profit sharing

Profit sharing refers to the process whereby companies distribute a portion of their profits to their employees. Profit-sharing plans are well established in American business. The annual U.S. Chamber of Commerce Employee Benefits Survey indicates that somewhere between 19 and 23 percent of U.S. companies have offered some form of profit sharing since 1963. Other estimates place the number of companies offering profit-sharing plans in the 1990s somewhere between one-fourth and one-third of all U.S. firms. For small businesses, profit sharing provides an important means of increasing employee loyalty and tying employee compensation to company performance. Profit sharing is a particularly attractive option for newer small businesses with uncertain profit levels, as it allows business owners to share the wealth during good times without obligating them to do so during lean years.

The Employee Retirement Income Security Act of 1974 (ERISA) provided a boost in the use of profits-haring plans. ERISA regulates and sets the standards for pension plans and other employee benefit plans. Many employers found that a simple profit-sharing plan avoided many of ERISA's rules and regulations that affected pension plans.

Types of Profit-Sharing Plans

Companies may use any number of different formulas to calculate the distribution of profits to their employees and establish a variety of rules and regulations regarding eligibility, but there are essentially two basic types of profit-sharing plans. One type is a cash or bonus plan, under which employees receive their profit-sharing distribution in cash at the end of the year. The main drawback to cash distribution plans is that employee profit-sharing bonuses are then taxed as ordinary income. Even if distributions are made in the form of company stock or some other type of current payment, they become taxable as soon as employees receive them.

To avoid immediate taxation, companies are allowed by the Internal Revenue Service (IRS) to set up qualified deferred profit-sharing plans. Under a deferred plan, profit-sharing distributions are held in individual accounts for each employee. Employees are not allowed to withdraw from their profit-sharing accounts except under certain, well-defined conditions. As long as employees do not have easy access to the funds, money in the accounts is not taxed and may earn tax-deferred interest.

Under qualified deferred profit-sharing plans, employees may be given a range of investment choices for their accounts, including stocks or mutual funds. Such choices are common when the accounts are managed by outside investment firms. It is becoming less common for companies to manage their own profit-sharing plans due to the fiduciary duties and liabilities associated with them. A 401(k) account is a common type of deferred profit-sharing plan, with several unique features. For example, employees are allowed to voluntarily contribute a portion of their salary, before taxes, to their 401(k) account. The company may decide to match a certain percentage of such contributions. In addition, many 401(k) accounts have provisions that enable employees to borrow money under certain conditions.

Other Issues Concerning Profit-Sharing Plans

Deferred profit-sharing plans are a type of defined contribution plan. Such employee benefit plans provide an individual account for each employee. Individual accounts grow as contributions are made to them. Funds in the accounts are invested and may earn interest or show capital appreciation. Depending on each employee's investment choices, their account balances may be subject to increases or decreases reflecting the current value of their investments.

The amount of future benefits that employees will receive from their profit-sharing accounts depends entirely on their account balance. The amount of their account balance will include the employer's contributions from profits, any interest earned, any capital gains or losses, and possibly forfeitures from other plan participants. Forfeitures result when employees leave the company before they are vested, and the funds in their accounts are distributed to the remaining plan participants.

Employees are said to be vested when they become eligible to receive the funds in their accounts. Immediate vesting means that they have the right to funds in their account as soon as their employer makes a profit-sharing distribution. Companies may establish different time requirements before employees become fully vested. Under some deferred profit-sharing plans employees may start out partially vested, perhaps being entitled to only 25 percent of their account, then gradually become fully vested over a period of years. A company's vesting policy is written into the plan document and is designed to motivate employees and reduce employee turnover.

In order for a deferred profit-sharing plan to gain qualified status from the IRS, it is important that funds in employee accounts not be readily accessible to employees. Establishing a vesting period is one way to limit access; employees have rights to the funds in their accounts only when they become partially or fully vested. Another way to limit access is to establish strict rules for making payments from employees accounts, such as upon retirement, death, permanent disability, or termination of employment. Less strict rules may allow for withdrawals under certain conditions, such as financial hardship or medical emergencies. Nevertheless, whatever rules a company may adopt for its profit-sharing plan, such rules are subject to IRS approval and must meet IRS guidelines.

