Determining the ideal profit sharing design for your organization.
Profit sharing is a powerful tool that goes beyond mere employee motivation. As businesses seek ways to inspire their workforce, and employees look for recognition and meaningful work, profit sharing emerges as a compelling business strategy that should not be underestimated.
According to the National Center for Employee Ownership, over 12,000 U.S. companies currently share ownership with more than 25 million employees. The reasons for adopting profit sharing plans vary, as do the benefits they offer. These plans act as effective employee attraction and retention tools, fostering increased productivity and loyalty by financially rewarding employees' efforts.
In essence, profit sharing serves as an incentive for exceptional performance, aligning employees with the overall success of the business and forging a deeper connection with their daily work. And certain profit sharing plans provide organizations with tax advantages, making them even more appealing.
Benefits of profit sharing:
• Enhanced employee loyalty and retention
• Increased attraction of top talent
• Promotion of employee engagement
• Cultivation of a culture of ownership
• Corporate tax advantages
• Strengthened employee link to business performance
Profit sharing plans come in various forms, offering structural flexibility in terms of profit allocation based on tenure or position, often with a vesting schedule.
From a distribution of periodic company earnings to a tool for succession, profit sharing can be an important tool. Before diving into employee-ownership trusts (EOTs), let's explore several popular profit-sharing designs that cater to different types of businesses and their owners, offering diverse benefits.
Per capita percentage allocation is a straightforward profit sharing plan design that distributes profits based on an equal percentage of each employee's salary. This plan works well for small and medium-sized businesses seeking a simple and transparent approach to reward their employees. It fosters a sense of fairness and camaraderie, encouraging teamwork and collaboration.
The Social Security integrated design is tailored to businesses with higher-earning employees, such as professional services firms or enterprises with executives. This plan coordinates profit sharing contributions with Social Security tax deductions, allowing employees to optimize their overall retirement benefits while minimizing their taxable income. By integrating Social Security planning with profit sharing, businesses can attract top talent and provide valuable long-term rewards.
Cross-tested profit sharing is a more complex design suitable for companies with varying employee demographics, such as businesses with a wide range of ages and compensation levels. This plan allows the business owner to divide employees into different groups and allocate profit sharing contributions proportionally based on factors like age, compensation and service. Cross-testing ensures equitable distributions that align with the company's goals and the employees' individual circumstances.
For business owners nearing retirement or looking to exit the company, employee ownership can provide a viable succession plan. Selling the business to employees allows the owner to pass on their legacy and ensure the company's continuity while maintaining its values and culture. Certain employee ownership structures, such as employee stock ownership plans (ESOPs) or employee-ownership trusts (EOTs), can offer tax benefits for both the company and the selling owner. These structures may allow the business owner to defer capital gains taxes or receive tax deductions, depending on the specific plan.
Employee-ownership trusts, also known as perpetual employee trusts, blend long-term planning with employee involvement. In an EOT, employees receive a share of company profits without directly owning an asset susceptible to annual valuation fluctuations. These plans allow employees to participate in critical decisions, such as board member selection, giving them a voice in shaping the company's direction. The increased engagement resulting from such participation fosters a sense of ownership and responsibility for the organization's future. Notably, employees are not required to contribute to purchase ownership stakes; instead, they receive a portion of ongoing profits. While EOTs boast low setup and maintenance costs, they may lack the potential tax benefits found in other options.
Worker-owned cooperatives grant equal decision-making power to each employee ("one employee, one vote"). The cooperative is entirely owned and governed by its workforce. Although profits are not distributed equally, co-op members receive a "patronage share" based on factors like hours worked or negotiated agreements. The value of these shares does not appreciate, supporting long-term employee ownership. Employees typically make a small equity buy-in, and the board of directors often comprises employee-owners elected by the members. Worker-owned cooperatives offer low setup and administration costs and come with a significant tax advantage – the 20% federal pass-through business deduction.
Beyond these designs, there are many ways to foster a sense of ownership and connection among employees while rewarding them for their contributions. Besides profit sharing plans, businesses can consider equity compensation, where employees receive non-cash pay in the form of restricted stock or performance shares.
To determine the most suitable profit sharing option for your business and employees, it's essential to conduct thorough research and seek advice from profit sharing plan experts. It is important to ensure that the plan is properly designed and complies with all relevant legal and regulatory requirements, such as those outlined by the Internal Revenue Service (IRS), Department of Labor, and the Employee Retirement Income Security Act (ERISA). An improper fit or noncompliance could lead to penalties, disqualification of the plan, and potential legal liabilities.
Sources: nceo.org; project-equity.org; smallbusiness.chron.com; uschamber.com; bankrate.com; investopedia.com
Raymond James and its advisors do not offer tax or legal advice. For tax or legal matters, consult the appropriate professional. Investing involves risk, and profits or losses may occur regardless of the strategy employed, including diversification and asset allocation.
