In addition to providing qualified plans to employees, many business owners implement nonqualified alternatives in order to supplement retirement benefits. These selective benefit plans are generally offered to key employees and owners. One popular nonqualified benefit is deferred compensation.

Basically, nonqualified deferred compensation refers to an arrangement between an employer and an employee in which compensation for current services is postponed until some future date or the occurrence of a future event. The effect is to postpone taxation for the employee until compensation is received – usually at retirement or disability.

Types of Deferred Compensation

Deferred compensation plans can be categorized several different ways. Plans can be:

• Funded or unfunded.
• Forfeitable or nonforfeitable.
• Defined benefit or money purchase.
• They can also provide one or a combination of death benefits, disability benefits and retirement benefits.

Funded plans generally involve a trust fund or escrow account where the employer transfers money at a later date for its “promise to pay” deferred compensation. These are not very popular as the participant may be deemed to have “constructive receipt” of such funds and therefore inherits a current tax liability when funded.

IRS Revenue Ruling 60-31, 1960-2 CB 174, states that an employee’s right to receive deferred compensation, backed during the deferral period solely by an employer’s “naked promise” to pay, produces no currently taxable income for the employee. A deferred compensation plan is not regarded as funded merely because the corporation purchased and owns a life insurance policy or annuity contract to make certain that funds will be available when needed.

Rabbi Trusts

One of the problems with a typical unfunded deferred compensation plan is that the employee has no guarantee that future payments will be made. If the employer defaults in making promised payments, becomes insolvent, or files bankruptcy, the employee simply becomes a general creditor waiting in line with all the other creditors hoping to recoup some of their receivables.

The rabbi trust protects an executive from an employer’s future unwillingness or inability to pay promised benefits while retaining the benefits of deferred income taxation. The IRS has stated in a series of private letter rulings that an irrevocable trust or an escrow account can be established to fund a deferred compensation agreement as long as the assets placed into the rabbi trust remain subject to the claims of general creditors. If this condition is met, the employee will not be deemed to have “constructive receipt” of the assets, and, therefore, will not have received a current economic benefit. Hence, the employee will not be required to pay taxes until the payments are made at a future date.

The rabbi trust gives the employee security in knowing that the employer is, in fact, setting aside money to fulfill its obligation under a deferred compensation agreement.

Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal, or investment advice.  Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary therefore, the information should be relied upon when coordinated with individual professional advice. Past performance is no guarantee of future results. Diversification does not ensure against loss. Source: Financial Visions, Inc.

Internal Revenue Code 125 allows an employer to implement an employee benefit plan, which allows employees to select the benefit programs they prefer.

The plan offers two or more options and the employee chooses the option most appropriate for him or her from the “menu” of benefits available. It’s sort of like ordering lunch from the local deli – which is why the plan is referred to as a “cafeteria plan”!

Cafeteria plans, along with 401(k)s, are among the most popular employee benefit plans of the past decade. The tax benefits to the employer and employees far exceed the minimal required government reporting.

Cafeteria Plan Benefit Options

In general, the IRS allows the following benefits to be present in a Section 125 plan:

• Group-term life insurance (up to $50,000; amounts above that level of death benefit may be subject to Social Security and Medicare taxation)
• Accident and health plans
• Long- and short-term disability benefits
• Flexible spending accounts to save for health, medical, and childcare expenses
• CODA [401(k) plans]
• Dependent group life, accident, and health insurance coverages
• Vacation

Employee Tax Aspects

The plan essentially allows expenses that normally would be paid by the employee on an after-tax basis to be paid via salary reductions on a pretax basis. This allocated income will not be subjected to FICA or income taxes. The result is that taxable dollars have been converted to nontaxable dollars – thereby increasing the employee’s take-home pay.

Employer Tax Aspects

Generally, employer contributions to a plan are income tax deductible. In addition, contributions on behalf of the employees, if such contributions are not included in the employee’s income, are not subject to FICA (Social Security) or FUTA (Federal Unemployment Tax Act). This can result in significant savings to the company’s bottom line.

The employer must file an annual information return (IRS Form 5500) stating plan participation, cost and business type.

The vast majority of small-business owners accept the wisdom of insuring the firm against the loss of its property values. We take care to insure the physical assets against fire, tornados and other disasters. Yet, protection from the loss a key executive may be far more important.

