Business owners often need to secure the services of a key executive for a period of time in order for their business to survive or thrive. Business owners may also count on these executives to purchase the owner's business interest to facilitate an in-house exit strategy. Both of these needs may be met by a new form of nonqualified deferred compensation benefit known as a "short-term" deferral.
Easy to administer
In addition to meeting pressing needs for business owners, this new deferred compensation arrangement is relatively simple to administer. This simplicity is available because, if drafted properly, the arrangement operates free from much of the Internal Revenue Code Section 409A rules for nonqualified deferred compensation.
Generally, the short-term deferral exception provides that if a benefit, which is subject to a substantial risk of forfeiture, is paid in full to an executive within two and one-half months after the close of the tax year in which the executive becomes entitled to the benefit, then compliance with the remaining rules of Section 409A is not necessary.
Let's look at a specific plan design example that fits within this exception. If an employer has an executive which he or she wants to 'lock-up' for the next 10 years, and is willing to finance a solution, the employer may offer a nonqualified benefit program to the executive with the following simplified plan design. If the executive is still employed with the firm in 10 years, the employer will pay the executive a lump sum of $250,000 no later than 30 days following completion of the 10-year period. It may be easiest to think of this plan as a deferred executive bonus with a very strong handcuff.
As an alternative benefit, the executive may use the lump sum bonus as a down-payment to the business owner on an installment note for the sale of the business. The advantage of this approach is that business dollars are used to finance transfer of the business to a key executive who otherwise might not have the means to make such a purchase.
From a taxation perspective, with a short-term deferral plan, the employer gets a tax deduction when paying the lump bonus to the executive. Prior to that point, the employer receives no tax benefits, unless he or she chooses to create an informal sinking fund to pay the benefit by purchasing a cash value life insurance policy with tax-deferral of policy cash values. The executive is taxed on the bonus when it is paid. If desirable, the bonus amount may be 'grossed-up' for income tax purposes.
If a life insurance policy is used to informally finance the lump sum benefit, a portion of the policy's death benefit could be used for an endorsement split-dollar plan to provide a tax-free death benefit for the executive's family. The executive's cost for this benefit is the tax due on the amount of economic benefit provided, generally measured by government Table 2001. Another portion of the death benefit could serve as key person protection for the business.
