The Inequity of Equity Part III The Tax Deferred Perspective

In addition to arranging plans that provide employees with the right to participate in current profits, consider providing deferred profit participation. This is usually a very selective benefit reserved only for key employees. 

The plan should provide a significant incentive for retirement income, while not placing additional current income tax burdens on the employee. Since it is the intention of the employer to accumulate funds for the employee over an extended period, select an investment that defers the tax on the funds' earnings. 

This arrangement is a non-qualified deferred compensation plan. The plan's purpose is to retain key people. Furthermore, it can provide partial indemnity for the company against the loss of a key person because permanent life insurance owned by the employer funds deferred compensation plans. 

Insurance values become a balance sheet asset. Death proceeds that exceed payments promised to the key employee become a tax free addition to company surplus. 

Finally, an important benefit is that it doesn't require Internal Revenue Service approval. An owner can choose the people he wants to participate in the plan. 

There are special advantages for the key employee as well. The plan helps meet needs for retirement income planning in a measurable and effective way. It recognizes the key executive's value to the company and becomes an incentive for continued exemplary performance. 

The mechanics of the plan are simple. By contract, the company agrees to pay the key employee or his beneficiary a stated sum of money over some period of years. The company funds the commitment through purchase and ownership of a permanent life insurance policy on the key employee. Although the premiums are not tax deductible when paid, the later payouts to the key employee are. Remember, the proceeds of the policy will ultimately be received income tax free by the company. (See Diagram A) 

Though it is important to build equity in the business, an argument can be made for extracting a small piece of this cash equity each year and setting it aside for future uses. The same rationale holds true for the interests of your key personnel. Creating a cash position for them on the books of the company's balance sheet represents an incentive as well as a reward. And, unlike a privately-held stock incentive, it's possible to create a predetermined benefit level at a selected future date and lock it in. 

Also unlike the stock incentive, it almost always results in a true wealth-creating opportunity for the key employee, and avoids the legal problems that too frequently result from privately-held minority stock ownership promises gone bad.

DIAGRAM A ‍

Deferred Compensation Plan

For Policy on Life of Keyperson:
Policy Values Owned by Aggressive, Inc.

At Death of Keyperson:

At Retirement of Keyperson: