Using Benefits To Compensate Key Management & In Succession Planning Scott E. Galbreath, JD, LL.M. (Tax) The Burton Law Firm Sacramento and Roseville, CA
What is Executive Compensation? A mix of salary and benefits Examples Fringe benefits Company car, jet Bonuses Incentive bonus Ability to defer bonus Retirement More than rank and file Equity/Phantom Equity
Purpose of Executive Compensation Attract talented management/executives Retain them Motivate them to increase sales or profits Give them some skin in the game Make it harder for them to leave Help identify possible successors
Qualified Retirement Plans ERISA Income tax advantages Qualification rules Exclusive benefit trust Fiduciary duties Personal liability Prohibited Transactions Penalties Reporting and Disclosure
Inadequacy of Qualified Retirement Plans Limit on compensation considered Limit on total annual benefit or contribution Limit on annual elective deferrals Nondiscrimination tests Elective deferrals Overall
What Is Nonqualified Deferred Compensation? General-Any arrangement that defers compensation outside of a qualified plan Deferred compensation- generally, any arrangement that may defer the receipt of compensation earned (legally binding right) in one year until a subsequent year May or may not be a plan
Regulation of NQDC ERISA If payable at retirement, must be limited to Top- Hat Group Taxes Key management and highly compensated employees Can t be constructively received Can t have economic benefit Can t be funded Subject to employer s creditors Must meet Code section 409A or exception
NQDC advantages Higher taxes make deferral to future year of lower taxes more attractive Escape most of ERISA Discrimination, limits on compensation, contributions and deferrals, etc. More flexible in design Can attract key people because of extra benefits Can provide incentive to stay e.g., vesting
FICA on NQDC FICA = 6.2% S.S. up to limit ($118,500 for 2015) and 1.45% Medicare EE withholding and ER match For FICA NQDC is taxed on later of services or vesting New.9% EE withholding only On EE wages over $200,000 for the year Gets benefit of nonduplication rule If already taken into account then not subject to tax on payment
FICA Nonduplication rule If income already properly taken into account then neither it nor its earnings are subject to FICA tax again on payment Ex. EE s 2015 salary is $110,000 and electively defers $15,000 to NQDC plan account where he is 100% vested 2015 income tax wages? 2015 FICA wages? Paid in 2020 when grew to $30,000 none subject to FICA on payment.
FICA NQDC nightmare case Davidson v. Henkel (1/6/15) Davidson retired in 2003 with supplemental DB pension for life Plan said ER would withhold from other salary ER never withheld FICA Should have taken into account pv of annuity in 2003 In 2011 ER began withholding FICA on all payments and for make-up EEs sued under ERISA Court granted summary judgment to EEs Violated terms of plan
NQDC Disadvantages Lack of security for EE that money will be there because subject to ER creditors Notional account Life insurance Rabbi trust ER doesn t get a deduction until EE has income ER is taxed on all earnings Code section 409A compliance FICA tax risk
Rabbi Trust ER established trust designed to hold assets of nonqualified plan for purposes of paying future plan obligations Restricts ER from using trust assets for other purposes Rabbi Trust DOES NOT protect assets from corporate creditors (Substantial Risk of Forfeiture)
NQDC Disadvantage Code section 409A requirements Written document Deferrals and subsequent deferrals Distributions Prohibits acceleration Public company key employees If violated, taxed when no longer subject to forfeiture Plus additional 20% federal tax California additional 5% tax
Common Plan Designs Deferred Compensation Plan Elective/nonelective Deferred Bonus Plans Supplemental Executive Retirement Plans (SERP) Split Dollar Plans Phantom Equity Plans Discounted Stock Options violate 409A Options to buy at FMV on date of grant can help successor get equity Option to buy private stock that is restricted is not taxable on exercise
Equity and Phantom Equity Comp Equity- a true ownership interest in ER or related entity Stock, partnership interest, LLC interest Can be restricted by a vesting schedule and transfer restrictions Phantom/Synthetic Equity- a deferred compensation/bonus arrangement measured as if EE owned a true ownership interest in the entity Phantom stock, stock appreciation right, phantom LLC membership unit
Equity Advantages True ownership rights often governed by statute Easier to subject to non-compete provisions Taxed under Code section 83 as transfer of property in connection with services Excepted from compliance with 409A Special section 83 tax election can save tax Capital gain treatment upon sale Phantom Equity Provides income and appreciation as owner Plan documents govern contractual rights of parties
Equity Disadvantages Statutory ownership rights e.g., voting, disclosure Securities regulation Vesting causes phantom income Owners of partnership entities are self-employed Phantom Equity Subject to Code section 409A Can be difficult to administer like true entity ownership of a flow-through S-corp, partnership, etc.
