Owners and key employees of S Corps should be treated differently when it comes to retirement plans.

Owners of S corporations often ask advisors about nonqualified retirement plans for the owner and a few key employees. Initially, it is tempting to suggest a nonqualified deferred compensation plan to cover all employees. The owner and the key employees, however, should be treated differently.

The tax consequences of nonqualified plans are very different for owners and employees. For example, a nonqualified deferred compensation plan allows key employees to defer income taxation. For the owner, any salary or bonus deferral into a nonqualified deferred compensation raises the company’s taxable revenue. That means owners pay income tax on their deferrals in the form of taxable revenue.

Some non-tax factors also are distinctly different for owners and key employees. For instance, the owner of an S corporation would not participate in a Restricted Executive Bonus Arrangement. The owner is already motivated sufficiently to remain at the company and drive profitability, eliminating the need for golden handcuffs or a vesting schedule.

A three-step approach

How do you approach this opportunity? First, understand that the solutions for the owner and the key employees are different. Second, explain to the owner that the tax consequences of various types of retirement plans are not the same for owners and key employees. Third, take the owner through a step-by-step explanation of the options:

  • Step 1 – Qualified Plans: If the company currently has a qualified retirement plan in place, such as a 401(k), evaluate its pros and cons. For example, there are limits on the contributions employers and highly compensated employees can make to a 401(k) plan. A safe harbor 401(k) would allow the highly compensated employees to make larger contributions but it would be more expensive for the company. If the S corporation has no qualified plan, consider implementing one. A qualified plan treats the owner and key employees similarly: The business receives a current income tax deduction for the plan and the owner does not include that contribution in current income or taxable net revenue. The qualified plan allows the best of both worlds for the business owner. The rank and file must also be included, creating additional cost and a possible point of resistance.
  • Step 2 – Nonqualified Plans: Under a nonqualified deferred compensation plan, employees defer some of their compensation back into the company. This deferral increases company profits which are taxable to the owner because it is characterized as profit to the company. This analysis applies to a C corporation, S corporation or partnership. Though the application may vary slightly depending on tax status, the owner of a company that defers salary does not really receive any income tax benefit because the deferral is considered taxable profit.
  • Step 3 – Personal Planning: The third step is to introduce personal planning for the owner and key employees. This is an option for companies that have maxed out existing qualified plans, decided that qualified plans are too expensive, or concluded that a nonqualified plan does not create income tax advantages for the owner.

The next best thing

The next best thing is redeploying after-tax dollars to a tax-deferred vehicle such as life insurance, which also provides tax preferred access. This gives the owner tax-preferred income at retirement and is not subject to the income tax or the 3.8 percent health care tax. The business owner will not, however, get the up-front income tax deduction that qualified plans provide.

Some tax-deferred products provide attractive non-tax features. Indexed universal life insurance is an example. It provides market protection with a floor, which is a minimum amount at which negative market returns affect the growth. On the flip side, the upside market opportunity also is capped at a rate that varies among life insurance carriers.

It is important to make sure the owner of the S corporation understands that this third step diversifies personal planning overall and on a tax level. Riders on the product, such as disability and long-term care coverage, may also be attractive non-tax features for the S corporation owner.

Confidence through analysis

When an S corporation owner inquires about nonqualified retirement plans for the owner and non-owner key employees, it might be best to treat the two groups separately. Discuss with the owner the logic behind this approach. When the owner understands and agrees to treat the two groups separately, use the three-step approach outlined above. The desired result is that the owner feels confident that a thorough analysis has been completed and will implement a distinct plan for both the owner and the non-owner key employees.