Retaining top talent – a short-term arrangement?

According to the Small Business & Entrepreneurship Council Small Business Check-Up Survey released in July: 

» 67% of small-business owners rate the current economic climate as positive and 12% rate it as negative.

» 76% of small-business owners are confident about their financial prospects for this year and 22% are not.

» 39% of small-business owners expect better economic conditions in six months, 33% expect worse and 25% anticipate no change.

With that in mind, it is no wonder that employees are feeling confident in their employment and employers are feeling confident in doing more to retain the top talent they have. 

Let’s focus on a simple retention strategy with conditions. Before beginning, though, it is recommended that advisors first ask certain questions that may help clients discover the value of this top talent benefit strategy. Here are some examples that can help start the conversation:

» Do you have key employees with unique skills, experiences and leadership qualities; valuable relationships with key clients and centers of influence; and specialized training that makes them difficult, time-consuming and expensive to replace?

» Which executives, managers or salespeople in your firm make substantial contributions to your business’s bottom line?

» What would happen to your business should any of these key people leave your company?

» Is your business stable and well positioned for the future?

» Can you afford to lose any of your top talent to the competition — and if not, what have you done to help prevent that from happening?

One way employers can achieve these objectives is with nonqualified deferred compensation plans such as supplemental executive retirement plans or salary deferral plans. The problem? Most SERP and deferral plans don’t pay a benefit until the key executive has retired. For many top executives, that’s too far into the future to think of it as a meaningful benefit or to consider it enough of an incentive to stay with the company.

The retention bonus plan is like many other nonqualified benefits — designed to attract and retain top talent. But unlike a SERP or salary deferral plan, the retention bonus plan can be designed to provide a reward that is within reach, and one that the executive believes they have a chance of staying long enough to earn.

What is a retention bonus arrangement?

In a retention bonus arrangement, the business agrees to pay the specified employee a bonus if the employee stays for an agreed-upon period or at a triggering event, such as the retirement, disability or death of the owner. A retention bonus can also be used, for example, by the business owner to have one of the top sales employees mentor the business owner’s child, who is entering the business and has a five-year time frame for hitting various sales goals.

The employee will have more incentive to stay until the end of the period because otherwise the employee will forfeit the bonus. The owner and employee can negotiate the bonus amount and the stay period. For example, a bonus amount can be a set dollar amount or some multiple of salary (e.g., two times salary). The retention period can be one or two years, or some other time frame, although the stay period is not ordinarily longer than 10 years to make the benefit more attainable. The plan is flexible, and after the initial stay period is achieved, a new stay period can be added.

The retention bonus solution is ordinarily created using a retention bonus agreement and is usually funded with permanent life insurance.

The strategy 

With the employee’s written permission, the business owner purchases a whole life insurance policy that is owned by the business and insures the employee. If the employee remains with the company after the time specified in the retention bonus agreement, the employee will receive, from the policy’s cash value, the amount of the bonus that is specified in the retention bonus agreement.

Let’s consider how a 10-year retention bonus, funded with a whole life policy, was the answer for one employer who wanted to retain an extremely valuable employee.

Tom Barbar owns a successful scientific and technical consulting services firm. Elsey Smart is one of his top consultants, and she’s been incredibly instrumental to the success of the firm. Tom is anxious to do what he can to ensure that Elsey will stay with the company for many years to come. So, Tom and Elsey enter into a retention bonus arrangement in which Tom agrees to pay Elsey an additional $250,000 in a single lump sum if she stays with his company for 10 years and continues her outstanding performance. 

With Elsey’s written permission, Tom purchases a whole life policy on Elsey to fund the plan. At the end of 10 years, Tom pays Elsey the bonus and uses the policy cash value to recover his cost. At that time, he offers her an additional bonus of $500,000 if she stays another 10 years.

Tax considerations  

The business owner should consult an advisor for guidance, but here are some general guidelines you and your client may wish to keep in mind with respect to how this strategy can affect your client’s business taxes.

» Life insurance premiums are not deductible by the business itself.

» Insurance proceeds are received income-tax-free by the business.

»  In pass-through entities, such as S corporations, limited liability corporations and partnerships, the death proceeds increase the basis of the owner’s business interest. Premium payments, policy cash values and policy dividends may also impact an owner’s basis.

Protecting the income tax exclusion for the death benefit

To protect the income tax exclusion for the death benefit, there are four general requirements:

1. Notice must be given to the insured, and the insured’s consent for the coverage must be obtained.

2. Either the insured must fit into certain categories, or the proceeds must be used for certain purposes.

3. There must be recordkeeping.

4. Reporting to the IRS concerning these policies must be completed using IRS Form 892.

For the employer, this program builds loyalty, is flexible and cost-effective with the possibility of recapturing the payout, and (within reasonable compensation) is deductible when paid out. For the employee, it is a valuable income benefit and attainable.

Ernest J. Guerriero, CLU, ChFC, CEBS, CPCU, CPC, CMS, AIF, RICP, CPFA, national president of the Society of Financial Service Professionals, is the director of qualified plans, business markets for Consolidated Planning. He may be contacted at [email protected].