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Executive Compensation Plans For Employees Explained

Todd J. Preti

Many business owners struggle with the dilemma of how to retain their key employees without deluding their stock ownership in the company. This is especially applicable for closely held business owners who want to retain key personnel not only during the term of their ownership, but possibly when the owner turns over control to the next generation.

There are a number of different strategies that business owners can use that makes the key employee’s position with the company so attractive that it would be financially irresponsible for them to walk away. This article outlines many, but not all, golden handcuff arrangements that you may want to consider implementing for some or all of your Company’s key employees, including the Owners.

Before you can make a decision on which type of golden handcuff arrangement to implement, you should consider the following with regards to the key employees who would be covered by the applicable plan:

  1. Who would be eligible and entitled to participate?
  2. What would be the vesting options?
  3. Would there be any triggering events overriding the vesting schedule such as death, disability, sale of the company, etc.?
  4. Will there be any targets, objectives, or goals of the company or the specific department or specific plan participant that must be met in order to require the Company to comply with the terms of the plan?
  5. Will the plan participant have the right to review the Company’s books and records in order to verify the terms of the plan, i.e. revenue goals, etc.?

In deciding whether to implement a key executive golden handcuff arrangement, you need to first decide whether the plan is going to accomplish its objective, i.e. long-term key employee retention based on a desire to build a successful business and participate in its success, or whether those goals can be accomplished simply by using an incentive bonus plan that would be written into the applicable employee’s employment agreement.

The following are golden handcuff arrangements that you may want to consider along with a brief explanation of the applicable plan.

Phantom Stock Plan

A Phantom Stock Plan is a contractual agreement between a Company and key employee(s) who would be entitled to the phantom stock bestowing upon the key employee the right to a cash payment at a designated time or in association with a designated event in the future which payment is to be in an amount tied to the market value of an equivalent number of shares of the Company’s stock. Simply put, it is an employee benefit to select key employees that give them many of the benefits of stock ownership without actually giving them any Company stock. The applicable employee does not have to take on any of the Company’s debts or obligations and is not subject to capital calls.

401k Mirror Account

This is a non-qualified plan used by companies who have been told by their 401k Administrator that their plan is “top heavy” due to highly compensated individuals contributing excessive amounts into the qualified 401k retirement plan compared to the rest of the employees contributing to the plan who are not highly compensated employees. The 401k mirror plan allows these highly compensated employees to contribute to the 401k plan up to the maximum permitted amount; however, there is no discrimination testing guidelines and no contribution limits for a non-qualified 401k mirror plan.

Supplemental Executive Retirement Plan – SERP

A SERP is a non-qualified retirement plan for key Company employees that provides benefits above and beyond those covered in other retirement plans such as an IRA, 401k or non-qualified deferred compensation plan. The Company and the key executive enter into a formal agreement that promises the executive a certain amount of supplemental retirement income based on vesting and other eligibility conditions to be met by the executive. The Company funds the plan out of current cash flow or through the funding of a cash value life insurance policy and the deferred benefits are not currently taxable to the key executive. Upon retirement the executive receives the income which is taxed as ordinary income.

Stock Option Plan

An employee stock option plan is a contractual arrangement between the Company and its key employee(s) that gives the key employee(s) the right to buy a specific number of the Company shares at a fixed price within a certain period of time. The fixed price is often called the grant or exercise price. Key employee(s) who are granted stock options hope to profit by exercising their options to buy shares at the exercise price when the shares are trading/valued at a price that is higher than the exercise price. This type of plan is typically used for larger entities and if the Company is willing to give up some of its stock ownership. It is not the best plan to retain key employees.

Non-Qualified Deferred Compensation Plan

There are two main types of deferred compensation plans: a true deferred compensation plan and a salary continuation plan. Both plans are designed to provide key employees with supplemental retirement income. The primary difference between the two is the funding source. A true deferred compensation plan requires the applicable employee to defer a portion of their income into the plan. The income is usually bonus income. A salary continuation plan requires the employer to fund the future retirement benefit on behalf of the key executive. Both plans allow for the earnings to accumulate tax deferred with the income received by the employee at retirement taxed as ordinary income. Additionally, this arrangement allows employers to provide retirement income to a select group of key employees.

It is a contractual commitment between the employer and employee specifying when and how future compensation will be paid. Since it is non-qualified it means that it does not have to be pre-approved by the IRS and the employers can discriminate in favor of selected employees. The plan can be customized for each key employee, which means that they can have different vesting schedules, different achievement goals to be reached, etc. The agreement typically provides that a key employee will receive a stipulated sum for a fixed period of time or for life beginning at a future date, such as an employee’s scheduled retirement (i.e. age 65 or 67). If the employee dies after payments have begun, the arrangement may direct that any remaining benefits be paid to the employee’s designated beneficiary.

Employers have the option of funding the arrangement or it can be unfunded. Many employers purchase life insurance on the life of the key employee to provide a source of funds to pay the deferred compensation to the key employee. The key employee is generally not taxed until they actually receive payments, distributions are typically only permitted upon separation from service, death or disability, a fixed time specified in the plan, a change in an employer’s ownership or control, or an unforeseeable emergency such as severe financial hardship. Distributions at any other time would result in the loss of income tax deferral.

