Every company has key managers that they depend on to keep the business running smoothly. But if those key managers decided to leave, would your business be able to survive?
To help attract and retain these key executives, many businesses offer bonuses as an incentive, on top of their salary. But that just may be the starting point, says Tony Brant, a financial planner with Skylight Financial Group.
“Typically, that bonus will be paid in cash, but maybe it should be paid differently,” says Brant.
Smart Business spoke with Brant about how to creatively structure an executive bonus plan to benefit both the employee and the company.
Where do you begin to structure a plan?
The objective is to use a compensation-based award to retain key management, and to do so in the most tax-efficient way. So how do you do that using a variation on the traditional bonus? You need to design an executive bonus plan that fits within the guidelines of Section 162 of the Internal Revenue Code, which allows a deduction by the business for ordinary and necessary expenses paid or incurred during the firm’s tax year in the course of conducting business. An employer can deduct bonuses as long as they are reasonable payment for services.
What options exist for executive bonuses beyond a lump sum?
You can grant employees bonuses but limit access to them. Under Section 162, the bonus is paid to the employee as ordinary compensation, taxable as W-2 wages and fully deductible by the business as an ordinary expense. But instead of paying the bonus directly to the employee, funds are used to fund life insurance or an annuity contract.
The policy is in the employee’s name, and the employee is the owner, but access to the cash is limited by the bonus agreement.
Under this plan, the business enters into an agreement with an executive to pay (via a bonus) all or part of the premiums for a life insurance policy or annuity contract owned by the executive. This bonus is tax deductible to the employer and taxable to the employee. The benefits to this option are that the employee has a contractual agreement to receive a set amount of money each year for a period of years and has access to that asset after a period of time per the agreement. In addition, it enables the employer to take a deduction each year, and the employee has no out-of-pocket expense as this asset builds over the term of employment.
This type of plan is particularly useful for small, closely held businesses that choose not to offer equity or ownership stakes in the company and for family businesses interested in attracting and retaining the next generation of management.
The complicating factor with these plans is that taxes are due on the compensation even though the employee hasn’t yet received it.
How does the employee pay these taxes?
One way is for the employer to loan the employee money for the taxes due. This loan agreement, in addition to the bonus agreement, binds the employee to a repayment obligation if he or she leaves the company prior to an agreed-upon date.
The loan, which must include interest, can then be repaid at retirement or departure from the company from the funds that have accumulated in the executive’s policy, or the loan can be forgiven by the employer. However, forgiveness of the loan cannot be implied or contractually agreed to; otherwise, it may constitute a deferred compensation arrangement. If the loan is forgiven, the employee must still pay taxes due on the forgiven amount.
Is there any benefit to the employee during his or her employment?
Because the employee owns the policy, he or she can access the cash before retirement, tax free, by borrowing or surrendering cash value from the insurance policy in the event that money is needed.
And if the employee dies prematurely, his or her family has a substantial life insurance benefit to make up for lost career earnings.
What are the challenges of this type of executive bonus plan?
The challenge is the employer’s commitment to fund this obligation. However, the plan can be designed with the flexibility to allow the company to suspend or partially fund the policy in lean years.
Some companies may be nervous about making that kind of cash flow commitment, but it can be viewed as a business decision to pay base salary plus bonuses. Employees often want adequate life insurance protection and tax-free cash accumulation with some guarantee above and beyond the company retirement plan. With the tax benefits to the company, there is a mutual advantage.
Attracting and retaining the best people is a challenge for many businesses. The success of a business can often be attributed to the abilities of a select group of key employees or executives. That is why it is essential for businesses to hire and retain talented, hard-working individuals who can help them prosper and grow. Executive bonus plans are simple, cost-effective and flexible benefit programs that are relatively easy to implement and administer. Talk to your financial planner about the several plan design options available that can help you to tailor the plan to meet the specific objectives that the business is trying to achieve.
The information provided herein is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any federal tax penalties. Entities or persons distributing this information are not authorized to give tax or legal advice. Individuals are encouraged to seek specific advice from their personal tax or legal counsel.
Tony Brant is a financial planner with Skylight Financial Group. Reach him at (216) 592-7352 or [email protected]. Anthony M. Brant is a registered representative of and offers securities, investment advisory and financial planning services through MML Investors Services, LLC. Member SIPC. OSJ: 1660 W. 2nd St., Ste. 850, Cleveland, OH 44113, (216) 621-5680. CRN201309-152734
