and Reward with Deferred Compensation
Greg Hunter, owner of Rotary Metric Corp. (RMC), couldn’t believe that it had already been ten years since Mark Thompson came on board. Mark was, hands down, the company’s most successful salesperson. Greg knew that he would eventually need to do something extra special to make Mark a permanent part of the company’s future. Greg could ill afford to lose Mark to a competitor, let alone withstand the loss of revenue that would undoubtedly follow Mark’s possible departure. Fortunately for Greg, he’s uncovered a strategic way to keep Mark with RMC for the remainder of Mark’s career—it’s called nonqualified deferred compensation.
On the Surface. . .
Nonqualified deferred compensation simply is a plan whereby a portion of Mark’s salary is deferred until a later date—such as retirement. In essence, Mark will exchange additional current income for a promise by RMC to pay the income, with interest, at a future time. Such an arrangement can be very desirable to a high-income executive like Mark because: 1) he is already limited in the amount he can save for retirement under the company’s existing retirement plan, and 2) he is in a high tax bracket today and expects to be in a lower tax bracket during retirement. Thus, deferred compensation allows RMC to informally fund an additional, and potentially substantial, retirement benefit for Mark. He will receive the deferred income during retirement, which could mean a lower income tax liability (depending on his tax bracket).
Behind the Scenes. . .
Nonqualified plans, such as deferred compensation, escape restrictive Internal Revenue Code (IRC) requirements that are inherent to traditional qualified plans (e.g., limitations on the amount highly-paid employees can contribute to retirement plans and rules that require an employer to provide such benefits for all eligible employees). Thus, a deferred compensation plan provides RMC with the flexibility to offer additional benefits to a highly-valued employee such as Mark. However, such a plan generally has its own complex restrictions and limitations that could potentially result in adverse tax consequences.
Generally, deferred compensation is an unfunded and unsecured agreement. This means that RMC does not have to set aside money for Mark, nor is RMC legally obligated to pay Mark if he leaves RMC or if the company’s solvency or ability to pay in the future comes into question. RMC merely makes a promise to pay. Consequently, Mark bears the risk should the company be unable to meet its future obligation. Suddenly, deferred compensation doesn’t sound very exciting for Mark, does it? This is where life insurance enters the equation.
To help meet its obligations under the deferred compensation plan, RMC can informally “fund” such a plan with the use of a cash value life insurance policy. The key benefits of using life insurance are: 1) no current income taxes are incurred on any cash values, and 2) an income tax-free benefit will be payable to the corporation upon Mark’s death. RMC can use the cash values as a source to pay Mark’s deferred compensation, and potentially receive an income tax deduction for the payments. To make the plan even more appealing to Mark, RMC can include certain “triggers” in the agreement—that is, certain events, such as retirement or disability, that require immediate payment of benefits.
An Intriguing Benefit
A nonqualified deferred compensation plan that is informally funded with life insurance can be an excellent method for retaining the revenue generation of a key employee. In addition, it may be particularly attractive as a supplement for a successful executive, like Mark, who has a greater need for future income, but whose retirement benefits are limited under the rules for qualified plans.
Employee Life Insurance may Hold the “Key”
If you employ a key person who significantly contributes to the success of your business, have you considered the impact losing him or her could have on your operations? Key employee life insurance can help protect your business from the financial consequences of a key employee’s death. Consider the following hypothetical case study.
Sarah Wilde works at 2-Day Technology, a growing software development company. In her seven years with the company, she has developed several, innovative digital media products. Because she has been so instrumental to 2-Day Technology, and her work has propelled the company to the forefront of its industry, Sarah is considered one of the company’s most key employees.
2-Day’s owners, George Hamilton and Hilary Greene, realized the importance of Sarah to the lifeblood of the company and established a key employee life insurance policy. Such a policy can be of great benefit in the event of the loss of such a valuable employee.
How Does the Employer Benefit?
A company such as 2-Day Technology may benefit from life insurance held by the company on key employees by the following:
- Proceeds of the policy can provide 2-Day Technology with funds to compensate for the loss that could result in the event of such a valuable employee’s death. The company could then use the money to: recruit a new employee with credentials/ capabilities similar to those of Sarah Wilde; train the new employee; promote additional sales; or provide for new improvements that would eventually compensate for the loss sustained as a consequence of the death of such a key employee.