The IRS also limits the amount that employers may contribute to their profit-sharing plans. The precise amount is subject to change by the IRS, but 1996 tax rules allowed companies to contribute a maximum of 15 percent of an employee's salary to his or her profit-sharing account. If a company contributed less than 15 percent in one year, it may exceed 15 percent by the difference in a subsequent year to a maximum of 25 percent of an employee's salary.

Companies may determine the amount of their profit-sharing contributions in one of two ways. One is by a set formula that is written into the plan document. Such formulas are typically based on the company's pre-tax net profits, earnings growth, or some other measure of profitability. Companies then plug the appropriate numbers into the formula and arrive at the amount of their contribution to the profit-sharing pool. Rather than using a set formula, companies may decide to contribute a discretionary amount each year. That is, the company's owners or directors—at their discretion—decide what an appropriate amount would be.

Once the amount of the company's contribution has been determined, different plans provide for different ways of allocating the funds among the company's employees. The employer's contribution may be translated into a percentage of the company's total payroll, with each employee receiving the same percentage of his or her annual pay. Other companies may use a sliding scale based on length of service or other factors. Profit-sharing plans also spell out precisely which employees are eligible to receive profitsharing distributions. Some plans may require employees to reach a certain age or length of employment, for example, or to work a certain minimum number of hours during the year.

Although profit sharing offers some attractive benefits to small business owners, it also includes some potential pitfalls. It is important for small business owners who wish to share their success with employees to set up a formal profit sharing plan with the assistance of an accountant or financial advisor. Otherwise, both the employer and the employees may not receive the tax benefits they desire from the plan. Also, small business owners should avoid making mentions of profit sharing or stock ownership to motivate employees during the heat of battle. Such mentions could be construed as promises and lead to lawsuits if the employees do not receive the benefits they feel they deserved.

Further Reading:

Blakely, Stephen. "Pension Power." Nation's Business. July 1997.

Blencoe, Gregory J. "Utilizing Profit Sharing to Motivate Employees: The Logic Behind Sharing a Piece of the Pie." Business Credit. September 2000.

Crouch, Holmes F. Decisions When Retiring. Allyear Tax Guides, 1995.

Hussain, Syed Asad. "Impact of Profit Sharing on Productivity." Economic Review. April 2000.

The U.S. Department of Labor defines a profit-sharing plan as a "defined contribution plan under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution."

Annual cash bonuses, particularly to white-collar or administrative workers, have a long history in Europe. Plans to distribute a percentage of profits to all workers appeared in the United States shortly after the Civil War. These plans were largely confined to medium-sized family or paternalistic companies and never became widespread before their general abandonment during the Great Depression. The difficulties encountered in such plans were formidable: many employers feared the effect on prices and competitors from a public disclosure of large profits; it was hard for managers to see how a share in profits could raise the productivity of many types of labor; workers feared that a promise of a bonus based on profits was in fact an excuse for a low wage, antiunion policy; and most working-class families preferred a reliable to a fluctuating income. As a consequence, when unions became strong in the manufacturing field after 1940, their leaders proposed fixed fringe benefits such as group insurance, pensions, or guaranteed annual wages, rather than profit sharing.

An allied movement, particularly popular in the prosperous 1920s, was the purchase of stock in the company by employees. Management offered easy payments and often a per-share price lower than the current market figure. It was hoped, as in the case of profit sharing, that such plans would reduce labor turnover and give workers a stronger interest in company welfare. The decline in value of common stocks in the Great Depression to much less than the workers had paid for them, especially when installment payments were still due, ended the popularity of employee stock-purchase plans.

