How do closely held companies reward, retain and recruit key personnel? Public stock isn’t an option, and opening the books and selling off shares of the business generally doesn’t appeal to entrepreneurs.
Still, irreplaceable employees deserve reward for their contributions to the company, and owners can’t afford to lose them.
Nonqualified key employee incentive plans, otherwise known as nonqualified deferred compensation, give valuable management their just desserts — if they promise to stay loyal to the business.
“Employees are looking for other sources of supplied post-retirement income, and nonqualified plans can provide that,” says Richard Gary, associate director of SS&G Financial Services in Akron.
What closely held businesses must know is which program design will best fit their needs and how to administer these plans so they serve as the “golden handcuffs” that keep employees on board until retirement.
Smart Business talked to Gary about planning for post-retirement income.
What sort of plans focus on providing post-retirement income?
There are defined benefit, defined contribution and profit-sharing plans that reward employees with additional compensation after a predetermined period of time.
For example, say you want to reward a manager who helped grow the company, and you’d like to do more than give him a year-end bonus. You could create a plan that promises to pay him an additional 50 percent of his final pay for 10 years after retirement at age 65. You can also design a plan that promises to pay the manager $50,000 a year for 15 years after age 65. You can design several variations to create a plan suitable for your business.
A defined contribution or a profit-sharing plan provides more flexibility and control for the business owner. Say you deposit 20 percent of the manager’s base salary in an account and then credit the account with a competitive interest rate. The manager cannot claim funds until he reaches the designated age.
Can business owners design a plan that models public stock to appeal to managers who are accustomed to this benefit?
You might be familiar with the buzzword, phantom stock. This is how one variation works: For every year the manager works at the business, you agree to consider crediting his account with a contribution of up to 10 percent of the value of the business. Say you agree on 1 percent for the current year. If the business is valued at $1 million, you would contribute $10,000 the employee’s account. On the other hand, if the business loses money that year, the manager also takes a loss by a reduction in his account balance. The theory is, since you are ‘sharing’ the business, when the company goes down, everyone goes down. The incentive motivates managers to help the business grow, so they can also add profit to their personal accounts.
Is a nonqualified deferred-compensation plan an alternative to qualified programs, such as profit-sharing or 401(k)?
Absolutely not; your employees should maximize all qualified plans. Nonqualified deferred-compensation plans cater more to business owners who want to model a supplemental plan for their key employees in addition to the qualified benefits plans they already offer.
All benefits paid out under a nonqualified plan, whether to a survivor or the employee at the time of retirement, are taken out of the business as ordinary income. In other words, employees must pay taxes on the compensation, and corporations then take a deduction for tax purposes.
What are business owners’ key concerns with nonqualified plans?
Initially, their greatest concern is that the funds they credit to deferred plans add a liability to their financial statements because they are promising to pay managers in the future. Many closely held business treat themselves like public companies when it comes to financial reporting, and many banks have loan covenants that need to be considered.
Also, nonqualified plans are technically unfunded, unsecured promises to pay benefits in the future. They have to be unfunded and unsecured for two reasons. First, you want to avoid reporting and disclosure requirements. The only paperwork the Department of Labor requires is a one-time letter at the inception of the plan that states its existence. Plans must be unfunded because you do not want your employees to incur taxable income before they retire and actually receive the funds.
How can owners match funds for the future so they can cover nonqualified plans?
If you are uncomfortable with waiting to pay the benefit from future earnings, you can choose to match assets against the liability of a nonqualified plan. Some ways of doing this are through stocks, bonds, mutual funds and corporate-owned life insurance.
RICHARD GARY is an associate director of SS&G Financial Services in Akron. Reach him at (330) 668-9696 or [email protected].
