Compensation and benefits alone may not be enough for small employers to attract, retain and reward employees. One option is to offer key employees a non qualified plan that provides some benefits today and a lot of benefit in the future. A few strategies to consider include the following:

Executive Bonus

An executive bonus or Section 162 plan is when an employer pays the premium for a life insurance policy that insures the employee. The premium payment is a taxable bonus to the employee, under Section 162 of the Internal Revenue Code, and fully deductible for the employer.

In a bonus plan the employee owns the policy, and if they leave or performance suffers the employer can stop making contributions. The employee has complete control over the policy, including the right to surrender the coverage and take the cash value at any time. Some employers may object to giving the employee that much control and add a side agreement or restrictive endorsement that limits the employee’s right to modify the policy. However, enforcement of the side agreement or restrictive endorsement can be tricky.

A single bonus plan is when the employer pays the employee an amount equal to the premium. The employee is responsible for paying any income tax associated with the bonus. A double bonus plan commits the employer to paying the premium plus the projected tax on the overall bonus.

Split Dollar Plan

In a split dollar plan, an employer and employer enter into a formal written agreement outlining how the premium, cash value and death benefit of a life insurance policy will be shared. The employer does not get a tax deduction for the premium when paid but, depending on the agreement, can recover some or all of the premium paid when the plan is terminated. The agreement also spells out what happens if the employee leaves or if performance suffers.

These plans do require annual tax reporting, and since 2001 the IRS has recognized two different split dollar arrangements:

Under the economic benefit regime, the value of the life insurance that the employee receives is calculated each calendar year, using the government’s Table 2001 annual renewable term rates, and the employee recognizes that as taxable income. As long as the employee pays an amount of premium equal to the value of the term life insurance, there are no immediate income tax consequences.

Under the loan regime, the employer’s premium payments are treated as loans to the employee. As long as the employee pays the employer interest on the loan at or above the applicable federal rate, there is no taxable benefit.

The final design of the plan can vary. One example is endorsement split dollar, where the employer owns the policy’s cash value and the employee controls the death benefit. The employer pays most of the planned premium, and the employee pays an amount each year equal to the cost of the policy’s death benefit. The employee’s premium contribution usually increases each year as the insured gets older. If the employee dies, the employer receives an amount equal to the cash value and the employee’s named beneficiary gets the remainder. If the employee fulfills the terms of the agreement, the plan is terminated and the employer transfers ownership of the policy to the employee. The employee can surrender the policy for the cash value or continue paying the premium, if needed, with personal funds to keep the policy in force.

Non-Qualified Deferred Compensation (NQDC)

NQDC plans offer a variety of funding, design and benefit options. Employers also have the flexibility to decide which employees are allowed to participate in the plan (See also: What is the difference between qualified and non-qualified plans?)

One common NQDC is a Supplemental Executive Retirement Plan (SERP). A SERP is an agreement in which the business promises to supplement the key employee’s income at retirement. The SERP can be coordinated with existing qualified plans and individually tailored to meet the employee’s retirement income needs. A vesting schedule helps ensure that employees who leave the business receive a reduced benefit.

Employers are not required to formally set aside assets to pay the future retirement benefit. However many choose to fund a permanent life insurance policy to help assure the employee that future benefits will be paid. The employer is the owner, beneficiary and premium payor of a life insurance policy on the employee’s life. At the employee’s retirement, the employer can use the policy cash value to pay the promised benefits. These payments are taxable income to the employee and tax deductible for the employer.

If the employee dies before retirement, the employer receives the policy’s death benefit income tax-free and pays a survivor benefit to the employee’s beneficiaries. These payments are deductible by the business and are taxable income to the beneficiaries. The death proceeds above and beyond those intended for payments are retained by the employer to help offset the loss of a key employee. 

The Bottom Line

These are just a few examples of non-qualified plans. Since the plans are not subject to ERISA and many other government regulations, there is lot of opportunity for creative plan design to help attract and reward key employees. (See also: Which of the following accounts does ERISA cover?)

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.