Professional service firms may want to consider a form of nonqualified (NQ) deferred compensation plans for key employee retention. NQ plans may seem more suited to C corporations, but they can be a valuable tool for pass through entities, the favored tax structure of professional service organizations.
NQ plans are not subject to the same strict guidelines as qualified plans and can be tailored to meet the specific needs of the business. An example of this is a plan designed to offer additional retirement income to key employees who are already taking full advantage of their qualified retirement plans. This can be a useful retention technique for key employees who may never meet owner criteria.
With an NQ plan, a key employee may be awarded a phantom amount or be allowed to defer a portion of either pretax or after-tax compensation. The firm borrows money to purchase a high-cash-buildup whole life insurance policy owned by the firm, equal to the amount collateralizing the loan, thereby neutralizing the current use of operating cash and the current tax impact on the firm.
The policy targets a specific return that is deferred inside the policy until a future date. At the defined future date, the policy is cashed, with proceeds equal to the loan used to pay off the entity loan, and the excess is realized as income to the firm. The firm pays the employee the excess as deferred compensation and takes a tax deduction. The employee recognizes the income at the later date. If, as part of the plan, the firm has agreed to any other pretax deferral that is part of this NQ plan, the firm and its owners obtain the deduction at the time that compensation is paid. The employee recognizes income at that date.
As with any plan, there are some limitations. The performance of the assets inside the policy is difficult to predict and may change throughout the life of the policy, depending on the type of policy used. The premiums paid on the policy are not tax deductible, as the company is the beneficiary and the full benefit of the policy is not realized until cashed. However, the insurance provides some assurance of funds availability to a beneficiary in the event of an untimely death.
Professional service firms may need to consider the implementation of a nonqualified deferred compensation plan to retain the people who play an important role in maintaining and improving their success. This plan may allow the firm to retain cash for growth or ensure adequate cash for distribution to owners while providing an added perk to these key employees.
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