Employees are the backbones of every business – they make it work, and they bring in the profit the company needs. This means helping them learn the required skills is necessary for them to excel in their job. Some companies choose to do this with team-building exercises like the ones on sites like BreakoutIQ, others choose to have schemes in place within the business for praise or improvement. Every business has some employees who work hard every day and do their best to bring in sales. From the people doing your hong kong secretarial services to your sales team to your board members – everyone is striving to better the business and allow it to continue to grow. Without these employees, your business wouldn’t be where it is now. Unfortunately, there will be some employees who don’t work as hard and just do the bare minimum to get by. While it’s the job of the manager to work out how to tell an employee they are not meeting expectations, it’s also the job of the manager to reward the employees who are working extra hard to support the business. And many businesses have these small groups of key high potential employees whose skills, expertise and dedication are critical to keeping the business successful. Employees like these are hard to find and difficult to replace. It could take the business a long time to recover if one of them leaves or decides to join a competitor. To recognize their worth and motivate them to continue performing at a high level, businesses often give their key employees additional financial incentives.
Structuring incentive plans can be challenging. They need to be appreciated by the key employee and still make financial sense for the business. Businesses often use cash value life insurance (CVLI) policies as part of the funding for their incentive plans. CVLI is a popular funding tool because it has several important potential benefits: (1) income tax-free death benefits for an employee’s beneficiaries if he dies prematurely, (2) income tax-deferred cash value growth while the employee is alive, and (3) the potential for income tax-free distributions to supplement the employee’s retirement income.
Traditional Approaches
CVLI policies can be structured in a number of ways. They are often used in two popular incentive benefit strategies: 1) Section 162 Bonus Plans (Bonus Plans) and 2) Supplemental Executive Retirement Plans (SERPs). These strategies are very different. Here’s a short summary of each:
Section 162 Bonus Plans. In these plans the business pays the employee an annual year-end bonus over and above his normal salary and benefits. The employee pays income taxes on the bonus and uses the after-tax funds to purchase a CVLI policy. The employee owns the policy and the business has no interest in it. Bonus Plans give key employees death benefit protection for their families and the potential to use policy cash values for supplemental income during retirement. If the policy is properly managed, both the death benefits and supplemental retirement income can be received income tax-free. The business deducts the bonus payment (as long as the employee’s total compensation is reasonable). However, it generally can’t recover the bonus if the employee leaves the business.
SERP Plans. In these plans the business promises to pay the employee additional compensation starting at an agreed upon future date-usually the employee’s retirement date. The additional compensation can be forfeited if the employee leaves the business before retirement. The business owns and controls the funding for the benefit, including CVLI policies on participating key employees. The key employee often has to wait several years before receiving benefits. Policy premiums generally aren’t deductible and the business only gets income tax deductions when it pays benefits to participating employees.
Which plan is better? How effective a particular incentive plan is depends on the objectives a business and its key employee want to accomplish. Businesses generally prefer incentive plans that give them control of the funding (the policy) and the ability to change the benefit and payment schedule as circumstances change. They also prefer incentive plans that generate income tax deductions as they are funded (i.e., when life insurance premiums are paid).
Key employees have different objectives. They prefer incentive plans in which their benefits vest quickly and grow in value over time. They also prefer to control life insurance policies that insure their lives and other assets that fund their benefits. They want to delay income taxes for as long as possible and they want their benefits to be not forfeitable.
Unfortunately, neither Bonus Plans nor SERP Plans meet all the objectives of either businesses or key employees. SERP Plans generally favor the business because it owns and controls all the funding (including the life insurance policies) and the employee runs the risk of losing the benefit if he leaves the business or retires early, or if the business runs into financial difficulty. Unfortunately, SERP Plans are not very flexible under the tax law and income tax deductions for the business are delayed until the benefit is actually paid out to the key employee at retirement. Bonus Plans, on the other hand, generally favor key employees because incentive payments are received immediately and because the key employee owns and controls the policy. If he leaves the business he is able to take the policy with him. Unfortunately, key employees must pay income taxes immediately when the bonus payments are received.
A New Alternative: The HEX Benefit
The Hybrid Executive (HEX) Benefit is a new approach that avoids some of the problems of SERP Plans and Bonus Plans. It may do a better job of helping businesses and key employees meet their respective objectives. The HEX Benefit strategy is flexible and can be revised as needed to meet business and employee goals from year to year. It is a hybrid because it combines two distinct types of benefits. It combines bonuses and employment loans to retain and reward key employees. The employee purchases the CVLI policy that funds the benefit. The business provides funds for paying annual premiums through a combination of bonuses and loans. The key employee collaterally assigns the policy to the business as security for the repayment of the loans. From year to year the business can change both the amount of funding it supplies and how those funds are allocated between bonuses and loans. The business retains indirect control over the policy through the collateral assignment that secures repayment of the loan. It can deduct the bonus portion of the payments immediately. The CVLI policy gives the employee an immediate life insurance death benefit to protect his family, while policy cash values have the potential to grow in value over time to repay the outstanding loans and generate supplemental retirement income. Here’s an example of the HEX Benefit strategy in action.
Example. Robert Smith (age 50) is vice president for sales and marketing at ABC, Inc. During his five years with ABC, his efforts have helped the company triple its revenues. ABC wants to retain him and motivate him to continue being productive until he retires in 15 years at age 65. ABC is willing to allocate $40,000 annually as incentive compensation for Smith. Each year ABC expects to split that $40,000 equally between a $20,000 bonus and a $20,000 interest-free demand loan. Let’s assume the fair market interest rate is 3 percent annually for the 15 years and that Smith is in the 28 percent tax bracket. A summary of the year to year bonuses and loans and projected costs of the arrangement can be found in Table 1.