Annual bonuses in stock, cash, or both continued in many companies as an incentive to employees in management positions. Especially when managerial talent has been scarce, as in the booms of the mid-1950s or 1960s, options to buy large amounts of stock over a span of years at a set price were used to attract and keep executives.

In the 1960s, the Supreme Court ruled that professionals could incorporate, which meant that they could also take advantage of retirement benefits that paralleled plans available to people working in corporations. In 1963, Harry V. Lamon, Jr. drafted the first master Keogh plan, a tax-deferred retirement program for self-employed people and unincorporated businesses.

The Employment Retirement Income Security Act was passed in 1974 to protect retirement plan participants. This act established numerous reporting and disclosure rules and provided additional incentives for Keogh plan participants. Another important element of the act was the establishment of employee stock-ownership plans.

Retirement plans were simplified by the Revenue Act of 1978, which, among other changes, established the 401(k) retirement plans. A contributor to a 401(k) plan is not taxed on the income deposited in the year it was earned; the money is taxed at the time of withdrawal.

While each of the legislative changes over the last third of the twentieth century addressed different elements of profit sharing plans, the overall focus has shifted from a clearly defined benefit to defined contribution.

Bibliography

Allen, Everett T. Jr., et. al. Pension Planning: Pensions, Profit Sharing, and Other Deferred Compensation Plans. 8th ed. New York: McGraw Hill/Irwin, 1997.

Profit sharing, when used as a special term, refers to various incentive plans introduced by businesses that provide direct or indirect payments to employees that depend on company's profitability in addition to employees' regular salary and bonuses. In publicly traded companies these plans typically amount to allocation of shares to employees.

The profit sharing plans are based on predetermined economic sharing rules that define the split of gains between the company as a principal and the employee as an agent.^[1] For example, suppose the profits are x, which might be a random variable.^[1] Before knowing the profits, the principal and agent might agree on a sharing rule s(x).^[1] Here, the agent will receive s(x) and the principal will receive the residual gain x-s(x).^[1]

Contents 1 Europe 1.1 Management's share of profits 2 USA 3 Gainsharing 4 See also 5 References

Europe

Management's share of profits

The share of profits paid to the management, or to the Board of Directors is sometimes called the tantième ^{[2] [3]}. This French language term is generally applied in describing the business and finance practices of certain European countries -, including Germany, France, Belgium, and Sweden. It is usually paid in addition to the manager's (or director's) fixed salary and bonuses (bonuses usually depend on profits as well, and often bonuses and tantieme are treated as the same thing); laws vary from country to country.

USA

Main article: Profit-sharing agreement (USA)

In the United States, a profit sharing plan can be set up where all or some of the employee's profit sharing amount can be contributed to a retirement plan. These are often used in conjunction with 401(k) plans.

Gainsharing

Gainsharing is a program that returns cost savings to the employees, usually as a lump-sum bonus. It is a productivity measure, as opposed to profit-sharing which is a profitability measure. There are three major types of gainsharing:

• Scanlon plan: This program dates back to the 1930s and relies on committees to create cost-sharing ideas
• Rucker plan: This plan also uses committees, but although the committee structure is simpler the cost-saving calculations are more complex.
• Improshare: Improshare stands for "Improved productivity through sharing" and is a more recent plan. With this plan, a standard is developed that identifies the expected number of hours to produce something, and any savings between this standard and actual production are shared between the company and the workers.^[4]

See also

• Retirement plans in the United States

References

1. ^ ^{a b c d} Moffatt, Mike. (2008) About.com Sharing Rule Economics Glossary; Terms Beginning with S. Accessed June 19, 2008.
2. ^ [1] UBS Dictionary of Banking: Letter M, "management's share of profits"
3. ^ 'Share of profits'
4. ^ Gomez-Mejia, Luis R.; Balkin, David B. (2007), Managing Human Resources (Fifth ed.), Upper Saddle River, New Jersey: Pearson Prentice Hall, ISBN 0-13-187067-x 

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