Profit-sharing plans can be an effective incentive tool to help employees focus their efforts on the long-term success of your startup. Profit-sharing plans reinforce the importance of the long-term success of the company, because the employee will see that their stake in the profit sharing depends on your startup’s ongoing success.

Types of profit-sharing plans

Essentially, there are two basic types of profit-sharing plans: a cash or bonus plan or a registered deferred plan.

Cash or bonus plan

Under a cash or bonus plan, employees receive their profit-sharing distribution in cash at the end of the year. The main disadvantage to a cash distribution plan is that these profit-sharing bonuses are then taxed as employee income. Even if distributions are made in the form of company stock, they are taxable upon receipt.

Registered deferred plan

To avoid immediate taxation, companies are allowed by Canada Revenue Agency (CRA) to set up registered deferred profit-sharing plans. Under a deferred plan, profit-sharing distributions are held in individual accounts for each employee. Employees may only withdraw from their profit-sharing accounts under certain conditions such as termination or retirement.

Under registered deferred profit-sharing plans, employees may be given a range of investment choices for their accounts, including stocks or mutual funds. Such choices are common when the accounts are managed by outside investment firms.

Profit-sharing plans for startups: Advantages and disadvantages

Type of profit-sharing plan Advantages Disadvantages
 Cash or bonus plan
  • Is received in cash
  • Payment is immediate
  • Is easy to create and administer
  • Payments are taxed each year
Registered deferred plan
  • Taxation is deferred
  • Investment gains are exempt from tax
  • Has many investment choices
  • Employee must wait to receive payments

Calculating the profit sharing

Companies may use different formulas to calculate the distribution of profits to their employees, and establish a variety of rules and regulations regarding eligibility. For example, allocation of profit can be:

  • Divided equally among all staff
  • Based on position or level
  • Based on individual contribution

Establishing profit-sharing plans: Key considerations

When setting up a profit-sharing plan, consider the following:

  • Has your startup decided to hire a financial institution or a retirement-plan professional to set up and manage the plan?
  • Have you adopted a written plan that describes the features your startup wants to offer? These features may include:
    • How contributions will be allocated
    • When they will be vested
  • Have you arranged a trust fund for the profit-sharing plan assets?
  • Have you notified eligible employees and provided them with information to help in their decision making?
  • Have you developed a record-keeping system?
  • Have you decided how much to contribute to the plan this year?
  • Are you familiar with the legal responsibilities of profit-sharing?
  • Are you familiar with the reporting and disclosure requirements?
  • Are you prepared to monitor and evaluate the plan’s service providers?

For help in establishing and operating a profit-sharing plan, contact a retirement-plan professional or a representative of a financial institution that offers retirement plans.