Its just before three oclock in the afternoon and Im driving down Route 128 South in Massachusetts. A friend and longtime CPA client, Tom Barrows (pseudonym), calls to give me a referral to a Brian McCarthy (pseudonym), sole owner of ABC Corp.

During the call, Barrows tells me McCarthy is concerned about his companys retirement benefit plan and his desire to “plan for the future.” Later, after arranging an initial interview, I enter the office of McCarthy, a well-dressed man who greets me with a warm smile and firm handshake.

The Initial Interview

LS: Im glad to be here to discuss your companys retirement benefits and your concerns about planning for the future.

BM: Im 58 years old and, during the past 35 years, have built a multimillion-dollar enterprise from scratch by offering a good product at a fair price, and by treating my customers and employees as if they were the most important people in the world to me.

My concerns are as follows: First, while my three children are in the business, I also have two key people whom I cannot afford to lose to the competition. Second, while I plan on being active in the business well past ones normal retirement age, I want my children to own the business. I also want to ensure that the business continues to support my wife and me over our lifetimes.

I have a plan, protected with life insurance, stipulating that each of my children will inherit an equal portion of the business upon my death. The two employeesSteve, who is 42 and head of sales; and Vicki, who is 38 and chief of operationsare very capable people who share our business values.

As with other employees, we offer these two individuals a pension and 401(k). But given todays market conditions, I want to ensure that they can retire comfortably.

LS: Brian, you have expressed an interest in a strategy that would reward your key peoples value, performance and loyalty using a supplemental retirement benefit. This represents a win-win situation for you and them. Would you agree with my assessment thus far?

BM: Yes. However, I am concerned about locking myself into a plan for Steve and Vicki or otherwise creating a discrimination issue. Also, I want to ensure the plan doesnt cost too much and is tax-deductible.

LS: Brian, creating a supplemental retirement plan exclusively for Steve and Vicki should not be about tax-deductibility. In fact, as with all such plans, you will pay taxes, one way or another. You need to shift your focus to maintaining high performance, enhancing the retirement income of those in leadership positionsSteve and Vickiand helping to grow the company.

Presenting the Solution (Two Weeks Later)

LS: Brian, I have prepared a supplemental executive retirement plan, or SERP, that I believe will satisfy all of your requirements. Funded with life insurance, the program should also be attractive because it offers additional benefits.

I proceed to outline the strategy as follows:

The agreement. You and your employees, Steve and Vicki, enter into a agreement wherein the business pays a certain amount into a plan. In return, the company provides a benefit to Steve and Vicki at some future date. Your accountant or a third-party can easily administer the agreement and plan at little cost and without significant ERISA requirements.

Purchasing Life Insurance. The company applies for, owns and is the beneficiary of a life insurance policy on both Steve and Vicki. ABC Corp. pays the non-tax-deductible premium and maintains control over the tax-deferred cash values.

Now, lets talk about the pre-retirement and retirement benefits.

Pre-retirement. Should either employee die prior to retirement, a portion of the death benefit will go the employees family. With proper structuring using a pre-retirement endorsement split-dollar agreement, the death benefit may be income tax-free.

Retirement. At retirement, the company pays a retirement benefit (as stipulated in the agreement) to the employee from the policys cash value or from the companys surplus. These payments are tax-deductible when paid by the company and are taxed as ordinary income to the employee. Any remaining death benefit proceeds in excess of this obligation may be used to offset company costs.

In summary, Brian, you can selectively reward Steve and Vicki for staying with the business until they retire. You also show you recognize their value to the firm and keep them focused on high performance.

BM: The plan sounds good, but why do we need life insurance to fund the arrangement? Why cant we pay the benefits from current or accumulated earnings?

LS: That may be possible to do, but life insurance provides funding for both a pre-retirement death benefit and a means to recover some of the retirement benefit cost from the insurer.

Let me explain further. There is a natural triangle to deferred compensation planning. The sides of the triangle consist of: (1) funds set aside each year into your sinking fund; (2) benefit payments that will be made according to the promises in the agreement; and (3) the recovery your company receives from the insurer in the form of a death benefit later on.

The relationship between these three elements make life insurance the best choice.

BM: I follow, but why arent these life insurance premiums deductible?

LS: Brian, the plan Im recommending falls under a broader concept known as a nonqualified benefit plan. You can, as with Steve and Vicki, choose who you provide this benefit to, without running into discrimination issues. And you can add others to the plan as you deem appropriate.

As to tax deductibility, keep in mind that your company will be able to deduct the full amount paid to each employee. This will most likely be a larger deduction tomorrow than you would have had for the contribution you make today.

BM: Well, Len, you have proposed a plan that appears to meet all of my initial concerns head-on. Youve even pointed out that I can include other key employees later on. Well need to run this by my CPA first, but I like it. By the way, can I include my kids in the plan?

Two more meetings followed, one with Brians CPA and another with Steve and Vicki. Both were excited and pleased that Brian thought to offer them a SERP, one that allows them to maintain their current salary. My next order of business is to evaluate Brians business succession plan for his family and himself.

Len Scholl is assistant vice president, Individual and Small Business Markets, at Sun Life Financial, Wellesley Hills, Mass. You may e-mail him at len.scholl@sunlife.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, February 11, 2005. Copyright 2005 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.