Why Install an Executive Compensation Plan?
Simple. Quite often qualified plan contributions, even at the limits, will be inadequate to meet the retirement income needs of highly compensated employees.
Executives at companies with 401(k) plans actually often find they’re severely limited by plan limits as to how much they can contribute; and, that severely limits their ability to achieve the necessary levels of retirement income to continue their pre-retirement standard of living, even when coupled with Social Security.
For example, it’s not uncommon to find that a typical wage earner will achieve about 60-80% of final compensation from a combination of Social Security and qualified plan distributions. But, a highly-compensated executive (HCE) may only achieve retirement income of about 10-30% of final compensation.
Will Your Top Executives Exercise “Free Agency”?
It’s no secret: It can take years to find or develop the executive talent needed to build the business to the next level. Not only is executive talent is hard to come by, it is even more difficult to replace when it walks out the door.
What keeps a key executive? There are many reasons, of course; but, a strong monetary incentive package is likely a bedrock requirement. People tend to stay where they feel appreciated and appropriately rewarded. Structured incentive plans can help keep key executives in place and motivate them to higher levels of performance.
Plans such as Nonqualified Deferred Compensation, Executive Bonus, and Split Dollar Life Insurance are quite often life insurance-based plans utilized by business owners because they enable the business to offer current and future benefits to their key executives in exchange for their continued service for a specified period of time. 1
Nonqualified Deferred Compensation Plan
A nonqualified deferred compensation (NQDC) plan is an arrangement between an employer and a key employee whereby the employer agrees to pay additional compensation for a specified period of time in exchange for the continued service of the employee. When certain tax code requirements are met, this arrangement allows the employer to single out highly compensated employees for the purpose of rewarding them for their contributions to the company, and as an incentive for the employee to stay with the company.2
The amount of compensation to be deferred is agreed upon by the employer and the employee. The plan can be funded or unfunded. If it is funded the employee must be at risk to forfeit his rights to the compensation or else it will be currently taxable. In other words, the money becomes taxable once ‘vested’. As long as the compensation is beyond the control of the employee, it isn’t currently taxable; so, the key is to avoid “constructive receipt” by the key executive. An unfunded plan, of course, allows for the taxation of compensation to be deferred until it is actually received.
Many plans are informally funded through the use of life insurance which is owned by the employer on the life of the employee. The accumulated cash value funds the plan and is distributed as compensation over a specified period of time. The death benefit paid to the company is available to compensate the family of the employee if death occurs prior to the planned distribution. The employer may also use the death benefit proceeds to offset the cost of funding the plan. The distributions are taxable to the employee when they are received and the employer receives a tax deduction as the benefits are paid.
Executive Bonus Plan
Another way an employer can reward selected key employees is through an Executive Bonus Plan (IRC Sec. 162). Under this approach, the employer bonuses the employee for the premium paid by the employee for a life insurance policy owned by the employee. The policy, including the cash values, belongs to the employee who can maintain the coverage on his own if he were to leave the employer.
The bonus which equals the amount of the net premium payment is considered to be additional compensation to the employee and is taxed currently. In some cases, an employer will bonus an extra amount to offset the employees tax on the premium. The bonuses are tax deductible to the employer.
Executive compensation plans such as nonqualified deferred compensation and executive bonus plans involve legal, tax and insurance issues. The guidance of a qualified tax or financial professional is strongly recommended.
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.