Why Executives, Business Owners Use Deferred Compensation Plans

Employers and employees alike are interested in personally taking an increased responsibility to supplement their own retirement income. Doing so on a tax advantaged basis is always a plus. While life insurance is usually thought of as an estate planning tool primarily used to provide a tax-free death benefit to an insured’s beneficiaries, it can also be used to provide a significant “Living Benefit” to the insured during the insured’s lifetime whether the insured is a business owner, key person of a business, or a key executive.

If a client wishes to provide a financial incentive to encourage an employee to stay with their company for a number of years, they can use a deferred compensation plan (DCP) that acts as a ‘Golden Handcuff’ because it’s only available to the employee if they meet certain pre-set conditions related to the completion of an employment requirement.

Why should one of your business-owner clients consider using such an arrangement? Because it gives an employer an opportunity to do something special, to reward an employee, or group of employees, for their past or future service on a discriminatory basis. This is done by allowing that specially selected employee(s), or even themselves, to defer a portion of their current income to supplement their retirement income. Further, if the employee doesn’t have the financial ability to defer any part of their current income, the employer can lend the employee the money. If the employer chooses, the DCP can pay 100% of the deposits or match a particular employee’s deposits.

That deferral to supplement their future retirement income can be arranged on a pre-tax or after-tax basis. If the deposits are made pre-tax, the distributions will always be significantly larger than if they were made on an after-tax basis, as the tax on the funds distributed now have the ability to increase tax deferred in their DCP, for the next 20-30 years rather than in the government’s tax coffers. In addition to the larger future payout, there are also current benefits such as reducing the payroll tax, the 3.8% Medicare tax savings for the employer and the employee, as well as a 100% tax-free death benefit.

The objective in designing a DCP should always be to use the lowest available tax bracket, corporate or personal. A strategically designed DCP often creates such alternate beneficial options when it comes to choosing between the employers’ lower tax bracket and the employees’ higher tax bracket. Lastly, in a closely held business, the employer can also be the employee and take advantage of those benefits and savings themselves.

Although there are no surveys for businesses that have implemented a DCP in the closely held marketplace, they are primarily implemented for the business owner to provide a means to supplement their retirement on a discriminatory basis in addition to any qualified retirement limits, IRA, or 401k.

Regardless of whether you’re considering the use of a non-qualified DCP for the owner of the business, for a key person or for other top executives, you’ll either be using mutual funds or life insurance. The great majority of non-qualified deferred compensation plans (NQDCPs) in the Fortune 500 companies in the US are funded with corporate owned life insurance (COLI) as are the majority of supplemental employee retirement plans (SERPs). So, for purposes of this article, I’ll be describing the mechanics and benefits of using a life insurance policy primarily because it builds up a significant amount of cash value on a tax deferred basis. The sum of which is then used to provide a 100% income tax-free distribution from the DCP to the employee at some point down the road, assuming no AMT complications. In addition, in the event of a premature death, the beneficiaries receives a 100% tax-free death benefit.

Before we look at some of the uses, their intended benefits, and the mechanics of how these strategies work, let’s first define a DCP. It’s a contractual promise between a corporation or employer and one or more of its key executives, or owners. The corporation promises to pay benefits either in the event of death, disability, or retirement, provided that the executive is employed by the corporation at the time the benefit becomes payable. The typical DCP is drawn up in a written agreement between the two parties and should contain the benefits to be provided by the employer and the requirement(s) thekey- person must fulfill before he/she can receive these benefits. While there are two types of plans, a qualified and non-qualified plan, for purposes of this article were going to be discussing a NQDCP in which the employer/business owner can discriminate as to whom they choose to provide a benefit for, including themselves. It should also be noted that there are very few government reporting requirements for this type of benefit which minimizes costs for setting up such a plan.

Let’s look at a typical situation in a C Corp where a female employee or the employer aged 45, non-smoker in good health might consider a NQDCP to provide a supplemental retirement income. If an employee were to defer $25,000 of their pre-tax current income into a DCP funded with a life insurance policy earning 5.75% annually that will continue to grow its cash value on a tax deferred basis till the executive reaches age 65. At that point the executive, after 20 years, will have paid $500,000. Then on the 25th year at age 70 that employee can begin to draw out an annual tax-free income of approximately $119,000 for the next 15 years to age 85. All the while having been covered for between $1 mil -$350,000 of tax- free life Insurance coverage.

The main reason life insurance is so often the funding vehicle of choice is because a life policy can be strategically designed so as to not only have its deposits accumulate tax deferred, but to also have the income that’s ultimately distributed to the employee, done on a 100% income tax-free basis as long as the policy survives the insured. This occurs as a result of a life insurance policy having the unique ability to make a series of withdrawals from its cash value up to basis and then switch over to loan’s that never have to be repaid as long as the death benefit survives the employee/Insured. The employer can determine whether they select a traditional plan where the employee pays for and owns the policy himself. Or whether a non-traditional plan is employed, in which the employer will make a loan to the employee and by using a split dollar arrangement, allow the employee to take full advantage of the inherent tax benefits.

An employee of a Sub S, LLC or any other pass-through entity can enjoy the benefits of a DCP by establishing a non-qualified SERP. Or for the owner of a business through a supplemental owners retirement plan (SORP). In so doing, they could continue to take advantage of the tax deferred accumulation aspects of a 401 plan. This type of arrangement also has the ability to take 100% income tax -free distributions at any time, with no income restrictions, nor penalties for early withdrawals. This strategy is similar to a Roth IRA on steroids.

In summary, while the employer will determine whether a traditional plan, or a non-traditional plan is used, the balance of the features is left to be decided, providing a great deal of creativity and flexibility as to the design capabilities that can be arranged between the employer and employee, or as previously mentioned for the employer/business owner themselves.

Another significant use of a maximumly funded life insurance policy could start out as a funding vehicle for two or more business partners funding a buy-sell agreement. As long as the premium funding the life insurance policy is below the Modified Endowment Contract (MEC) threshold, it will avoid the adverse tax consequences of a MEC. That would then allow the life insurance policy’s accumulated cash value, assuming a death benefit was not paid out, to be used to supplement the partners retirement income on a 100% income tax- free basis. It’s like having your cake and then eating it.

Many in the corporate world have already taken advantage of the significant benefits of a strategically designed DCP, a SERP or SORP. My personal observations as a practitioner with 35+ years’ experience indicates that these popular corporate benefits are now increasingly finding their way into the ranks of the many smaller closely held businesses due to their significant tax deferred accumulation and tax free distribution benefits found in no other financial tool as well as the ease of administration in setting up a plan, the ability of the owner to discriminate as to who can participate and for the corporation or business to tie in,(Golden Handcuffs), the services of a key person.

Lastly, and most importantly, life insurance, whether it’s for a DCP or any other purpose, business or personal, must be actively managed and evaluated every 2-3 years over its 20-30-year life span similar to the way a real estate or stock and bond portfolio would be managed. This should be done to make certain the selected coverage will accomplish its intended objectives for the insured and their beneficiaries.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Henry Montag, CFP, Managing Partner of The TOLI Center East, in practice since 1984 with offices in Long Island, NY, has authored articles and acted as a source for NYSBA, NYSSCPA, Bloomberg’s EG&T Journal, Trusts & Estate, Accounting Today, and The Wall Street Journal. He has appeared on Wall Street Week and Fox Business, and co-authored an ABA flagship book, The Advisors’ & Trustees’ Guide to Managing Risk.

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