi, J. R., & Kruse, D. L. (2010). In Shared capitalism at work: Employee ownership, profit, and gain sharing, and broad-based stock options (pp. 1-37). University of Chicago Press. This paper uses general social survey (GSS) and NBER data sets to scrutinize the relationship between shared capitalism programs and a number of employee outcomes such as job security, job satisfaction, training, pay, etc. The paper outlined both the positive and negative impacts of shared capitalism programs on these outcomes. The result of the GSS indicated a kind of complementary relationship among the employee outcomes which is based on the individual impacts of shared capitalism on each of the outcomes.

Profitsharing and employment variability: Microeconomic evidence on the Weitzman theory, Kruse, D. L. (1991). ILR Review44(3), 437-453. The study investigates the implication of Weitzman’s profit-sharing theory on employment variability. With the use of panel data analysis, a number of manufacturing firms were examined. It was revealed that, in a scenario whereby the unemployment rate increases by one point, employment in manufacturing firms that adopted the Profit-sharing plan decreased by two percent (2%). However, employment in manufacturing firms that adopted a nonprofit-sharing plan decreased by three percent (3%). Moreover, there are no significant differences in employment stability in non-manufacturing firms.

 

The impact of profit sharing on the performance of financial services firms, Magnan, M., & St‐Onge, S. (2005). Journal of Management Studies42(4), 761-791. This study employed a comprehensive methodological approach to examine the effect of profit sharing plan (PSP) on the performance of financial services firms. To this end, financial services firms that adopted the plan and those that did not were compared. Results revealed that firms that adopt PSP experienced increased profitability. Furthermore, the adoption of PSP also leads to long term positive impact on external profit drivers than internal ones.

Profitsharing and employee share ownership, Estrin, S., Grout, P., & Wadhwani, S. (1987). Economic Policy2(4), 13-52. This paper seeks to investigate possible resulting effects of linking a worker’s remunerations to the employer’s profit, such that the higher the employer’s profit the higher the worker’s pay and vice versa.  Profit sharing schemes may bring both positive and negative effects. Weitzman proposed that its positive effect stems from increased productivity and employment, by decreasing the cost of employing an extra worker. On the other hand, evidence revealed that profit-related pay might be inflationary hence, its negative effect. Therefore, the study posits that performance-related pay is much more effective.

Do Broadbased Employee Ownership, Profit Sharing and Stock Options Help the Best Firms Do Even Better?, Blasi, J., Freeman, R., & Kruse, D. (2016). British Journal of Industrial Relations54(1), 55-82. This paper investigates the relationship between Broad-based Employee Ownership, Profit Sharing, Stock Options (group incentive method) and increased firm performance. It was revealed that firms that allow a considerable level of input from its employees in major decision making, culminates into positive workplace culture and promotes greater efficiency in the firm.

 

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