Executive Compensation for Business Owners
In a small business setting, it is a challenge to find and develop executive talent. The executive team is the lifeblood of a thriving business, leading the charge to succeed and grow in the competitive market space that is today’s business world. Retention of these highly valued employees is vital to the health of your business.
It is an obvious but frequently ignored fact: key executives who are presented with a strong monetary incentive package are more likely to stay. Structured incentive plans can help keep key executives in place and motivate them to higher levels of performance. We specialize in creating executive retention plans for small businesses.
The Nonqualified Deferred Compensation Plan and the Executive Bonus Plan are examples of strategies that enable a business to offer current and future benefits to their key executives in exchange for their continued service.
Nonqualified Deferred Compensation Plan
Nonqualified deferred compensation plans (NQDC) are designed to provide supplemental retirement benefits for a select group of key employees, officers, directors, and independent contractors. They assist in establishing an incentive to remain with the company and may be designed to contribute to the company's growth and profitability. There are basically two types of deferred compensation plans:
A defined benefit plan, where the future retirement benefit is calculated in advance of retirement and the future benefit is informally "funded" based on the projected benefits. The most common type of plan is referred to as a Supplemental Executive Retirement Plan (SERP)
A defined contribution plan, where the benefits are based on employee and/or employer contributions plus any future increases or decreases in value based on the participant's underlying investment choices. These types of plans are commonly referred to as Deferral Plans and 401(k) "Mirror" plans.
NQDC's are typically used in both public and privately held companies where the owners would like to:
- Encourage executives to build wealth through tax favored savings vehicles
- Motivate and reward executives for long-term employment and productivity
Typical objectives for a deferred compensation plan include:
- Retention of Top Talent
- Provide an additional tax favorable savings mechanism for the key people
- "Golden Handcuff's" - To provide a Long Term incentive based arrangement for the key people
- Provide an additional benefit over and above traditional retirement plans
- Ability to motivate executives through a performance based company contribution
- Highly compensated individuals retain more of their hard earned money
- More design flexibility than qualified retirement plans
- Unlimited participant contributions (pre-tax)
- Corporate contributions can create a retention "hook"
- Employee/employer contributions, plus growth, are tax-deductible when paid
- Unlike traditional retirement plans employer contributions are not tax deductible until benefits are paid
- Participants are general creditors and subject to a substantial risk of forfeiture
In an employer/employee relationship, eligibility must be limited to a select group of management or highly compensated employees (plus independent contractors). Unfortunately, the exact interpretation of a "select group" remains ambiguous. Therefore, plan designers must understand the requirements, evaluate the potential eligible group, and consult with the client and counsel to make a good faith determination of the group of persons who will be eligible for the plan. With that in mind, the following factors should be considered when deciding on eligibility:
- Percentage of workforce
- Ownership interest
- Executive or management responsibilities
- Combined compensation of participants
- Ability to affect or substantially influence the design of the plan
Once eligibility is established the scope could be narrowed to the individuals who:
- Are in the highest tax brackets
- Have the means to save additional dollars
- Are receiving "refunds" back from the 401(k) plan
The type of plan design will dictate the type of contributions made to a NQDC. For example, a SERP would be funded 100% by company contributions, unlike in a true deferral plan where the participant's deferrals are used as the source of contributions. In addition, many times plans will be designed so that both the company and the employee contribute. Typical forms of contributions include:
- Participant deferrals
- Company match as a percentage of deferrals
- Fixed company contribution
- Profit sharing contribution
- Production/incentive contribution
- Phantom stock
- Company stock
Vesting and Award Payment
Company contributions to a NQDC may vest over any time period desired by company management. Most commonly, they vest over a 3-5 year period. Unusually long vesting periods may cause participants to minimize their perception of the expected value of the future award.
The company may also reserve the right to accelerate the vesting schedule based on performance, age, years of service, etc. Some companies will have different vesting schedules for different classes of employees. Generally, vesting is accelerated in the event of death or permanent disability.
NQDC are typically financed (informally "funded") in one of the three ways:
(2) traditional investments
(3) Corporate Owned Life Insurance (COLI).
Self-funding occurs when the company chooses not to "earmark" specific assets for future benefit payments. Although this is permissible, it creates an "unfunded liability" to the company. In most situations the company will choose to match the liability with an offsetting asset.
Investments could include almost any asset (stocks, bonds, certificate of deposits, mutual funds, etc). However, unless an asset is in itself tax exempt or tax deferred, the income (interest, dividends) or gains earned by an employer in connection with a NQDC would be taxable to the company.
The clear disadvantage of using such an asset is the potential tax cost the company will incur on the earnings. Consequently, the employer's asset reserve and the plan's liability can become negatively mismatched over time.
Corporate Owned Life Insurance (COLI) - A specialized product designed for NQDC's
COLI is a common asset used as a reserve for NQDC's. This version of COLI is a specialized product design for the use within NQDC's different from your standard retail Life Insurance. The primary advantage of using COLI is the tax-deferred growth of policy cash values in contrast to Traditional Investments where gains are taxable at the corporate level. Lastly, the policy death benefits can provide the company the opportunity to recover the costs of the program and any replacement cost of the key person.
Currently, mutual funds and COLI are the most common ways to finance NQDC's. Typically mutual funds are more attractive in the near-term, while COLI will look better over a longer period of time (6-7 years or longer). This is due to the tax-deferred growth in the COLI compensating for the insurance related charges. In addition, mutual funds do not provide the employer the opportunity to recover plan costs.
Consequently, a thorough understanding of the employer's objectives, financial considerations, number of participants, age of participants, size of deferrals, etc., is necessary in order to make the correct financing decision.
The crediting rate within a NQDC is established by the employer. Most NQDC participants earn interest/growth on their account balances in one of several ways:
- Tie benefits directly to a corporate asset (COLI cash value, Traditional Investments value, etc.)
- Fixed interest rate to be determined by the company/plan committee each year
- Fixed interest rate tied to a pre-determined index (Prime rate, Moody's etc.)
- Phantom stock value
- "Hypothetical" investments
Many times, companies will use a combination of some or all of these approaches.
Accounting and Tax Treatment
- The deferred compensation value, plus any appreciation, is treated as a compensation expense.
- The deferred compensation plan value is accrued as a liability on the company's balance sheet, offset by a deferred tax asset.
- Employee - No tax when deferred. Taxed at ordinary tax rates when actually paid to employee. Tax withholding is required. FICA taxes payable in year of deferral.
- Company - Receives a tax deduction when paid to employee equal to the employee payment.
For more information on executive compensation plans for business owners, please contact us today.
1 Nonqualified deferred compensation arrangements may be funded, unfunded, or informally funded with the use of life insurance policy.