Every business has one common goal – profit. And employees play a significant role in generating profits. Some of the most successful business owners have said, “Hire people smarter than you”. More competent people bring with them the expertise, skill, and experience your business needs to expand. However, attracting such a talent is expensive. Thankfully, many such skilled people look for profit sharing rather than a fixed salary or bonus as they know they can bring in the moolah. They would like to be rewarded for their efforts.
If you are searching for such talent, you can offer them a profit-sharing option, either in direct cash or in employee stock options.
Profit Sharing: A Win-Win for Both Employer and Employee
In profit sharing, whenever a company makes a certain amount of profit, it will share a portion of it with employees as cash or stock. This is beneficial for both employer and employee.
Employer:
- Unlike bonuses and high salaries, the business pays extra to the employees in the year they make profits, giving them business financial flexibility.
- Since employees’ pay is linked to the company’s performance, they remain motivated to deliver results.
- It also boosts loyalty as an employee may not leave the company midway through a major project.
- The employer can design the profit-sharing program as per the business needs.
- The profit contributed to the profit-sharing program is tax deductible for the business.
Employee:
- Employees get rewarded for their hard work. They feel a sense of ownership and have better control over their performance.
- Several profit-sharing programs are taxed at the present, and some defer tax, allowing them to diversify their investments.
- Unlike investors in stocks of other companies, employees have more control over employee stocks. Since they are insiders, they can invest more and have skin in the game if they see a bright future for the company. They can also withdraw their profits if they expect headwinds.
How Can Small Businesses Use Employee Profit-Sharing Plan?
In a profit-sharing plan, the business calculates the quarterly or annual profit and contributes a certain percentage (formula for which the business owner decides based on the work profile and outcome) to a savings account or a trust. The employee can also contribute to this account.
The profit accumulates and is given to the employee after a certain lock-in period. Ensure the lock-in period is not very long, which may deter talent from accepting the offer. Employees can withdraw the money during their tenure or when they leave the company.
When designing the employee profit-sharing plan, you could have different plans for different teams (sales team, operations team) or some plans exclusively for higher-level executives directly responsible for higher profits. You could give bonuses to those who contribute indirectly.
Four Types of Profit-Sharing Plans
There are four types of profit-sharing plans, which differ based on their tax treatment.
- Cash profit sharing plans—This is the simplest plan. The business directly credits the profit to the employee’s account through cash, cheque, or stocks. The company deducts it from business income, and the employee adds it to their taxable income. There is no tax deferral and no need to register with the CRA.
- Employee profit-sharing plans (EPSP)—In this, a share of annual profits is placed in a trust fund, and any interest and returns are accumulated here. Employees can also contribute their after-tax income to the trust. The employee pays tax annually on the profit transferred and the interest and capital gains accumulated in the trust. The withdrawals are tax-free.
The drawback of the above two plans is that employees cannot do tax planning. The two plans below defer tax payments until the employee withdraws money, giving the employee more control over their tax planning.
- Deferred profit-sharing plans (DPSP)—The employer can contribute the profit to the trust account. However, employees cannot contribute unless it is transferred from other registered tax-assisted plans. The employee pays tax when they withdraw the money or receive a lump sum at the end of their employment. Employees can transfer this lump sum into a Registered Retirement Savings Plan (RRSP) and defer tax payments to RRSP withdrawals.
- Register profit-sharing pension plans. These plans work like pension plans, where employer and employee contributions are tax deductible. However, interest is taxable. The employee pays tax when they withdraw the money, retire, or end their employment and receive a lump sum amount.
Contact Black and Gill LLP in Etobicoke to Help You Prepare a Profit-Sharing Plan
Setting up a profit-sharing plan is complex and needs thorough accounting and calculation. You have to do a lot of number crunching to get the correct ratio. A professional accountant can help you crack the numbers, and design and maintain a profit-sharing plan with detailed accounting. To learn more about how Black and Gill LLP can provide you with the best accounting and bookkeeping expertise, contact us online or call us at 416-477-7681.