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.
An alternative is to use a bonus plan to allow the owner to get a current tax deduction on employer contributions. Since any bonuses received will be taxable to the employee, a tax bonus also can be used to neutralize the expense to the employee.
ABC Company chooses to offer a $20,000 bonus to Julie. In addition, the company wants to cover the tax to Julie at 36%. The total bonus is $31,250 (20,000 , 1 – .36).
There is flexibility in the bonus, since annuities, mutual funds or life insurance can be used. Each option provides advantages and disadvantages. (See Bonus chart.)
Any additional contribution made by the employer, including the “tax bonus,” provides a current tax deduction to the owner.
Variations on the traditional plan design also may be attractive to employees and employers. Employees, for example, can select after-tax contributions. The employer can participate by matching all or a portion of the employee’s contribution. The employer also can offer a tax bonus that covers a portion or all of the tax impact to the employee.
A bonus is also an excellent vehicle for supplementing an owner’s retirement benefits. There are several options:
Option 1: The owner takes additional bonus compensation. Whether the owner takes the increase as compensation or not, it is taxable income to him or her. By taking it as compensation, it is also subject to Social Security and Medicare tax.
Option 2: The owner takes a distribution from the S corporation. The distribution is subject to income tax but avoids Medicare tax. If compensation is under the Social Security Wage Base, this also can reduce Social Security tax.
Option 3: This approach only applies if the S corporation has Accumulated Earnings and Profits (AE&P) typically from either being a C corporation prior to the S election or an S corporation prior to 1983. Under current law, certain dividend distributions are taxed at 15%. Distributions of AE&P from the S corporation can qualify for this tax treatment. This tax-favored treatment of dividends is only available through 2008. Now may be the time to access AE&P and use it for the benefit of the owner outside the corporation. (See Option chart.)
Once the need to fill the retirement gap for the owner is established, the financial advisor needs to work with the client’s CPA to determine the most appropriate distribution option.
Owners and key employees of S corporations have the same need to fill the retirement gap. By offering plan designs tailored to address the unique tax aspects of an S corporation, you are providing an excellent service to your clients.
Mark West is director, advanced markets, at Principal Financial Group, Des Moines, Iowa. He can be reached at [email protected].
Reproduced from National Underwriter Edition, June 11, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.