Blackman on Taxes
Experience Has Taught Us the Best Way to Attract and Keep Great People
Our typical consulting assignment is to put together a wealth-transfer plan for a successful business owner. Invariably, the client brings up two critical and related operational problems: “How do I keep my top executives?” (the headhunters, usually working for a competitor, are always circling); and “How do I attract new quality people?”
No, the problem is not new. It’s been a problem in the past and, more than likely, will get worse in the future as the bidding war for talented people escalates. What to do? Almost 20 years ago, after struggling with the problem for about a year, we decided to develop an organized plan to find the answers. We interviewed our few client/owners who did not have the two problems; we also interviewed their key management people. Then came the hard part: getting permission to interview the key people at clients that were suffering with the problem.
What quickly became clear was that almost all of the best key people had the soul of an entrepreneur. But for various reasons they did not want to strike out on their own or couldn’t—usually because they could not raise the required capital.
The answer turned out to be simple: “Mimic ownership.” Give these key people the same challenges as an owner and, if successful, most of the rewards. Additional interviews just kept reconfirming the original answers. The top non-owner executives wanted four core benefits of ownership: 1) A piece of the action (a share of company profits); 2) payment when they are sick or become disabled; 3) adequate retirement pay when it’s time to leave the company; 4) and a death benefit for their family. Over the years we have created hundreds of contracts (the technical name is a nonqualified deferred compensation agreement; the nontechnical name is a golden handcuff agreement) that attract and keep the kind of people you want in your organization.
Let’s take a closer look at each of the four desired benefits.
1) A piece of the action. Typically, this is a percentage of the yearly profits in excess of specific dollar amounts. Often, the percentage grows as the business and profits grow. For example, Sam Eager will get 3 percent of all before-tax profits in excess of $200,000 and up to $300,000; 5 percent from $300,000 to $400,000; and 7 percent from $400,000 to $500,000. Profits in excess of $500,000 will entitle Sam to 10 percent. Suppose the amount earned by Sam for year one, or any subsequent year, is $24,000. Usually, Sam will get about one-third ($8000) in cash with the balance ($16,000) deferred. The deferred portion is invested for Sam’s benefit. When does Sam get the deferred portion and the accumulated earnings on this portion (usually called the side fund)? When he becomes disabled, dies or reaches retirement age (the age is usually set around 58 for younger key employees and in the 65-age range for older key people). When the key employee becomes entitled to collect the side fund (say it is $500,000), it usually is paid out in equal annual installments (perhaps 10 years) or $50,000 per year plus the additional investment earnings for that year.
2) Disability. The employee gets paid when sick or disabled, whether for a day or for a lifetime. This benefit is covered by long-term disability insurance. It is essential that “disability” is defined “word for word” in your agreement the same as the word is defined in the disability insurance contract.
3) Retirement. The side fund (described in No. 1 above) supplements any regular retirement program, a 401(k) or profit-sharing plan. Typically, the executive is allowed to direct the investment of the side-fund, which remains an asset of the employer.
Following are the tax consequences of the arrangement: The side-fund earnings are taxable to the employer. When the employee receives a distribution, the company gets a deduction for the exact amount distributed and the employee must report the identical amount as taxable income.
If the employee leaves for any reason —except because of disability, death or retirement—the entire side fund is forfeited by the employee and remains the property of the company. Hence, the name “golden handcuffs.”
4) A set amount of money at death. When an owner dies, the family can sell the business, assuming it is not transferred to the kids. A similar benefit, really a death benefit, should be given to the employee. Of course, this benefit should be insurance-funded.
We have been doing these nonqualified plans for years. Done right, they work. Often, when an owner does not have a family member to pass the business to, the side fund serves as the downpayment by one or more of the key people to buy the business from the owner.
Two warnings: 1) This article does not attempt to cover every detail and the endless variations for tailoring an agreement that is perfect for your company. Always, and we mean always, work with an experienced advisor. Years of experience has proven that the right agreement will make your good people even better. 2) Sadly, there is no agreement we have ever seen that will make a bad employee even a little bit better.In a way this getting-and-keeping good people is a frustrating subject. The reason is that we have never been able to develop a cookie-cutter solution. The four core benefits are almost always the same or similar, but the bells, whistles and unique requirements of each situation makes it impossible to write a complete report or book on the subject. But if you have a question, call Irv Blackman at 847/674-5295. Let’s chat about your specific key-employee situation and how to keep ’em. MF
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