Executive Benefits for S Corp Owners and Key Employees
By Mark West
Owners and key employees of S corporations face the same retirement gap as their counterparts in C corporations. The first step in addressing retirement needs is to determine what benefits will be available using a qualified plan; S corporations can offer the same plans as C corporations, including 401(k), 412(i), SIMPLE and SEP plans.
Getting a qualified plan in place is an excellent first step. Unfortunately, for owners and key employees, qualified plan benefits and Social Security typically don’t provide enough income to meet their retirement objectives.
Properly structured nonqualified plans, including deferred compensation and executive bonus arrangements, can work effectively in an S corporation. Which design is best depends on a variety of factors, including whether the participant has an ownership interest in the S corporation.
The defined contribution plan is the most common type of deferred compensation package for key employees of an S corporation. The employee agrees to defer compensation on a pre-tax basis in exchange for the employer’s promise to pay a benefit in the future.
Most plans today resemble a 401(k) plan because key employees can self-direct their contributions among multiple investment options. The employee’s account grows or decreases in value based on the performance of the selected options.
Participation is limited to select managers or highly compensated employees under the Employee Retirement Income Security Act and benefits promised under the plan are not secured for plan participants. In addition, when an S corp sponsors the plan, it doesn’t generally make sense for owners to participate. Since an S corporation is a flow through entity, any deferrals made are taxed to the owner. For a 100% owner, compensation that deferred by employees or the owner will be taxed to the owner.
XYZ Corporation offers a deferred compensation plan to Jon, a key employee. Jon elects to defer $100,000, which reduces his current income by $100,000, but increases the income of Dave, the owner of XYZ Corporation, by the same amount. Assuming Dave is in a 40% tax bracket, his tax liability increases by $40,000 this year. In the future when distributions are made to Jon, the deduction flows through as a deduction for Dave.
Once a plan is in place and deferrals are made, an S corp owner must decide on financing the plan. Taxable investments or COLI (corporate-owned life insurance) are the most common vehicles.
An unfinanced plan is also an option. Any income recognized on a taxable investment flows through to the owner and is currently taxable. Earnings are tax deferred using COLI, just as in a C corporation.
In some situations, the owner will elect to use the full deferred amount, $100,000 based on the XYZ corporation example, to finance the plan. This results in the owner needing $40,000 in cash flow to cover his increase in tax.
In other situations, the owner will take $40,000 (40% tax) to cover the cash flow hit created by the deferral to pay the tax and place the remaining $60,000 in COLI or a taxable investment to help finance the plan. Benefits paid in the future will result in a deduction that flows through to the owner.