Providing Compensation And Benefits To Owner-Employees

Many businesses look to alternatives outside the qualified plan arena to recruit, retain and, when the time comes, generously reward key employees.

Providing compensation and benefits to owner-employees, key executives and other highly skilled people is a concern to businesses large and small. However, the increasing restrictive regulatory environment imposed on qualified plans coupled with escalating costs and ongoing anti-discrimination rules have made executive benefit planning through qualified plans like 401(k)s, SIMPLE and SEP IRAs more difficult and expensive.

That's why many businesses look to alternatives outside the qualified plan arena to recruit, retain and, when the time comes, generously reward key employees. Deferred compensation fills this niche by providing employers with a nonqualified plan that rewards selected executives by helping them set money aside for retirement, death and disability. Nonqualified arrangements may be used as a supplement to, or as a replacement for, a qualified retirement plan.

Deferred compensation is most useful when one or more of the following indicators are present:

  • The employer wished to benefit a select, highly compensated employee or select group of highly compensated employees.
  • The employer has a need to attract, retain or reward one or more employees.
  • The employee is "maxed out" on contributions or benefits to a qualified plan.
  • The employer has no qualified retirement plan in place and does not want to establish one.

Why deferred compensation? A deferred compensation arrangement can provide business owners with the kind of flexibility that is unavailable in a qualified plan. Next, they can provide generous benefits to selected, key-executive employees, including a different level of benefits for different employees. Paperwork is kept to a minimum since government supervision is not a factor.

Employer Advantages To Deferred Compensation:

  • The employer has the right to pick and choose participants from their select group of highly compensated employees, and who is covered remains confidential.
  • It's an attractive method for recruiting, retaining, rewarding and retiring valuable employees.
  • It provides benefits in addition to qualified plans or can be used in lieu of these plans.
  • No IRS pre-approval is required.
  • The benefits are tax deductible by the employer when paid.
  • It's cost-effective because it is easy to establish and administer.
  • The terms of the arrangement can be structured to serve the individual needs of covered employees.

Employee Advantages To Deferred Compensation:

  • The employee generally pays no tax on benefits until they are received.
  • The arrangement can supplement retirement benefits provided under qualified plans or personal savings.
  • Death and disability benefits can be added to the arrangement.
  • The arrangement can include a survivor benefit.

Meeting The Employer's Deferred Compensation Obligation
Most businesses promising deferred compensation benefits will choose to set aside funds to meet their future obligations. To avoid having contributions taxed immediately to the employee, the corporation should hold all property during the accumulation period, being careful not to grant vested rights in any of the assets to the employees before benefits are due.

Life Insurance
Life insurance can fit neatly into unfunded arrangement requirements. The select employee is insured. The employer is the owner, premium payor and beneficiary. As a corporate asset, the policy is available to creditors, and the employee has no beneficial ownership rights in the policy. Life insurance can help provide flexibility while helping employers pay promised benefits with potentially no drain on future earnings. Here are some of the benefits life insurance offers:

  • Its proceeds help assure the employers that funds will be available to help pay the promised benefits regardless of when death occurs, subject to the claims-paying ability of the insurer to help meet its financial obligations
  • The potential cash values of a life insurance policy accumulate income tax deferred, unlike other vehicles that may require the employer to pay tax during the accumulation period. Withdrawals and loans will reduce policy cash values and the death benefit and may have tax consequences.
  • Life insurance death benefit proceeds are generally federal income tax-free to the beneficiary (the employer in this case).

Annuities
Since income from annuities owned by a corporation is currently taxable, the advantage of tax deferred inside buildup would be lost if annuities were used to accumulate promised deferred compensation benefits.

Mutual Funds
For employers and employees who favor the potential rewards and inherent risks of investing in the stock and bond markets, mutual funds can offer a funding alternative. Mutual funds provide both professional management and diversification, but diversification cannot eliminate the risk of investment loss.

Whether it's a non-qualified plan or a traditional qualified retirement plan, start planning for the future—yours, your employees' and your company's today.

Reprinted with permission from The Family Business Report sponsored by the Goering Center at the University of Cincinnati College of Business Administration.