[intlink id=”439″ type=”post”]non-qualified deferred compensation plan[/intlink] (NQDC) designed solely for management employees. Being a NQDC plan, it does not have to comply with the bulk of ERISA
regulations – and there are no IRS reporting requirements. The business must still file Form 5500 with the Department of Labor; however, if the business sends the DOL a letter notifying it of the presence of the plan, no further filing is necessary.1
Substantial rewards for the executive who becomes fully vested. Most golden handshakes are discreetly offered as extensions to executive employment contracts. Typical arrangements include:
- 401(k) mirror accounts (NQDC plans) into which an executive can defer X% of salary and/or bonus annually. There may be a company match – perhaps the company kicks in 50¢ for each $1 deferred.
- The money can be withdrawn at retirement or merely at some other future point, and the executive can bolster his or her retirement savings using pre-tax dollars.
- SERPs (supplemental executive retirement plans) funded entirely by the employer.
- Upon retirement, the SERP assets can foster a pension-style income for the key employee.
- Stock options with a vesting period of 3 years or less, perhaps complemented by subsequent options down the line. (This could also take the form of restricted or phantom stock.)
- Many key managers owe sizable income tax to the IRS corresponding to their considerable salaries. In the sweetest scenario, the key employee defers most or all of his or her annual salary – so instead of regular income tax, he or she faces a lesser burden of paying capital gains tax linked to the income from the options.2,3,4
To fully reap benefits like these, a key employee must fulfill the designated terms and conditions of the golden handshake. Usually this requires staying in the executive position for X number of years and/or completing a specific major task. (Most NQDC plans also provide a death benefit to a designated beneficiary if there are still benefit payments remaining for the employee at the time he or she passed.)2
If the key manager quits or jumps ship before becoming fully vested, he or she could lose the matching dollars contributed to the plan by the company. There will also be the matter of having to deal with a lump sum of income and a big tax bill.3
How do companies fund top hat plans? Many businesses elect to do this with corporate-owned life insurance. Other options include a private annuity contract, company stock, or even earnings from a company investment portfolio.
You may be wondering how a life insurance policy can be tapped to make payments to a living individual. Here’s how: loans are made against the cash value of the policy, or policy withdrawals are made. Such loans are commonly tax-free, and withdrawals are also tax-free to the extent of the premiums paid toward the coverage.2
COLI funding offers the business the potential for tax savings and cost recovery. If a 45-year-old executive puts away $15,000 annually into an NQDC plan for 20 years at 7% interest, in 20 years he or she will end up with $658,000. If those assets enjoy tax-deferred growth with COLI funding of the plan, the business can save 35% (nearly $120,000) in federal taxes on the gains in that period. If the executive passes away at age 78 with the company still owning the life insurance policy, the company would collect a $2.3 million death benefit.2
NQDC plans are commonly unsecured. This means that if a company goes belly-up, a golden handshake may amount to an empty promise. Bankruptcy and cash flow factors may delay or reduce payments to the key manager. The company may undergo a change of control; acrimony between the key manager and ownership may even result in a change of heart. Some firms conscientiously address these risks by establishing trust funds with banks and trust companies.
A top hat plan is usually not a good idea for a small family business due to tax reasons. When a closely held business sponsors a NQDC plan, it can’t deduct employee contributions to the plan until the year in which the employee recognizes income. If it sponsors a qualified retirement plan such as a profit-sharing plan or a 401(k), it can deduct such contributions before the worker has to recognize them as income.1
A useful tool to help big companies retain their superstars. A golden handshake can make key managers feel appropriately rewarded – and cause them to think twice if they are ever tempted to leave your business.