Taking Care of the Key Executive
Investors are scrutinizing executive compensation and benefits more than ever. A business today, whether publicly or privately owned, is likely to need a direct link between its 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 also can be used to sweeten the compensation package.
Nonqualified Deferred Compensation Plans
The popularity of nonqualified deferred compensation plans has risen dramatically in recent years, especially among mediumsize to large businesses. Their relative flexibility means that the plans are limited only by your compensation objectives and creativity.
KEY ATTRIBUTES OF A NONQUALIFIED DEFERRED
- Must be for a select group of management or highly compensated employees.
- Flexibility allows design for maximum employee incentive/retention.
- Must be deferred 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 business’s creditors.
- Distributions are not subject to the various penalties, restrictions and requirements that qualified retirement plans are.
- A life insurance contract can be used to informally finance the agreement.
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 new guidelines.
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, certain 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.
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 aren’t taxable to executives and aren’t deductible to the company until paid out of the trust, and
- Earnings within the trust are taxed to the company.
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 could cause adverse tax consequences to the company, which may help ensure it will continually pay the premiums.
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