Profit-Sharing Plans For Businesses

Profit-sharing plans (PSPs) have been around for decades. Employers may use them to attract and retain workers and incentivize employee productivity. However, PSPs have gradually faded into the background as 401(k) plans gained popularity.

In today’s tight labor market, some proactive employers are implementing PSPs to help them stand out. Should your company jump on the bandwagon? Here are some key factors to consider.

The Basics

PSPs and 401(k) plans are “defined contribution plans” that must meet certain requirements to qualify for tax-favored status. But PSPs are funded exclusively by employer contributions, whereas 401(k) contributions are made primarily by employees (with some employers also making matching contributions up to a certain percentage or amount).

With a PSP, the employer contributes a portion of its profits to be distributed to employees’ accounts. These contributions are in addition to each employee’s regular pay. Assuming the tax law requirements are met, PSP contributions are tax-free to employees and deductible by the employer, up to 25% of wages paid to employees.

Important: Contributions are subject to annual IRS limits. For 2025, the maximum contribution to an individual employee’s defined contribution account is the lesser of 100% of the employee’s compensation or $70,000 (up from $69,000 in 2024).

A PSP can be set up to make contributions in cash, company stock or both. (Note that special rules may apply to employee stock ownership plans.)

A plan may provide that employees can’t access monetary contributions until they’ve “separated from service” — for example, by retiring or changing jobs. When funds from an employee’s account are withdrawn, they’re taxable at ordinary income rates under the usual rules relating to qualified plan distributions. Unless a special exception applies, distributions made before age 59½ are subject to a 10% penalty, in addition to any income tax that ordinarily would be due on a withdrawal.

4 Types of PSPs

A PSP plan is funded by an employer setting aside a discretionary percentage of its annual profits. The plan must have a set formula for determining how the contributions are divided. This money goes into a separate account for each employee.

Four common methods may be used to allocate the funds to employees’ accounts:

1. Same-dollar-amount method. Under this technique, each employee receives the same flat-dollar contribution, regardless of their compensation level. For instance, if an employer with 20 employees sets aside $200,000 of its annual profits for its PSP plan, each employee will receive a $10,000 contribution to his or her account.

2. Percentage method. This method (also called the pro-rata method) requires the employer to allocate profits based on a percentage of each employee’s compensation. This is often the easiest and most convenient method to implement.

Percentage-Method PSP in Action

Employers with profit-sharing plans (PSPs) can use several methods to allocate profits to employees. One of the most popular is the percentage method, which allocates contributions among employees based on a percentage of their compensation.

To illustrate how this method works, suppose a plumbing contractor earned profits of $2 million in 2024. The company has a PSP with a 10% annual allocation. So, the profit pool for 2024 is $200,000 ($2 million times 10%).

The company has 12 employees who are eligible to participate in the plan based on its minimum service and age requirements. The total compensation for these employees was $1 million for 2024.

The next step is to calculate the “contribution percentage” by dividing the total contribution amount ($200,000) by the total compensation of eligible employees ($1 million). In this example, the contribution percentage would be 20%.

Each eligible employee receives a contribution equal to the contribution percentage (20%) multiplied by their individual compensation. The following table summarizes the company’s 2024 PSP contributions:

Employee Position                2024 Total Compensation                     2024 PSP Contribution

Owner                                                 $200,000                                                      $40,000

Office manager                                  $100,000                                                      $20,000

10 licensed plumbers                        $700,000                                                     $140,000

Total                                                 $1,000,000                                                    $200,000

For 2024, each of the company’s 10 plumbers would receive a $14,000 contribution to his or her PSP account. The amount contributed to each employee’s account is invested and compounds without current tax so the savings can grow substantially over time.

3. Age-weighted plan method. Under this method, PSP contributions are based on years of service. This variation is often popular with business owners who are older than most or all of their employees.

4. New comparability plan method. Under this method, the employer defines various classes of employees and establishes PSP contribution percentages for each class.

Potential Upsides

PSPs offer both tax and nontax advantages to employers and employees. First, plan contributions are discretionary and can be adjusted each year. Thus, if the company is underperforming, it can skip contributions altogether. From the employer’s viewpoint, a PSP offers more flexibility than matching employee contributions to a 401(k) plan.

Second, a PSP may be a powerful motivational tool. Employees are encouraged to work harder to boost overall plan contributions.

Additionally, PSPs are a win-win tax strategy. Employers can generally deduct the full amount of their contributions, and employees owe no current tax on employer-paid contributions to their accounts. Employees’ accounts compound on a tax-deferred basis until they withdraw funds. This setup may be preferable to a 401(k) plan, where employees must defer part of their regular salary to their accounts.

Beware of the Downsides

PSPs also come with some disadvantages. Most obviously, sharing profits with employees during boom times leaves the company with fewer resources during lean times. By comparison, employers typically contribute less for 401(k) matching contributions than for PSP contributions, so matching contributions tend to be less draining on the company’s reserves.

From the employees’ perspective, there are no guarantees that PSP contributions will be made each year. This can make it difficult to plan and save for retirement. Plus, each employee’s plan contribution isn’t directly tied to individual performance. Other forms of compensation — such as performance-based bonuses, raises and stock options — may serve as better ways to motivate workers.

Finally, setting up and maintaining a PSP can be complicated and costly. Like a 401(k) plan, employers must meet strict nondiscrimination requirements and comply with reporting rules to maintain tax-favored status.

Weigh Your Options

Is a PSP right for your business? The good news is that you don’t have to choose between offering a PSP and a 401(k) plan. Suppose your business already has a 401(k) plan. In that case, you can supplement it with a profit-sharing feature, combining some of the advantages of both types of employer-sponsored defined contribution plans. Contact your financial and tax advisors to determine what’s right for your situation.

Copyright 2025

This article appeared in Walz Group’s January 27, 2025 issue of The Bottom Line e-newsletter, produced by TopLine Content Marketing. This content is for informational purposes only.