What Is Succession Planning? The process of identifying one or more successor owners and implementing strategies to aid in the transfer of the business to the successor(s)
Who Is The Successor(s)? Family member? Child, children, grandchildren, brother, sister, etc. Non-family Insider Current key employee(s) All employees-esop Look to hire would be successor Outsider Sale to third party
Why You Need A Plan Remember, it s a process It takes time Owner should not just start thinking about it after deciding to retire Want sufficient time Get house in order Identify successor Get successor involved Identify and implement strategies Change course if not working out
House in Order Business records, financial statements, minutes, insurance, taxes, etc. Litigation Employment agreements with key EEs Other key business agreements Owner s personal life Owner s estate plan Coordinate with succession plan
Using Benefits In Succession Plan Insider-bring into leadership/management position Generally means higher compensation Can use deferred compensation to defer salary or bonus to later date to help in purchase of business Can be performance based bonus or phantom equity As business does well, deferred account increases Can use actual equity to give skin in the game Easier to enforce covenant not to compete Can use options to have Successor buy interest in company tax-free
Using Benefits In Succession Plan Owner- Can use NQDC to increase retirement income over qualified plan Plan benefits are a contractual liability of company Reduces the purchase price Converts capital gain to ordinary income Can defer income over installments Can use rabbi trust to secure
Example- Dryin King, Inc. DK is an S corporation with 20 employees owned by Mo Fassa in his late-50s, wants to retire in 5 years Mo is CEO and works in the business $300K salary No family interested in business Simba is the best salesman, MBA, early 30 s earning $100K base and $50K in commissions DK has a 3% safe harbor 401k
DK contd. Simba has no employment agreement Likes the business but only knows the sales end He is entrepreneurial and wants to run his own business some day Simba defers 12% into 401k plan ($18,000 limit) and is taxed on $132K. 3% safe harbor contribution is $4,500 (3% of compensation of $150K)
DK contd. Mo defers 10% into 401k plan and gets 3% nonelective contribution. 401k elective deferral limit is $18,000, which is 6% of $300K, loses $12K. But Plan can only consider $265K so deferral must be 6.8% Safe harbor contribution is $7,950 (3% of compensation limit of $265K)
DK Succession Plan? Pursuant to employment agreement Increase compensation to $200K Promise to sell him the company in 5 years for $1,000,000 in exchange for cov. not to compete Simba defers 10% into 401k plan. 401k elective deferral limit is $18,000, taxed on $182K can t defer on $20K of salary or any commission. Assume $75K in commission Safe harbor contribution is $7,950 (3% of compensation limit of $265K)
DK Succession Plan Have company professionally valued ($1,000,000) Promote Simba to VP in charge of sales Pursuant to employment agreement $200K base Make him a minority stock holder (e.g. 25%) Grant restricted stock subject to vesting 5% per year for 5 years Stock valued with discounts, e.g., 40% = $100,000 He files section 83(b) election pays tax on $100,000 as if fully vested No tax in subsequent years when vest
DK Succession Plan-Alternative Option Have company professionally valued ($1,000,000) Promote Simba to VP in charge of sales Pursuant to employment agreement $200K base Grant an NSO to buy 25% restricted stock interest over next 2 years at FMV. Stock valued with discounts, e.g., 40%, FMV = $100,000 Restricted stock subject to vesting 5% per year for 5 years and not transferable until vesting Simba saves $50K increase for 2 years Exercises option in 2017, files 83(b) election No tax in subsequent years when vest
DK Succession Plan-Accomplishments Skin in the game Incentive to stay for 5 years As shareholder signs shareholders agreement Death, Disability, Right of first refusal on offer Covenant Not to Compete in EA likely enforceable Duties include training sales force and learning management
DK-NQDC for Succession Use NQDC to help Simba pay less tax and save for down payment in 5 years Provide for a deferred annual bonus based on: Discretion; or Performance measurement-e.g., sales X% of sales $X for every percent increase in sales Not vested until 2020
