Deferring Compensation Can Be Sound Strategy

Even with the market correction over the past year, small business owners and senior executives may still be opening their retirement plan statements and immediately running for rolls of antacids.

A recent study by AXA Equitable Life Insurance Co. showed that four in 10 Americans plan to delay their retirement by six years. Moreover, three in four persons surveyed believe that taxes will increase over the next year. A growing majority of Americans seem to be concerned about having enough money to retire comfortably.

Relief may be at hand in the form of a deferred compensation concept which is one of the most important yet underused in the small business market.

Over the past 20 years, we’ve seen prolific changes in the way in which owners of small- to medium-size businesses compensate their key employees. Pension, profit-sharing, and 401(k) plans are now so widely accepted as to be commonplace. These benefits are typically referred to as “qualified plans,” because they satisfy certain criteria to qualify for favorable income tax treatment.

But small business owners and key executives also may defer compensation which does not meet the criteria for qualified plans. Imagine having the ability to implement a plan that allows for:

• Selectivity and control where the business owner maintains complete control of the plan and is able to choose the participants as well as the contributions;

• Exemption from IRS rules that regulate qualified plans;

• Preferential treatment to top executives;

• Low set-up and administrative costs.

Sound too good to be true? Hardly.

Such “non-qualified” deferred compensation arrangements are utilized by many small- to mid-size businesses. Non-qualified plans are essentially agreements by an employer to make future payments to an employee as compensation for future services.

Restrictions in place on qualified plans have made non-qualified plans increasingly important. A company’s 401(k) or profit sharing plan may be an adequate retirement savings plan for the majority of employees, but this may not be the case for either the business owner or her highly compensated executives.

A highly compensated senior executive is actually working at a disadvantage in trying to fund his or her retirement income goals through qualified plans. So it’s no surprise that business owners and executives value benefits that build and maintain their wealth. Therefore, establishing a non-qualified retirement plan for key executives may help them reach their retirement income goals, as well as help business owners retain their loyalty.

Consider the hypothetical example in the chart, which shows how key employees could be receiving substantially less of a deferral opportunity (as a percentage of income) plus company matching contributions.

One possible solution is the so-called “golden handcuff.”

Here, the employer initiates a plan in an effort to lock in or “golden handcuff” key employees with attractive fringe benefits. In this type of plan, no salary reduction is involved and part of the employee`s total compensation package is simply deferred until a later date. The “inducement-to-stay” plan or “golden handcuff” is most beneficial for an employer in an industry dominated by a few key individuals, or in a company in which profits are heavily dependent upon one or more key employees. This type of plan is sometimes referred to as a “supplemental income plan,” or a “salary continuation plan.”

The best candidates for non-qualified deferred compensation plans are generally closely held corporations. These corporations should have surplus cash or other liquid assets; one or more executives it wants to retain; and a competent successor management team.

Another entity to benefit from these plans would be a business organization utilizing an independent contractor. For example, a hospital may set up a salary continuation plan for an emergency room physician who is an independent contractor.

“Non-qualified” deferred compensation is simply the deferred payment of earned compensation under a plan or arrangement that is not eligible for the tax benefits accorded “qualified” pension and profit sharing plans. With a deferred compensation arrangement, the employer agrees to pay the employee compensation in the future for services the employee currently renders. This generally takes place at retirement, but can also happen at a time in which his or her personal expenses are expected to increase (e.g. children reaching college age).

In the most popular “funded” plan, the employer sets aside specific assets to meet its future obligation. If the employee has no present right in these assets, the employee escapes taxation on the current contributions until his rights are substantially vested.

If a funded plan is selected, employers must determine a funding mechanism. Solutions which generate taxable interest, dividends, or capital gains create an additional asset for the corporation to track, not to mention current corporate tax liability. Other solutions which are often chosen may have ancillary benefits such as tax-deferred growth, tax free income distribution, and an income tax free death benefit to the surviving spouse.

As attractive as these plans are, setting them up properly is not a “do it yourself” project. They require the assistance of a team including a financial planner and often times a CPA and attorney. Make sure the professional with whom you engage has significant experience both designing and implementing these plans. Doing so will insure they are executed properly so that the return on your investment will pay dividends through the years to come.

Daniel J. Munroe of AXA Advisors, LLC, has over 10 years of experience in the field of wealth transfer and planning for private clients and corporations. He has served as an assistant attorney general for the Commonwealth of Virginia, as an insurance carrier general counsel, and as head of the estate and business planning divisions and life insurance product development division for AXA Equitable Life Insurance Co. He holds both the JD and CLU designations. Reach him at 860-966-2977, or via e-mail at Dan.Munroe@axa-equitable.com.