Profit-Sharing Plan: What It Is and How It Works

A profit-sharing plan is a company-sponsored program that distributes a portion of a business’s profits to employees. Payouts can be immediate cash or deferred into retirement accounts (deferred profit-sharing plans). Employers fund profit-sharing plans — employees do not contribute — and distributions are typically tied to quarterly or annual company performance.

Key points

• Employer-funded plan that shares company profits with employees.
• Can be paid immediately or deferred into retirement accounts (taxed on distribution).
• Employers decide whether and how much to contribute each period, subject to IRS rules.
• Companies may offer profit-sharing alongside other plans, such as a 401(k).

How it works

• Employer discretion: The employer chooses whether to make contributions and the amount each period. Contributions are not guaranteed and can vary year to year.
• Allocation formulas: Employers must use a fixed allocation method so distributions aren’t unfairly skewed toward highly compensated employees. A common method is the “comp-to-comp” formula, which allocates shares in proportion to each employee’s compensation.
• Retirement treatment: When structured as a deferred plan, employer contributions go into long-term retirement accounts. Employees pay taxes when funds are distributed, generally at retirement.
• Compliance: Plans must meet IRS nondiscrimination rules and other qualified-plan requirements.

Example (comp-to-comp)

Company profit: $100,000
Company decides to share: 10% → $10,000 to distribute
Employee A salary: $50,000 (1/3 of total payroll) → receives $3,333.33
Employee B salary: $100,000 (2/3 of total payroll) → receives $6,666.67

Requirements and limits

• Any-size business can establish a profit-sharing plan and may have other retirement plans concurrently.
• Employers must document the allocation method and comply with nondiscrimination rules.
• Annual contribution limits are set by the IRS and can change year to year (for example, recent limits have been around $69,000–$70,000, higher if catch-up contributions apply). Check current IRS guidance for the exact amounts.
• Employers that sponsor a qualified plan generally must file Form 5500 and disclose plan participants.
• Early withdrawals from retirement-based profit-sharing plans may incur penalties, with some exceptions.

Profit-sharing vs. 401(k)

• Profit-sharing: Funded solely by the employer; distributions based on company profits; may be immediate or deferred.
• 401(k): Primarily funded by employee deferrals (pre-tax or Roth); employer may offer matching or profit-sharing contributions.
• A company can offer both types of plans concurrently.

Tax treatment

• Deferred profit-sharing contributions: Taxes are deferred until the employee receives the distributions.
• Immediate cash distributions: Taxed as ordinary income in the year paid.

Advantages and disadvantages

Advantages
* Aligns employee interests with company performance.
* Can motivate and retain employees by sharing success.
* When deferred, contributions grow tax-deferred until distribution.

Disadvantages
* Contributions are discretionary and can vary, so employees may not rely on them as predictable income.
* Nondiscrimination rules and reporting requirements add administrative complexity.
* IRS contribution limits apply.

Bottom line

Profit-sharing plans let employers reward employees with a portion of company profits, either as immediate pay or as retirement contributions. They can boost employee engagement and reward performance, but they require careful plan design and compliance with IRS rules. For current contribution limits and detailed requirements, consult the Internal Revenue Service guidance on profit-sharing and qualified retirement plans.

Sources: Internal Revenue Service publications and guidance on profit-sharing and qualified plan requirements.