DK-NQDC for Succession contd. Can have elective component for salary or commission as well Must make election before year earned begins Can make up for short fall of qualified plan Will reduce tax burden until received Example-Defers $50,000 increase in salary for 5 years Will have $250,000, plus earnings, for down payment in 2020 Will be taxable in 2020
What about Mo? He is only able to save around $25K per year for retirement in 401k plan Company can adopt an NQDC for him to supplement retirement Can be designed to work off the 401k formula Can be completely elective Can be performance/bonus based Becomes a liability of the company which reduces its value/purchase price
2020 DK worth $2,000,000 Mo owns 75% worth $1,500,000 Simba owns 25% (save tax on $400K) Deferred $250K electively, now $300K Deferred another $200K in bonus Mo defers $50K/yr in NQDC now $300K Simba could buy Mo s stock for $300K down (20%), finances rest Mo can stay employed as consultant
ESOPs Sale to all employees in concept Sale to QP designed to invest primarily in ER securities Offers significant tax advantages Very technical rules to follow Expensive Right fit
Does it fit? Profitable with cash flow Strong management Owner willing to stay involved Low basis stock
Benefits to Seller-Deferral Of Gain Corporation is a C corporation After sale, ESOP owns at least 30% Seller owned stock for at least 3 years Proceeds timely reinvested in qualified replacement securities (QRP) Under IRC 1042, gain on sale is deferred until sale of QRP Can defer until in lower tax rate On death, stepped up basis and gain is never recognized
Benefits to Corporation If ESOP owns 100% of stock, and elects S corporation status, pays no tax Tax-free financing to purchase stock because contributions to pay off loan principal and interest are deductible Employee ownership usually improves productivity
Benefits to Employees Retirement income tied to success of ER Employee ownership usually improves: Productivity Morale Quality Culture Pride in ownership Employees share in success of business they helped build
How an ESOP Works (Non-Leveraged) Other Shareholders 2. 3. ESOP ESOP Trust Accounts 2. 4. 1. Terminated Employee- Participants Company Save: IRA Spend 1. The Company makes annual tax deductible cash and/or stock contributions to ESOP Trust; and/or 2. ESOP Trust uses cash contributions to acquire stock from existing shareholders or the Company. 3. ESOP Trust allocates stock or cash to Participant accounts on annual basis and tells employees how much stock has been allocated to their accounts and how much such stock is worth. 4. Employees receive stock or cash when they leave the Company and must sell stock back to the Company, which must purchase such stock.
How an ESOP Works (Leveraged) 1. Other Shareholders 2. ESOP Trust 4. ESOP Accounts 2. Bank 1. 3. Company 1. Bank loans funds to the Company, which loans funds to the ESOP Trust. (Optionally, the selling shareholders can extend credit to the ESOP Trust through seller financing); 2. ESOP Trust uses loan proceeds to acquire stock from existing shareholders or the Company. 3. The Company makes annual tax deductible cash contributions to the ESOP Trust; ESOP Trust makes payments on the loan; the Company makes payments on the Bank loan. 4. ESOP Trust allocates stock to Participant accounts on annual basis and tells employees how much stock has been allocated to their accounts and how much such stock is worth. 5. Employees receive stock or cash when they leave the Company and must sell stock back to the Company, which must purchase such stock. 1. 3. Terminated Employee- Participants Save: IRA Spend
ESOP Cautions Not for everyone Feasibility study Need Independent Appraisal of Business Multiple parties, multiple hats Seller, Corporation, Trustee, Employees Counsel Lender, Appraiser ERISA Fiduciary duties Prohibited transactions
Conclusion Employee benefits aren t only for attracting, retaining, and rewarding good management Good managers are also potential successors Benefits can be used to: Align business and identified successor s interests Skin in game Build pool of assets for purchase Provide additional retirement assets for seller Create market for Seller s stock with ESOP
Thank You Scott E. Galbreath, JD, LL.M. (Tax) The Burton Law Firm Sacramento and Roseville, CA 916-570-2740 SGalbreath@lawburton.com