Profit sharing is a form of compensation in which a company shares part of its pre-tax profits with employees. This type of compensation can work in a number of different ways, depending on the structure of the company and the decisions made by employees and employers. As a general rule, such plans are designed as an incentive. When employees share in the profits, they have a vested interest in increasing the profits so that they can access more money. Businesses of a wide range of sizes can engage in profit sharing arrangements.
The profits may be distributed in the form of cash, stocks, and bonds, or a mixture of these forms of compensation. In a deferred profit sharing agreement, the profits are held in trust and used to fund a retirement account. One advantage to this type of arrangement is that it is usually tax-exempt, since the employees cannot yet access the funds and they are therefore not considered income. People who receive profit sharing payouts immediately, however, will need to pay taxes on them.
Cooperative businesses are often set up along a profit sharing model, with members of the business receiving varying shares depending on how long they have been working with the cooperative, how much they have invested in it, and so forth. Businesses which do not operate along cooperative lines can use the sharing model to incentivize hard work and innovation among employees, awarding shares of the profits on the basis of a variety of rubrics.
For pension and retirement plans, profit sharing can be highly effective. However, employees should consider enrollment in the plan carefully. If the company is growing and doing well, the pension plan will grow correspondingly large. However, if profit sharing is done in the form of stocks, employees risk having the stocks lose value, and long term employees may find that when they are ready to retire, they can't access as much money as they thought they would be able to.
Setting up a profit sharing agreement takes time. Companies and employees interested in pursuing such an agreement should do their research carefully and work with experienced lawyers to set up the terms in order to ensure that the plan operates fairly and smoothly. Sometimes it can be helpful to ask other businesses about the models they use and the pitfalls they have encountered while establishing their own plans, to generate a list of things to avoid or watch out for.