Smith buys a cash value life insurance policy with the death benefit set at an amount which maximizes cash value growth potential without causing the policy to be treated as a modified endowment contract (MEC). He contributes the $20,000 bonus and the proceeds of ABC’s $20,000 loan. He uses other funds to pay the income taxes due on the bonus and interest-free loan. Smith executes a collateral assignment giving ABC an interest in the policy to the extent of the outstanding loan balance. We will assume that Smith’s total life insurance death benefit protection is adequate. If he needs more, he can purchase additional coverage personally.
Splitting the $40,000 selective compensation budget into a $20,000 bonus and a $20,000 loan is merely a place to start. ABC can change both the amount and the split whenever it wishes. If either Smith or the company has a difficult year, the compensation budget for Smith can be reduced. On the other hand, in good years the compensation budget can be increased. Further, the bonus/loan allocation can be revised from 50/50 to 75/25 or something else from year to year. If there is “capacity” in the policy (without triggering MEC status), Smith may also contribute some of his personal funds into the policy. If he does a good job and stays with ABC until 65, he may use policy cash values to repay the demand loan balance. Remaining policy cash values could be used to supplement his retirement income.
ABC’s cash flow to provide Smith’s benefit is summarized in Table 2. At all times, ABC owns and controls the loan balance.
MECs. Distributions (withdrawals or policy loans) from life insurance policies treated as MECs under Section 7702A of the Internal Revenue Code are subject to less favorable tax treatment than distributions from policies that are not. If the policy is a MEC, distributions will be taxable to the extent that there is any gain in the policy. In addition, if the policyowner is under age 591/2 or is a corporation at the time of the distribution, there is a penalty tax of 10 percent on the taxable amount. Without regard to whether a policy is a MEC, a gain in the policy is taxable on full surrender of the policy.
Positive Features of the HEX Benefit Plan
To businesses:
??Control of the policy through the loan and the collateral assignment.
??Immediate income tax deduction for the annual bonus.
??Key employee incentive and loyalty; they are motivated to increase (1) how much money the business annually makes available for their benefit and (2) how that sum is divided between bonuses and loans.
??The loan balance is an asset on the balance sheet.
??No policy administration; the business only has to keep track of SD loans, interest due (if any) and the key employee’s taxable income.
??Partial cost recovery-the business can recover the SD loan balance subject to the terms of the loans.
??Flexibility-the business decides from year to year how much to pay the executive and how to divide it between bonus and loans; demand loans may be called at any time.
To key employees:
??Death benefit protection for the key employee’s named beneficiaries.
??Ownership of the policy and its cash values (subject to collateral assignment and repayment of loan balance).
??Cash values for potential supplemental retirement income.
??Only the bonus portion of the premiums are taxed immediately (the loan portion isn’t currently taxable, annual interest on the loans needs to be accounted for).
??Immediately portable (although demand loans will need to be repaid upon departure).
??Policy cash values may be available to pay off the loan balance.
??No IRC Section 409A or 101(j) reporting or potential penalties.
??May be able to use personal savings to make additional premium contributions (up to MEC limit).
Comparison to Bonus and SERP Plans
It is a balanced approach with features that are important to both businesses and key employees. The HEX Benefit is flexible and keeps key employees engaged. Here’s how it addresses business and key employee concerns about the two traditional plans:
Bonus Plans. Businesses are concerned about inability to retain control over the benefit and inability to recover any costs if the key employee leaves early. Structuring part of the payment as a loan preserves the business’ ability to recover some of the benefit costs. The collateral assignment preserves the business’ position and gives it the right to recover those loans before the key employee can access policy cash values for personal use. The loan balance remains an asset on the business’ balance sheet. Key employees are concerned about paying income taxes on bonuses they receive. By structuring part of the compensation as a loan, the HEX Benefit prevents the loan balance from being taxable (interest must be accounted for annually).
SERP Plans. Businesses are concerned that SERP Plans don’t provide any current income tax deductions; instead, deductions are delayed until the benefits begin to be paid out at retirement. The bonus portion of the HEX benefit creates an immediate income tax deduction (providing the key employee’s total compensation is reasonable). Also, the HEX Benefit gives businesses the option of avoiding plan administration costs by administering the plan themselves. All they need to do is to keep track of the outstanding loan balance, any interest due, and report the total income taxes generated. Key employees are concerned about having to wait until retirement to get any benefits. They have no access to or control over any of the benefit funding. They are totally reliant on the business to make the promised payments. They are at risk if something happens to the business or the funding before their payments begin. In the HEX Benefit they own the policy and receive the statements. They can verify that the business has paid its premiums and even if they leave, they can take the policy with them after the outstanding loan balance has been repaid. See Table 3 for a comparison of the three plans.
Conclusion
The Bonus Plan and SERP Plan strategies have traditionally been the most popular options for incentive plans. Both plans have some disadvantages which make it difficult for them to meet some important employer and key employee objectives. The HEX Benefit is a “middle ground” between them. The HEX Benefit strategy gives both parties much of what they want. It is flexible and can be adjusted from year to year to track business and key employee performance. In addition, it is easy to understand and simple to implement. The bonus portion of the plan gives the business an immediate income tax deduction. The key employee gets immediate death benefit protection for his family. The loan portion reduces the key employee’s taxable income and the collateral assignment that accompanies it gives the business control over the policy and the ability to recover some of its costs should the key employee decide to leave the business early.
