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. Some companies combine profit sharing with their 401(k) plans .
Historically, profit-sharing plans have their roots in the 19th century, when companies such as General Foods and Pillsbury distributed a percentage of their profits to their employees as a bonus. The first deferred profit-sharing plan was developed in 1916 by Harris Trust and Savings Bank of Chicago. There was a sharp increase in profit-sharing plans during World War II, when wages were frozen. Deferred profit-sharing plans enabled wartime employers to provide additional compensation to their employees without actually raising their wages.
The Employee Retirement Income Security Act of 1974 (ERISA) provided a further boost in the use of profit-sharing 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.
Many companies have turned to profit-sharing plans during hard economic times, when they are unable to provide guaranteed wage increases. Chrysler Corporation, for example, introduced profit sharing for its union and nonunion employees in 1988 during an economic recession. Its profit-sharing plan was offered as part of its union contract in exchange for wage concessions made by its workforce. Corporate earnings at the time were weak, so profit-sharing payouts were small. By 1994, however, Chrysler had recovered and was paying an average profit-sharing bonus of $4,300 per person, to 81,000 workers, a total outlay of approximately $348 million.
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 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. 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 1998 survey conducted by Coopers & Lybrand found that 20 percent of all respondents provided a qualified deferred profit-sharing plan. Such plans were more prevalent among larger companies, with 30 percent of the respondents with 10,000 or more employees offering a qualified deferred profit-sharing plan.
Deferred profit-sharing plans are a type of defined contribution plan. Such employee benefit plans provide for 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 employees' 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 is to establish strict rules for making payments from employees accounts, such as at 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 recent tax rules allowed companies to contribute a maximum of 15 percent of an employee's salary to his or her profit sharing accounts. 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. According to a 1998 survey by Employee Benefits Journal, companies with profit sharing plans contributed an average of 8.6 percent of their employees' earnings to their plans.
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 pretax 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 board of directors —at its discretion—decides 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 it 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 profit-sharing distributions. Some plans may require a certain length of employment, for example.
[ David P. Bianco ]
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' The Network Discusses: Improving Visibility of Profit Sharing Plans." Compensation and Benefits Review. November/December 1997, 30-31.