Taking Care of the Key Executive
Stockholders are scrutinizing executive compensation and benefits more than ever, especially when an economic downturn occurs. A business today, whether publicly or privately owner, is likely to need a direct link between the compensation package and the value it provides the employee. Deferred compensation plans, which enable companies to provide additional benefits to key executives, often are the best way to provide long term performance incentives. Welfare benefit plans and other insurance arrangements can also be used to sweeten the compensation package.
Non-Qualified Deferred Compensation Plans
The popularity of nonqualified deferred compensation plans has risen dramatically in recent years, especially among medium size to large businesses. These plans' relative flexibility means that they are limited only by your compensation objectives and creativity.
Recent tax law changes tighten up the rules governing how nonqualified deferred compensation plans are drafted and operated. Be sure to have any existing plans amended as necessary to comply with the
Because a deferred compensation program is not qualified under tax law, its creation or funding doesn't create an immediate tax deduction for the business. To avoid major ERISA requirements, nonqualified plans must be for a select group of management or highly compensated employees. This means that nonqualified plans are almost always a more cost effective way to provide benefits to a small group of key executives.
As a result, you can tailor your program to fit the specific needs of the business and each executive. Common examples include:
- 401(k) excess plans. These allow executives to defer plan amounts that they could have contributed to a qualified 401(k) were it not for qualified plans' nondiscrimination rules and compensation limits.
- Supplemental executive retirement plans. These provide retirement benefits above and beyond those defined by qualified plans' limitations.
- Stock and phantom stock plans. These provide benefits tied to the business's overall performance.
- Other deferred compensation tied to the performance of individuals, smaller work groups or divisions. These can be based on any criteria and may differ for each plan participant. They contain vesting schedules and other restrictions on the availability of funds.
Planning tip 3
Key attributes of a nonqualified deferred compensation plan
• Must be for a select group of management or highly compensated employees.
• Flexibility allows design for maximum employee incentive/retention.
• Deferral must be set in place before the compensation is earned.
• Amounts are deductible to the company when paid and income is taxable when received.
• Any amounts used to informally finance the benefits promised to participants must be reachable by the
• Distributions are not subject to the various penalties, restrictions and requirements that qualified retirement
• A life insurance contract can be used to informally finance the agreement.
Funding Deferred Compensation Plans
A key issue for any deferred compensation plan is the funding of future benefits (though a plan actually need not provide for any funding mechanism). Key executives generally want some security, however, that benefits will actually be paid.
An accepted practice, recognized by the IRS, is funding through what is known as a rabbi trust. The employer cannot have access to funds once they are contributed to a rabbi trust, but the business's creditors can. Thus, the plan's participants are protected unless financial disaster strikes the business.
Income tax implications of a rabbi trust include:
- Funds are not taxable to executives and are not deductible to the company until paid out of the trust, and
- Earnings within the trust are taxed to the company.
Planning tip 4
Key-employee life insurance can protect your business
In addition to offering attractive compensation to key employees, businesses need to protect themselves in case they lose such employees. Key-employee life insurance replaces the earnings that may be lost if executives or other valuable employees die. But these employees must have a great impact on the business's profitability, such as a salesperson who has the sole working relationship with most of the major customers. This type of insurance policy helps the business sustain itself during the initial loss period while it finds and trains a replacement.
Life insurance can be an ideal financing vehicle for a nonqualified plan. It allows the company to invest funds, directly or through a rabbi trust, and get competitive returns that are sheltered from current taxation. When the company or trust receives a death benefit, it incurs no taxable income. Of course, when benefits are paid out, they are deductible to the company and taxable to the recipient. But beware of the impact of the alternative minimum tax (AMT) if the business is a C corporation.
Using life insurance also can bolster participants' security. If a company refuses to pay premiums when due, the trustee could surrender the policies and generate cash to cover the benefits. This surrender would cause adverse tax consequences to the company, which may help ensure it continually pays the premiums.
Executive Bonus Section 162 Plans
By using an Executive Bonus Section 162 Plan, you can distinguish among employee groups. This plan type is an insurance policy not wrapped in a formal "compensation plan." The employee acquires the policy him or herself (ideally through an insurance trust as discussed below). The employer then pays the premium either directly or indirectly through an employee bonus.
This payment is deductible to the business as compensation, assuming total compensation is not unreasonably high. And the employee has a portable benefit that he or she can take to another job. This means that, while simple and effective, this plan may not be the best way to retain key people.
Group Term Carve-Out
Many businesses have group term policies covering their employees. Such policies are cost effective, particularly for larger groups, and are often the most appropriate means of coverage for the employee group as a whole. In addition, group term life enjoys a unique tax benefit: Premiums are deductible to the company while coverage of up to $50,000 per person is a completely tax free benefit to employees.
Including the company's key executives and shareholders in the group may not, however, make as much sense. Over the long term, this insurance may become very expensive and still leave you with nothing to take to retirement. And the abovementioned special tax break? It works for everyone except the partner, the LLC member, or the 2% or greater S corporation shareholder.
Instead, it may be advisable to "carve out" certain individuals from the group and convert their policies to permanent insurance. This may better meet their estate planning needs and may not actually cost as much over a period of years.