Profit sharing Plans

A plan whereby employees share in the company’s profits.

Profit sharing plans are plans in which all or most employees receive a share of the firm’s annual profits. Research on such plans’ effectiveness is sketchy. One study concludes that there is ample evidence that profit sharing plans boost productivity and morale, but that their effect on profits is insignificant once you factor in the costs of the plans payouts.

There are several types of profit sharing plans. In cash plans the firm simply distributes a percentage of profits (usually 15 to 20%) as profit shares to employees at regular intervals. The Lincoln incentive system, first instituted at the Lincoln Electric Company of Ohio, is more complex. In one version, employees work on a guaranteed piecework basis and the firm distributes total annual profits (less taxes 6% dividends to stockholders and a reserve) each year among employees based on their merit ratings. The Lincoln plan also includes a suggestion system that pays individual workers rewards for saving resulting from their suggestions. The plan has been quite successful.

There are also deferred profit sharing plans. The firm places a predetermined portion of profits in each employee’s account under a trustee’s supervision.

Home depot instituted a bonus program for all its store workers. Starting in 2003, it started paying store associates a bonus if their stores meet certain financial goals. In one recent year, Home Deport distributed a total of $90 million under that company wide incentive plan.

Employees Stock Ownership Plan (ESOP)

A corporation contributes shares of its own stock to a trust in which additional contributions is made annually. The trust distributes the stock to employees on retirement or separation form service.

Employee stock ownership plans are companywide plans in which a corporation contributes shares of its own stock – or cash to be used to purchase such stock – to a trust established to purchase shares of the firm’s stock for employees. The firm generally makes these contributions annually in proportion to total employee compensation with a limit of 15% of compensation. The trust the stock in individual employee accounts and distributes it to employees upon retirement (or other separation from services) assuming the person has worked long enough to earn ownership of the stock (Stock options, as discussed later, go directly to the employees individually o sue they see fit, rather than into a retirement trust).

ESOPs have several advantages. The company gets a tax deduction equal to the fair market value of the shares that are transferred to the trustee, and can also claim an income tax deduction for dividends paid on ESOP owned stock. Employees as noted aren’t taxed until they receive a distribution from the trust, usually at retirement when their tax rate is lower. The Employee Retirement Income Security Act (ERISA) allows a firm to borrow against employee stock held in trust and then repay the loan in pretax rather after tax dollars another tax incentive for using such plans.

ESOPs can also help the shareholders of closely held corporations (in which for instance a family owns virtually all the shares) to diversify their assets by placing some of their own shares of the company’s stock in to the ESOP trust and purchasing other marketable securities for themselves in their place.

Research suggests that ESOPs do encourage employees to develop a sense of ownership in and commitment to the firm. They do so in part because the ESOPs provide increased financial incentives create a sense of ownership and help build teamwork. Those responsible for the funds – usually the firm’s top executives – must be fastidious in executing their fiduciary responsibilities for the fund.

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