- Life insurance on a key employee could provide 2-Day Technology with an accumulation of funds to be used in emergencies. Annual premiums accumulate in a fund with an increasing cash surrender value. The fund has a definite and guaranteed cash value, as the cash surrender value can be determined for any period of time. These guarantees are based on the claimspaying ability of the issuing company
- By maintaining key employee insurance, 2- Day Technology may actually strengthen its credit. The insurance may be used to supply supporting collateral for loans and may be considered good evidence that they will be able to meet future obligations even when the insured key employee is no longer part of the company.
How Does the Employee Benefit?
While life insurance on a key employee can aid in protecting 2-Day Technology against the premature death of Sarah Wilde, there is no guarantee that such a key employee will remain with the company until retirement or death. Therefore, establishing a deferred compensation plan for that employee may act as an incentive for the desired employee to stay with the company.
Under this plan, 2-Day Technology would enter into a contract with Sarah to pay certain benefits upon her retirement. 2-Day Technology may require her to promise not to compete (a noncompete agreement) against the company after her retirement. Such an agreement is a separate plan and isn’t tied directly to the insurance contract. However, life insurance can be a particularly advantageous way to fund such an agreement.
A combination key employee deferred compensation plan may be adopted and funded with a single life insurance policy. That policy would function as indemnity to 2-Day Technology in the event of Sarah Wilde’s death and would also serve as a source of retirement income for Sarah upon her retirement. 2-Day Technology would merely take out a life insurance policy on Sarah; she would not be a party to this insurance contract. Then, at the same time, 2-Day Technology and Sarah Wilde would both enter into the deferred compensation plan.
Therefore, up until Sarah’s retirement date, 2-Day Technology would have indemnity protection. At that date, the company can surrender the policy and use the proceeds to make the deferred compensation payments. This type of key employee insurance plan doesn’t have to cover any specific number or class of employees, and may be particularly suited for companies that don’t wish to establish qualified deferred compensation plans.
If you have employees that are vital to the smooth, successful operation of your company, you may consider taking the steps that 2-Day Technology took and purchase life insurance as a tool of protection and incentive to key employees.
Guidelines for Business Reimbursements
Most executives are aware they can deduct certain expenses (e.g., travel, lodging, entertainment) incurred while performing services for their employer. Typically, the undertakings that involve employee business expenses are: sales activities, temporary work assignments in different locations, workrelated conferences, and jobrelated education. In many cases, employers will reimburse employees for some (or all) expenses under either an accountable or nonaccountable plan.
there must be a bona fide business connection for the incurred expenses;
1)With an accountable plan, reimbursements are excluded from your taxable income and do not appear on your Form W-2. For a reimbursement plan to qualify as accountable, three requirements must be satisfied:
2) the employee must substantiate employment-related expenses to the employer; and
3) any unsubstantiated advance payments (excess reimbursements) must be returned to the employer within a reasonable period of time.
If any of these three requirements are not met, reimbursements are considered to be under a nonaccountable plan and are included in your taxable income on your Form W-2. You can claim expenses reimbursed under a nonaccountable plan (and any unreimbursed expenses) as a miscellaneous itemized deduction on your income tax return.
What’s the Difference?
Does it really matter what type of plan your employer has set up? In a word, yes. As an employee, being reimbursed under an accountable plan may be more desirable for several reasons.
First, with an accountable plan, reimbursements would not be included in your taxable income. If all of your expenses were reimbursed, this would simplify your tax filing in that neither the expenses nor the reimbursements need be accounted for on your tax return.
Second, if you were covered under a nonaccountable plan, you would have to account for the expenses on your tax return in order to offset the reimbursements included in taxable income. However, you would lose part of the benefit of the deduction because miscellaneous itemized deductions (which include employee business expenses) are limited by the 2% of adjusted gross income (AGI) rule. In effect, you would lose miscellaneous deductions equal to 2% of your adjusted gross income.
For example, suppose you have $1,500 unreimbursed employee business expenses and your AGI is $50,000. Since 2% of $50,000 (AGI) is $1,000, you would lose that amount and only be able to deduct $500. Remember, if you take the standard deduction rather than itemizing, you would lose all the potential benefits of miscellaneous deductions.
Whether you are covered under an accountable or nonaccountable plan, good recordkeeping is essential. Keeping a daily journal of your business activities involving out-of-pocket expenses will help provide the documentation you need for adequate accounting to your employer and for substantiating employee business expenses on your tax return.