October 2014

The Fuel for Your Business

It may be cliché, but your business really is all about its people. Once you find the employees who will help you grow your business, how do you retain them over the long-term? "Deferred compensation" can refer to about any compensation that is not paid currently. Under nonqualified deferred compensation arrangements, employers can promise future compensation to key employees in addition to current salary. These plans can help both employees and employers achieve important goals.

One important key is for the plan to be elective. Where it is, the employee can:

  • Be taxed only when payments are actually received under the agreement;
  • Have deferred amounts grow on a pretax and tax-deferred basis; and
  • Receive payments at the time of some specific purpose (e.g., retirement).

Employers can benefit by:

  • attracting and retaining employees who are key to the growth and future of the company;
  • providing plans that simulate equity without dilution and minority shareholder issues;
  • incentivizing selected company goals;
  • providing early retirement enticements when reductions in force are necessary; and
  • implementing golden parachutes to ensure the continued loyalty and service of key executives in the face of a change in control.

Most deferred compensation plans will have in common the fact that they are unfunded. The employer makes the payment from general assets when it is due. Of course, nothing prevents the employer from earmarking assets in a bank account, brokerage account, or insurance or annuity contract to provide it with funds with which to pay the liability. Beyond this, there are strategies that give executives more assurance about timely payments. One of the most common involves a "rabbi trust," where the employer irrevocably transfers assets to a trust that will hold and invest the assets until the time for payment arrives.

Following are 5 broad categories of deferred compensation plans:

1. Account balance plan. The employee is credited with a fixed sum that will be paid at some point in the future, often with an earnings credit.

2. Non-account balance plan. The benefit is stated in terms of an amount determined under a formula, payable in a lump sum or in a stream of payments, in much the same manner as a traditional pension plan.

3. Stock or Equity. One that calculates the amount payable based on appreciation in stock or other equity.

4. Phantom Shares. Under some arrangements, the account balance is denominated in fictional shares of employer equity, with increases (or decreases) in value based on the equity of the employer.

5. Other Tracking Investments. Other arrangements treat the deferred amounts as though they are invested in hypothetical investments, with the employee's account balance increasing or decreasing as the deemed investments appreciate or depreciate. In some cases, the employer may merely use the deemed investments as a measuring stick to determine what it will ultimately pay the employee. Other times it may actually acquire the selected assets and hold them in a brokerage account or rabbi trust so that it can meet its liabilities under the plan when due.

Adding compensation that is paid in the future can be a win/win for employees and employers. Employees get additional compensation that can grow to a sizeable amount. For employers, even in a less than optimal situation, they will in some cases have created an account that can help deal with the loss of key people. In the best case, it will help them retain their key employees who are driving the growth of the business. We will enjoy having a conversation with you to discuss how a deferred compensation plan may benefit your company.