Attracting and retaining key executives calls for using benefit programs that are individually tailored to each key employee according to his or her contribution and needs.
While qualified plans are attractive because of their pre-tax contributions and tax-deferred compounding, the price of admission includes government non-discrimination rules and maximums on contributions and benefits.
Although many may dismiss it as simplistic, the Section 162 executive bonus plan meets the requirements set out above, in that it is selective and currently deductible. Unique programs can be designed for key executives according to their need for either maximum death benefit protection for their families or maximum supplemental retirement income.
These programs are selective in terms of participation. One only need consider potential Employee Retirement Income Security Act (ERISA) issues in determining who can participate. The contributions, if reasonable, are fully tax-deductible and may vary by individual. They are also confidential, so no participant need know what others are receiving.
The only cost to the executive is the tax on the bonus. So, one could consider this program another form of discounting. And when the bonus is put into a life insurance policy owned by the executive, the cash value grows tax-deferred, much like a qualified plan.
There are those who counter that the employee has to come up with the tax, so the program loses some of its luster. For very important participants (VIPs), the business can gross up the bonus to include the projected tax cost, resulting in no out-of-pocket expense to the employee.
Perhaps if you think of the executive bonus program as a Roth IRA alternative, with no salary caps and no maximum contribution, you’ll begin to see the attractiveness of this approach. Remember, the supplemental retirement income stream from life insurance withdrawals and policy loans is income tax-free, so long as the policy has been designed to avoid modified endowment contract (MEC) status.
Another attractive program for selected senior executives is salary continuation. It’s next on the radar because it uses company money to pay the executive an income stream at retirement or at a stated point in the future. This supplemental retirement income stream can serve as “golden handcuffs” to help keep the key employee with the firm for a certain period of time.
Consider also the tax dynamics of this program to the employer. If funds to pay the eventual benefit are placed into a (non-MEC) life insurance contract, they grow tax-deferred and can be accessed income tax-free through policy loans and withdrawals. This tax-free income stream is used to pay out tax-deductible payments to the executive, resulting in attractive leverage for the employer.
The latter need only access the after-tax cost of the deductible payment from the policy, since Uncle Sam is subsidizing the remainder of the payment through an income tax deduction.
The remaining death benefit of the policy serves as a cost-recovery vehicle for the employer to make up for the fact that payments into the policy were made with after-tax dollars. However, since the policy is carried as an asset on the books of the corporation, the transaction simply has been a repositioning of assets from cash to cash value of life insurance on the assets side of the balance sheet.
At the other end of the spectrum, a death benefit only program (DBO) can provide the executive with significant additional protection for the family in the event of death. The payments to the family upon death are tax-deductible to the corporation, yet are paid with income tax-free proceeds of a corporate-owned life insurance contract.
While DBO plans are not the most cost-effective death benefit for the executive, they can provide an additional death benefit at no current cost to the employee. The business funds them with corporate-owned life insurance, which matures income tax-free and can be increased to include a cost-recovery element to reimburse the corporation for the fact that the premiums paid were non-deductible.
Finally, deferred compensation may be an attractive nonqualified fringe benefit for the employee who does not need additional current income. While this program will reduce current earnings, it does allow for tax-deferred compounding and staged payouts in the future to maximize retirement income and reduce current income taxation.
Informally funding such a program with corporate-owned life insurance provides the business with the leverage of income tax-free policy loans to support tax-deductible payments. As with the salary continuation and DBO programs, cost-recovery can be built into the program through increased policy death benefits.
The aforementioned programs are relatively simple and take advantage of the tax advantages of cash value life insurance. Often the simple solution is the one most likely to be understood and implemented.