Profit sharing is an excellent alternative or addition to the traditional 401(k) plan. But one frequently asked question for potential profit sharing companies is, "Do we have to show a profit to give the benefit of profit sharing?"
Short Answer: Profit Not Necessary for Profit Sharing
Profit sharing plans offer significant flexibility to employers. If the company is profitable, the company may choose whether to distribute profit sharing benefits to its employees. And similarly, if the company is not profitable, the company may choose whether to distribute profit sharing benefits to its employees.
"Profit sharing" is an easy shorthand for splitting the fruits of the company's labor. Most of the time, that "fruit" equates to a portion of the profits. But it does not have to!
The "fruit basket" does not have to be filled solely by profits (and we will discuss the manner of how it is split up later in this article). If it makes sense to the business, it can distribute profit sharing to its employees even after the business has suffered an annual loss.
So Then What Is Required?
Since profits are not necessarily a prerequisite for a profit sharing program, what is required?
One of the most important aspects of a profit-sharing program is that it cannot favor highly compensated employees. The IRS is particular about what this means. A highly compensated employee is one who:
Owned greater than 5% of the interest in a business at any time during the year or the preceding year
Received compensation from the business of more than $130,000 if the preceding year is 2020 or 2021, and, if the employer so chooses, was in the top 20% of employees when ranked by compensation
And what constitutes "favoring" those highly compensated employees? In short, "favoring" those employees equates to giving them an oversized portion of the benefits pie. And who says what is oversized? That is determined by the IRS' non-discrimination rule, as stipulated under federal ERISA---the Employee Retirement Income Security Act.
How Can the Profit "Fruit Basket" Be Split?
Earlier, we referred to ways that an employer can choose to split the fruits of their labor among the employees. Here are the three most common methods for profit sharing splits.
The flat method of profit-sharing gives an equal profit share contribution to all employees. From the boss to the new associate, each employee gets an equal share of the profit-sharing pot.
The comp-to-comp method (a.k.a. the pro-rata method) doles out the profit-sharing in proportion to each employee's salary. If the boss's salary is twice as much as the new associate’s, the boss will receive twice as much profit-share as the new associate.
The new comparability method gives employers flexibility by judging each employee or group of employees separately. In short, the new comparability method recognizes that a dollar given to a young employee (decades from retirement) will grow more than a dollar given to an older employee (only years from retirement). Thus, the dollars given to the young employee have more value to them. As with the other methods discussed here, fair compensation audits from the IRS still apply.
What are the Benefits of Profit Sharing?
There are many upsides to profit sharing. Most notable are:
It is a tax-deferred investment vehicle, just like a match or salary deferral. Tax deferment makes profit-sharing attractive to your employees. And for the business, profit shared dollars are tax-deductible. It is a win-win.
Profit sharing provides flexibility and motivation for the owner(s) of the business. The flexibility is that the amount of profit sharing is variable and can be changed when merited by company performance. And the motivation is that the profit-sharing program directly benefits the employees of the company. The owners’ decisions directly affect employee well-being.
Lastly, profit sharing is a terrific benefit that attracts and retains employees. When employees know that their efforts can directly correlate to a 5-figure annual payout, they are more willing to work for you. It is plain and simple.