As discussed in Part 1 of this series, business succession and exit planning for an owner of a successful business is crucial yet challenging. A comprehensive plan considers the central role that the business plays in an owner’s overall financial, retirement and estate plan. This presents opportunities for the business owner and advisers to address:
- Business continuation. Transferring control to a family member, key employee or third party.
- Key talent retention. Ensuring continued success of the business through retention of key employees using special benefits (golden handcuffs).
- Retirement. Securing a comfortable retirement (which may not be primarily dependent on the business).
- Legacy issues. Preserving the business for family members or realizing its value to provide financial security for surviving family members while treating heirs fairly.
This article, the second in a four-part series, addresses how an owner can:
- Attract, reward and retain key employees; and,
- Protect the value of the business upon the eventual departure of a key employee.
Business owners, especially those who have lost a key employee to a competitor, know first-hand how hard it is to attract and retain good talent. Not only does the departure of a key employee hurt the bottom line, but valuable time must be spent to find and train a suitable replacement. If the executive was a possible successor to the business, the owner may have to consider other, less appealing options.
Indeed, for many businesses owners, the most important assets of the company are the key employees and executives. They drive revenue and are important to business perpetuation. But in today’s economy, key employees are less loyal and might be tempted to leave for even slightly greener pastures.
Executive Compensation
One way a company can retain and attract top people is to reward them with additional executive compensation.
A supplemental executive retirement plan (SERP) is a viable option to provide special compensation for special people. Highly compensated employees are typically not able to put away enough through the company’s 401(k) and profit sharing plans to adequately replace the executive’s pre-retirement income.
With a SERP, the company agrees to provide a benefit to an executive based on satisfaction of terms and conditions such as sales goals, performance and longevity. The business owner chooses who participates, the level of benefits, the types of benefits and the plan provisions. Benefits typically include retirement income, survivor benefits and disability payments and are subject to the company’s creditors.
By offering valuable benefits like these, business owners will attract more top talent, increase their productivity and make it more difficult for them to consider leaving the company.
Family Business Applications
A SERP can be especially useful in a family-owned business setting where a key employee, such as a CFO, is not a family member. Because these employees are unlikely to receive equity in the company as a benefit of employment, they can be provided with “equity-like” benefits through a SERP so they will stay with the organization and perform, especially as the business is transferred from one generation to the next.
Informal Funding
Most businesses earmark assets and current cash flow to pay future SERP liabilities. Otherwise, the “pay when due” approach may put too much financial pressure on the business. When the promise to pay isn't backed by assets, a slowdown in business can mean a slowdown in benefits paid out, as well.
To avoid these pitfalls, most organizations choose to informally fund SERPs with taxable investments, such as equities, or with tax-favored corporate-owned life insurance (COLI). Both offer attractive, growth-oriented investment opportunities.
Assuming the executive can medically qualify for the coverage, COLI can provide additional tax advantages: tax-free gains on investment earnings in the policy, tax-free access to cash values through policy withdrawals and loans and an income tax-free death benefit at the passing of the executive. In a rising tax environment, the benefits of tax-favored COLI can make it an even more compelling option.
The coverage can be even designed to allow a company to eventually recover all or a portion of its SERP costs, including benefit payments and policy premiums.
An Example
Suppose a company has a key employee it wants to retain. A SERP could be established with a COLI policy on the executive’s life that is sufficient to provide the future benefits outlined in the agreement, such as a retirement income benefit of $100,000 a year for 15 years. The business would own the policy, pay the premiums and serve as beneficiary. In specific cases, a business may be in a position to borrow some or all of the premiums and make interest payments to a lender rather than premium payments to an insurance company.
At the executive’s retirement, the company would access policy cash values to provide the agreed-upon income benefit to the executive. The retirement benefit would be taxable to the executive and deductible to the company.
When the executive eventually passes away, the company receives the tax-free death benefit proceeds as a mechanism for cost recovery.
If the executive dies before retirement, the death benefits are paid income tax-free to the company. The business can then provide the benefits promised to the executive’s beneficiaries and use the excess funds to recover the cost of the plan and protect the business from the loss of the executive.
If the executive decides to leave before retirement or meeting the terms of the SERP agreement, the executive may forfeit some or all of the promised benefits, which should make him think twice about departing. Even if the employee leaves, the company still owns the policy and can use it as source of funds to hire a replacement.
Although the premium payments are not tax-deductible to the business, using COLI can be extremely tax-efficient because: Cash values grow tax-deferred and can be accessed tax-free via policy loans and withdrawals; payments to the key employee (or employee’s heirs) are tax-deducible to the company; and death benefits are paid income tax-free.
Next Steps
It is comforting for a business owner to know that, with a SERP, there is a tool at her disposal to efficiently recruit, retain and reward the industry’s top talent.
Consulting with a corporate attorney and a knowledgeable life insurance professional, who is experienced in designing COLI products, is the place to start.
Part 3 of this four-part series will address business owner retirement, to ensure the business owners and their families maximize the value of the businesses they worked so hard to create.