First, the probability of losing a key employee is far greater than a loss due to fire. It has been estimated that the chances of death of a key executive is 14 times greater at age 45, 17 times greater at age 50, and 23 times greater at age 55 than a loss caused by fire. Further, about one out of every three individuals dies in the working period of life with a consequent loss to his or her business.

Second, the loss due to a fire is temporary. Plants and factories can be rebuilt. Inventory can be replaced. The new building is likely to be more useful and valuable than the old one. On the other hand, a new hire may need several months or even years to become as productive as her or his predecessor. In fact, the deceased employee may prove impossible to replace.

Who Is Key?

Every corporation has at least one key executive or an employee who makes a substantial contribution to the operation, profitability and success of the business. Any individual who has critical intellectual information, sales relationships, bank relationships, product knowledge, and/or industry contacts that may adversely affect profits in the event of their absence, may be considered key.

The Role of Key Person Life Insurance

Although life insurance cannot ever fully replace the value of a key employee, it can indemnify the business for the financial setbacks that can occur. Life insurance can provide the business with needed funds to keep the business running, to assure creditors that their loans will be repaid, to assure customers that business will continue operations, to cover the special expenses of finding, hiring, and training a replacement.

How This Strategy Works

There is no particular form of agreement or special contract needed by the business to obtain key employee insurance on an executive or owner. However, the board of directors should authorize the maintenance and payment of the policy.

The applicant is the company. The application is signed by an officer of the business other than the insured party. Generally, the premiums will be paid by the business on an after-tax basis and are not deductible as a business expense. The business will be designated as the beneficiary and the insurance proceeds received upon the death of a key executive are not subject to federal income tax.

Replacing a key person may be difficult, but the proceeds from the life insurance policy can help ensure a smooth transition following their passing. With key person life insurance, that’s one more risk that small-business owners can worry a little less about.

Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal, or investment advice.  Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary therefore, the information should be relied upon when coordinated with individual professional advice. Past performance is no guarantee of future results. Diversification does not ensure against loss. Source: Financial Visions, Inc.

Choosing the form of entity under which a business will operate is one of the first, and often the most important, decisions a business owner will make. Although the legal details underlying each entity type are inherently complex, exploring three major variables may help you determine which option is right for you: business control, owner liability, and tax implications.

The major business alternatives today include:

• Sole Proprietorship
• Partnership
• C-Corporation
• S-corporation
• Limited Liability Company

The following comparison illustrates the most dramatic differences, and similarities, between several entity alternatives.

Sole Proprietorship. As its name implies, a sole proprietorship has a single owner, and is perhaps the most simplistic of all entity types. The main benefits of the sole proprietorship include its ease of implementation and lack of regulatory requirements. In addition, the sole proprietorship allows complete business control to a single business owner (proprietor). Under a sole proprietorship, the business owner is required to file a Schedule C (profit or loss from a business or profession) with their personal income tax filing. The proprietor personally assumes all liability and business risk, which can often be “transferred” through the purchase of liability insurance.

Partnership. The main difference between the sole proprietorship and the partnership is the number of business owners. Although quite easy to establish, it is a good idea to begin a partnership with a formal arrangement known as the partnership agreement. The partnership agreement sets forth the intent of the business owners in the event of a wide variety of business events such as the sale of the entire business, the sale of a single individual’s holdings or the disposition of ownership in the event of the death of a partner.

Like the sole proprietorship, the partnership represents a “flow-through entity” where both cash flows and tax liabilities flow through to the business owners. The partnership provides its owners minimal protection from business risk.

C-corporation. Though often costly and time-consuming to establish and maintain, the C-corporation provides the greatest amount of liability and business risk protection to the business owner(s). Strict governmental regulations outline company structure, reporting, and disclosure requirements.

Corporations have unlimited lives with ownership rights passing to designated heirs upon the death of an owner. The corporate entity also has a great deal of income tax flexibility and can offer the broadest array of tax deductible benefits, but may also trigger “double taxation” of some corporate profits as they are taxed at the corporate level as profits and again, potentially, at the individual level as taxable dividends are paid to shareholders.

S-Corporation. The “S Corp” functions as something of a hybrid, assuming many of the best features of several other entity types. The S Corporation is a legal entity that offers owners the benefits of greatly limited liability, while allowing company profits or losses to flow directly through to the business owners for income tax purposes, thus avoiding potential double taxation. The legal requirements and costs associated with starting an S Corporation are modest, as are the regulatory requirements. There are limitations on the number of owners within an S Corporation, and a C Corporation may not be an owner.