The Types of Profit Sharing Plans Small Businesses Owners Need to Know About

by Corey Philip //  November 10, 2022

Even though there are several types of profit-sharing plans for small businesses. They all provide an enduring legacy for loyal employees. Especially those who made a significant contribution to the success of your business.

The three types of profit-sharing plans for small businesses include a pro-rata plan where employees receive identical amounts. An age-weighted plan that pays a higher percentage to those nearing retirement. A non-comparability plan with high and low percentage allocations for different groups.

Establishing a profit-sharing plan for your small business is relatively straightforward. However, there are a few crucial factors to take into consideration. So, read on if you want to create a successful profit-sharing plan!

Small Business Profit Sharing Plans: What You Should Know

Investing in a profit-sharing plan is a concrete way to demonstrate that you genuinely care about your employees and are willing to reward them in a meaningful way. Profit-sharing plans are suited to all-sized businesses. So even if you only have three employees, they can all reap the benefits of your shared success.

A deferred profit-sharing plan (DPSP)  is like a retirement plan. It allows optional employer contributions based on a pre-determined, discretionary percentage of the company’s pre-tax quarterly and annual profit earnings, including the employee's compensation.

However, profit-sharing plans differ from traditional retirement plans like 401(k)’ where employees contribute to the fund. And are also tied to certain restrictions that dictate when the funds can be withdrawn without incurring penalties. And should you consider setting up a profit-sharing plan, you can choose what percentage of your profits you are willing to share. Should your small business go through a difficult time, you can defer payments for a few years if necessary.

Although, when you make contributions, you will need a profit allocation formula to determine what percentage you are willing to pay employees. The easiest way to ascertain what your profit-sharing allocation for each employee should be is with the following comp-to-comp method:

  • First, add up all your employee’s compensation to get the total "comp."
  • Next, divide every person's compensation by the abovementioned total amount.
  • Finally, multiply every employee's portion by the total profit to determine their share.

Standard Profit Sharing Plan Options

There are three profit-sharing plans to consider. Although the most efficient way to manage any of the following plans is by using bespoke software like a compensation management tool to streamline the entire process from start to finish.

So, without further ado, let's look at your options to see which profit-sharing plan will suit your business needs and your employees.

  • Pro-rata plans are the most popular as they are relatively straightforward. All eligible employees are paid identical amounts, either as a percentage of their compensation or a set dollar amount.
  • Age-weighted plans allow business owners to consider how close employees are to their retirement age. So, older employees are paid a higher profits-share percentage because they are nearing retirement.
  • Non-comparability/cross-testing plans allow business owners to award lower and higher profit-share percentages or benefits to different groups or divisions within the business.

Benefits of Profit Sharing Plans

Although profit-sharing plans provide an additional level of financial security for your employees upon retirement, investing in their future has the following added benefits:

  • They benefit junior and senior-level employees
  • A profit-sharing benefit is a strong drawcard for talented recruitment candidates.
  • The contributed profit can be invested and grow significantly through mutual funds, bonds, stocks, or money market fund investments. 
  • Profit share earnings and contributions are tax-free until they are paid out upon retirement.

How to Set Up and Manage your Profit Sharing Plan

Once you have decided which type of profit-share plan suits your business and employees, you will need to determine whether you will create and manage the plan or appoint a financial institution like a mutual fund provider, bank, or insurance company to do so on your behalf.

Here are the most essential steps in creating your profit-sharing plan.

Draft a formal profit-share plan document that outlines the terms and conditions of your profit-sharing plan. If you have appointed a professional, they will have a template. Alternatively, contact a financial institution for assistance. The abovementioned profit-sharing plan should contain a formula that outlays what percentage of your profit should be allocated annually to employees. You also have the flexibility to include other details, like when payments should be made and which employees are eligible.

Establish a trust fund and a trustee/s to oversee the management of your plan’s contributions, investments, and pay-outs. You will need at least one trustee to ensure that the profit-sharing plan contributions grow in value.

Create a record management system to track the plan’s contributions, expenses, earnings, losses, and distributions. You can either invest in compensation management software or appoint a financial institution to oversee this record management system.

Share the profit-plan document with eligible employees when all the details have been finalized so that they know what benefits they are entitled to, including other pertinent information.

Profit Sharing Plan Requirements

Like 401(k) plans, you have the flexibility to choose the terms of your business’ profit-sharing plan. However, the only caveat is that the plan needs to benefit all your eligible employees and not only the highest earners.

Most importantly, any profit contribution may be at most $61,000. However, a $67,500 contribution is permitted for catch-up profit-share contributions, and eligible employees’ salaries are capped at $305,000 in 2022. Once all the details of your profit-sharing plan have been finalized. You are also required by law to complete an  IRS form-5500 to disclose your plan’s beneficiary details.

Final Thoughts

While there are three main profit-sharing plans for small businesses, choosing a plan that suits your business needs is essential. And consider whether you can oversee the plan or need to appoint a professional with the expertise to manage it.

(Related: Profit Sharing Plan vs. 401(k) for Small Business)

About the author

Corey Philip

Corey Philip is a small business owner / investor with a focus on home service businesses.

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