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The Choices in Non-Qualified Executive Benefit Programs

Posted on: April 9th, 2013 by deliafg (Author)

To attract and retain skilled employees, small businesses can use a variety of rewards and incentives including bonuses, group benefit programs, and 401(k) plans. For the top tier of executive talent, additional non-qualified executive benefit plans can be offered selectively. This article reviews four types of executive benefit plans:

  • Executive Bonus Arrangements
  • Split-dollar Arrangements
  • Non-qualified Deferred Compensation
  • Supplemental Employee Retirement Plans (SERPs)

What is a Non-Qualified Executive Benefit Plan?

The term "non-qualified" means that the plan does not comply with a section of the U.S. tax code that grants tax benefits to a "qualified plan." A non-qualified plan is not bound by many restrictions imposed on qualified plans, such as requirements to include all eligible employees. Non-qualified plans are not subject to most or in some cases any of the requirements of the Employee Retirement Income Security Act of 1974 (or ERISA). Thus, they are spared much of ERISA's red tape. To avoid ERISA requirements, some non-qualified plans (typically deferred compensation plans) must meet the definition of a "top-hat" plan that provides deferred compensation for a select group of management or highly-compensated employees. Although the types of plans described in this article generally meet this test, a tax attorney or employee benefit specialist should be consulted for a determination.

Executive Bonus Arrangements

These arrangements are among the simplest executive benefits to put into place and administer. The company pays the executive a bonus as taxable income, and the expense is deductible for the company. The bonus is used to pay premiums on a permanent life insurance policy with cash value. The executive owns the policy and its cash value and can name or change the beneficiary. The cash value of the policy can be used by the executive for any purpose, including helping to fund a personal retirement.

The "golden handcuff" element of these arrangements is built into the need to continue funding the life insurance policy with annual premiums (via bonuses). If the executive leaves the company, the policy will be worth less or may even lapse. To increase the strength of the "handcuffs," some companies add a "restrictive endorsement" that requires the employer's permission to access cash value.

Split-dollar Arrangements

A drawback of Executive Bonus Arrangements is their relatively high cost to the employer, which is equal to the cost of a cash bonus. A Split-dollar Arrangement can create similar advantages at reduced cost. The company and executive agree to split the benefits of a life insurance policy on the executive. Because the company can recover its cash outlays later (when the executive dies or retires) from the policy's cash value or, in many cases, the full cash value, at most the company's cost is limited to the "time value of money" on premiums advanced.

There are two basic types of split-dollar arrangements, collateral assignment and endorsement. In the first type, the policy is owned by the employee, who then assigns the cash value to the employer as collateral. In the second type, the company owns the policy and gives the executive (via an endorsement) the right to name the beneficiary. All endorsement arrangements, and those collateral assignment arrangements in which the employer recovers the full cash value, are taxed under what the IRS calls the "'economic benefit regime"; collateral assignment arrangements in which the employer recovers only the premiums it paid are taxed under the very different rules of the "loan regime".

Non-Qualified Deferred Compensation (NQDC)

NQDC plans fall into a broad category of executive benefits that may take many forms. In simple terms, the plan is an unsecured promise by an employer to pay a benefit in the future. In one common structure, called a "401(k) Mirror Plan," the executive may voluntarily defer more money from salary than is allowed under regular 401(k) rules. The executive also can decide how this money is invested. The key difference is that the executive does not own any investments in the mirror plan. The company promises to pay a future benefit to the executive, indexed to performance of the investments chosen.

When salary is deferred, the company may not claim a federal tax deduction for the amount deferred and the executive does not include the amount deferred in Federal taxable income. When the employee receives the compensation, the employer then deducts amounts from income taxes and the employee recognizes taxable income.

Supplemental Executive Retirement Plans (SERPs)

A SERP is a type of NQDC plan into which the executive is not required to voluntarily defer salary or bonus. Instead, the company makes a promise to pay a future benefit that can accrue over time based on agreement and executive performance. A key design issue in these plans is that they must be unfunded: the employee can have no right to any assets set aside to pay the benefits. Employers may however informally "fund" their obligations to pay with various types of assets. In most cases, this informal funding is earmarked among general assets of the company but in all cases, those assets are available to company creditors. In some cases, these assets are placed in a "rabbi trust," which provides the participants with some security because assets can't be touched by the company itself or a future acquirer, although they can be tapped by creditors in the case of the company's insolvency.

In summary, having a program for recognizing and rewarding key people is a sign of long-range planning. It shows that the owner has a vision for the future and wants the company's most valuable people to be part of it. The potential to participate in these rewards also can increase the incentive among rank-and-file employees to work harder, upgrade skills and assume responsibility. Also, rewarding key people can be a preliminary step in identifying a successor owner or manager. This process can potentially help the company survive the unexpected loss of a current owner, while creating the liquidity to buy out the owner's interest and provide financial security for heirs.

Lincoln Financial Advisors Corp. and its representatives do not provide legal or tax advice. You may want to consult a legal or tax advisor regarding any legal or tax information as it relates to your personal circumstances.