Tips for ‘top hat’ plans and nontraditional alternatives

Tips for ‘top hat’ plans and nontraditional alternativesCompensation and Benefits Bulletin
Owners of S corporations and limited liability companies (LLCs) are often frustrated when developing a nonqualified deferred compensation, or “top hat,” plan for themselves and their key employees. The pass-through tax nature of these corporations makes the traditional structure economically unattractive. The business owners can’t take a personal deduction on the contributions — and in some cases the investment growth — until the benefit is paid. S corporations and LLCs with a large number of shareholders, such as accounting and law firms, might consider it a cost of doing business to provide themselves and their top employees with this type of additional retirement funding. The S corporation or LLC with few shareholders might also like to provide themselves or key employees with a viable deferred compensation alternative. This article reviews traditional nonqualified deferred compensation plans and explores nontraditional options.

Nonqualified deferred compensation plans
Nonqualified deferred compensation plans allow employers to discriminate in favor of highly compensated employees and avoid qualified plan contribution limits. To be excluded from the extensive testing and reporting requirements under the Employee Retirement Income Security Act, plans must be unfunded and maintained by an employer “primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.” The plans must comply with extensive requirements under Internal Revenue Code Section 409A.

Nonqualified deferred compensation plans are funded by executive deferrals, employer contributions or a combination. Organizations provide the plans in order to recruit, retain and reward executive talent. Such plans are increasingly seen as a tool to focus executives on corporate strategy and long-term growth, as well as a powerful driver of executive performance.

A 2013 Towers Watson survey found that more than 80% of large private and publicly traded organizations offer nonqualified deferred compensation plans, including employee deferral plans, to their highly compensated employees. More than 70% of those organizations offer some level of employer funding.

Traditional plan structures and funding
The two common structures are defined benefit — which provides a specific benefit at retirement, usually defined as a percent of salary or total compensation — and defined contribution, through which an organization may target a percent of compensation to replace at retirement, with the employee assuming all risk. A third structure, known as a cash balance or a target benefit, is a hybrid of the two.

The two most common ways to set aside assets to pay benefits are through corporate owned life insurance (COLI), and mutual fund investments and/or corporate stock.

COLI is prevalent when a large number of participants with substantial contributions are involved. Although the contribution can’t be deducted as an expense until the benefit is paid, the life insurance structure allows investment growth to be tax deferred until paid. Because of the higher costs normally associated with life insurance, we recommend a thorough analysis to identify when the return potential to the executive is outweighed by the tax advantage to the corporation.

Mutual fund and corporate stock investments are common when there are a limited number of participants and the invested dollar amounts are fairly insignificant. Tracking stock of a publicly traded company is fairly straightforward, whereas Section 409A dictates acceptable valuation criteria for private companies.

S corporation and LLC alternatives
While no nonqualified deferred compensation structure can create perfect parity between a pass-through corporation and publicly traded companies or C corporations, certain techniques can reduce the disadvantage, such as providing deferred compensation on an after-tax basis through a Section 162 bonus plan. The executive receives a bonus reported on his or her Form W-2, yet unlike a traditional bonus, the funds are set aside to be paid out at a later date. As with traditional nonqualified deferred compensation, mutual funds and life insurance are the common funding vehicles to hold the contributions. A secular trust is commonly set up to protect the assets from corporate creditors.

An after-tax plan offers the following advantages:
  • Providing deferred compensation on an after-tax basis removes the plan from 409A compliance.
  • Pass-through entities appreciate that a deduction can be taken immediately for the compensation expense.
  •  Employees appreciate the structure because the assets are dedicated for their benefit and aren’t subject to corporate insolvency, or “golden handcuffs.”

There are also disadvantages. An after-tax plan that doesn’t place golden handcuffs on key employees may not fully satisfy the organization’s retention strategies; the immediate taxation may be seen as a negative; and pass-through owners don’t benefit from deferring income for their own retirement needs.

Techniques have been developed to help reduce or remove the negatives of after-tax plans.  

Golden handcuffs. Employers can effectively control the payout of deferred compensation through “restrictive agreements” on a life insurance policy. Unfortunately, restrictive covenants are generally available only with life insurance and are not enforceable on a secular trust.

Employee taxation. An employer can reduce the drawbacks to the employee of taxes due on after-tax plan contributions by outsourcing the tax liability to a third party. This is commonly achieved by borrowing an amount equal to the tax liability either through a bank, or if life insurance is used, as part of the policy structure. Both alternatives require repayment of the loan.

Owner deferrals. S corporation and LLC owners can effectively defer corporate profits with the same after-tax methods available for their key employees.  Use of a secular trust removes the funds from creditors. The cost of financing the tax liability (interest plus payback of the loan ) needs to be weighed against the ultimate benefit of the compounding effect on tax-deferred growth.

Review carefully before deciding
If a pass-through organization has the business need for nonqualified deferred compensation, it can go the traditional route, with its ensuing costs, or look at nontraditional after-tax alternatives. Weeding through the regulatory environment and determining the suitability of any particular structure can be complex, and an organization should work closely with its legal and tax professionals.

Ken Sandbakken
+1 612 577 5277

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