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Tax Savings for Business Owners Part 5 – Executive Bonus Plans and Non-Qualified Deferred Compensation Plans

Two Ways to Reward Key Employees & Optimize Tax Savings

Welcome back to our series on tax-saving strategies for business owners. Today, in our final blog topic, we’re going to unpack two highly effective tools: Executive Bonus Plans and Non-Qualified Deferred Compensation Plans. These strategies offer ways to reward key personnel while optimizing tax savings, ensuring your business remains competitive and prosperous.

Retaining and rewarding key employees is vital to the success of your business. Two strategies can be leveraged to achieve this while also providing substantial tax benefits: Executive Bonus Plans and Non-Qualified Deferred Compensation Plans. Let’s begin with an in-depth look at Executive Bonus Plans.

Executive Bonus Plans

Executive Bonus Plans come in a few different flavors, allowing businesses to optimize for their unique situations and needs. These plans all revolve around the core idea of providing a tax-deductible bonus to select employees in the form of paid premiums on a life insurance policy.

The most straightforward of these is the Section 162 Plan. With this, the employer simply pays the life insurance premium on behalf of a chosen employee. The premium counts as a bonus and is fully tax-deductible for the employer, while the death benefit is typically tax-free for the employee’s beneficiaries.

But this is just the beginning – Executive Bonus Plans can be customized to fit various scenarios. Here are a few examples:

1. Restricted Executive Bonus Plan (REBP): This modification of the standard plan includes a vesting schedule. The insurance policy isn’t fully owned by the employee until a certain period has passed or specific conditions have been met. This plan serves as a “golden handcuff” that incentivizes key employees to remain with the company.

2. Double Bonus Plan: In a Double Bonus Plan, the employer pays both the insurance premium and the tax incurred by the employee from the premium-as-bonus. This plan allows the employee to enjoy the full benefit of the life insurance without any tax liability, while the employer gets to deduct the full cost of both payments.

3. Group Carve-Out Plan: In this plan, part of an employee’s group term life insurance coverage is replaced with a permanent life insurance policy. The employer pays for term coverage up to the IRS limit, and the remainder is converted into a whole-life policy. The premiums for this whole-life policy can then be paid by the employer as an additional bonus or by the employee with pre-tax dollars.

Take, for example, a Double Bonus Plan scenario. Suppose you decide to pay a premium of $20,000 towards a life insurance policy as an executive bonus, plus an additional $6,000 to cover the tax incurred by the employee. You can deduct the entire $26,000 as a business expense, thereby reducing your taxable income. Meanwhile, your employee enjoys the benefit of the life insurance policy without any tax liability.

These variations of Executive Bonus Plans offer greater flexibility, allowing businesses to provide valuable benefits to key employees in a way that makes the most sense for their specific circumstances. As always, it’s important to consult with a financial advisor or tax professional to understand which strategy is the best fit for your business.

Next, let’s dive into Non-Qualified Deferred Compensation Plans, another powerful tool for rewarding key employees and driving tax efficiency.

Non-Qualified Deferred Compensation Plans

Non-Qualified Deferred Compensation Plans, or NQDCs, are agreements between the employer and employee where the employee can defer part of their income until a later date, often retirement. The benefits of these plans are twofold: the deferred income isn’t subject to income tax until it is received, and the income can grow tax-deferred in the interim.

NQDCs are “non-qualified,” meaning they do not need to comply with certain Employee Retirement Income Security Act (ERISA) requirements, including non-discrimination rules. This feature allows you to be selective in offering these plans to key employees.

There are several types of Non-Qualified Deferred Compensation Plans:

1. Salary Reduction Arrangements: The employee chooses to defer a portion of their income or bonus to a future date, reducing their current taxable income.

2. Bonus Deferral Plans: The employee defers receipt of a bonus to a future year, which reduces their taxable income in the year the bonus is earned.

3. Supplemental Executive Retirement Plans: The employer promises to provide supplemental retirement income to the employee, and the cost is deductible to the employer when the benefit is paid.

To illustrate the benefits, imagine a high-earning employee in the 37 percent tax bracket who decides to defer $100,000 of their salary into a NQDC plan. Their taxable income would be reduced by $100,000, saving $37,000 in federal taxes. Meanwhile, that $100,000 could be invested and grow tax-deferred, providing a substantial nest egg for retirement.

There is one caveat, though. The funds in an NQDC remain part of the company’s general assets and are subject to creditors in case of company bankruptcy. Therefore, financial stability is an important consideration when setting up these plans.

Executive Bonus Plans and Non-Qualified Deferred Compensation Plans offer versatile, tax-efficient ways to reward key employees and foster a motivated, loyal workforce. The right choice depends on your specific needs and circumstances, and it makes sense to consult with your tax and financial professional so they can help tailor the best strategy for you.

This concludes our in-depth series on Tax Savings for Business Owners. I trust you’ve found these insights beneficial in your journey to maximize tax efficiency and wealth creation. If you missed any previous blogs, please scroll back to read as each covered different, valuable tax-saving topics. And if you have any questions or need help, please don’t hesitate to reach out.

Chris Zeches is a certified financial planner and managing partner at Zeches Wealth Management. Zeches Wealth Management has one singular focus: To financial planning and tax expertise to help multi-generational families and business owners achieve more of what they love.

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