In summary, a non-qualified deferred compensation plan is an arrangement established by the employer to provide retirement income and often death and/or disability benefits to select managerial or highly compensated employees. When properly established, the employee can defer income taxation on the deferred amount until the benefits are paid.

Executive Bonus Plan

A key executive is issued a life insurance policy with premiums paid by the employer as a bonus to the executive. Premium payments are considered compensation to the employee but are deductible to the employer. The bonus payments are taxable to the key executive.

Split Dollar Plan

A Split Dollar plan is used when the employer wants to provide a key employee with a permanent life insurance policy. Under this arrangement, the policy is purchased on the life of the employee and ownership of the policy is divided between the employer and the employee. The employee is responsible for paying the mortality costs (i.e. term premium amount) while the employer pays the balance of the premium. At death, the main portion of the death benefit is paid to the employee’s beneficiaries while the employer receives a portion equal to the amount it paid in premiums during the life of the Split Dollar plan.

Performance Share Plan

This is a plan where the Company would issue stock to key employees only if certain companywide performance criteria were met, such as earnings per share targets or sales/revenue goals. The key employee receives shares as compensation for meeting targets as opposed to stock option plans where employees receive stock options as part of their usual compensation package. The distribution of performance shares is based on the Company’s performance compared to specific metrics. For example, the shares might only be issued if the Company stock attains a certain value on the market. A Company may structure performance share plans based on cash flow from operating activities, total shareholder return, return on capital, or a combination of several metrics of how well the Company is doing over a set period. Again, not the best option if you do not want to have your key employees own any stock in the Company.

Deferred Bonus Plan

The ideal client for this strategy is a key executive with discretionary income who has maxed out their 401k contributions and is interested in deferring compensation in an effort to reduce current income taxes. With this plan, the employee receives salary that would have been otherwise deferred. The executive then makes payments directly to a personally owned cash value life insurance policy.

The employer for their part effectively agrees to pay the tax on the amount the employee contributes to the policy by increasing the amount of the bonus. The premium paid into the policy in a deferred bonus plan represents the money the employee would have received without the employer providing an additional executive bonus. Presumably, that is the same amount that the employee would have elected to defer under a traditional salary deferral plan. However, as a result of the additional bonus for taxes, this technique represents a cash flow equivalent of a traditional salary deferral plan without many of the common drawbacks of that arrangement.

Executive Long-Term Care Insurance

Employer paid long term care insurance provided to select employees is a tax favored benefit that can help a Company recruit and retain key employees who play an instrumental role in the Company’s growth and success. The employer is free to select any employee(s) it wants to be covered under this plan (this is also a great benefit for Owners of the Company who can participate in the plan). The plan can also typically cover the spouses of the key employees. The employee owns the policy, but the employer pays the long-term care premiums. The premiums paid by the employer is not considered income to the employee. The employer can deduct the cost of the premiums. This plan really only works for a C corporation. If the entity is a partnership or S corporation, then typically the employer can still deduct the premiums but the amount of the premiums is included in the gross income of the employee.

Cash Bonus Plan

This plan provides the key employee(s) with a cash bonus each year based on some pre-set factors/metrics. For example, if the Company increases profits or gross sales by a certain percentage over the prior year. There are many other metrics that can be used to determine if payment will be made and the amount. This plan can be used annually, over a set period of time (such as 3 years, 5 years, etc.) or a combination of both.

There are some other options that allow Owners/Highly Compensated Employees (HCE) to maximize their 401K contributions. First, the applicable Owner/HCE should fully utilize the over 50 make up provision which allows any employee over 50 to contribute an additional $6,500 a year to their 401K account. Second, the Company can implement a Safe Harbor provision in the Company 401K

Plan so that all the Owners/Highly Compensated Employees can defer the maximum annual amount to their 401K – in 2018 that amount is $18,500. The Safe Harbor Plan requires the Employer to make a 3% contribution to all employees’ 401K accounts even if the employee does not defer any money to the Plan. Third, the Company can implement a Cross-Tested 401K/Profit Sharing Plan. This allows an Owner the ability to defer even more money in the 401K Plan but it is based on a complicated calculation that an actuary has to run every year.

The above list does not include every option but it does provide an overview of most of the commonly used plans. The options can also be used by the Owners of the Company as well – it does not have to be just for key employees. Many Owners want additional retirement income options or long-term care coverage and the plans can be tailored to provide these benefits to the Company Owners.

If you are interested in implementing or learning more about any of the options, please let us know and our corporate and commercial planning attorneys are be happy to assist you.

Todd headhshot

Written By Todd J. Preti


Todd J. Preti is a Founding Shareholder in the Law Firm of Midgett Preti Olansen. Mr. Preti is a graduate of Randolph-Macon College in Ashland, Virginia, and earned his Juris Doctor degree from the T.C. Williams School of Law at the University of Richmond. While at the T.C. Williams School of Law, Mr. Preti was a merit scholar and was named to the University of Richmond Law Review and the Moot Court Board.

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