Motivations for Deferred Compensation Plans

We noted at the outset that the reasons for establishing a deferred compensation or other nonqualified plan may be the employer's reasons or the executive's reasons.  In many cases, these plans are developed to meet the needs of both parties.  While enabling the employer to attract and retain the executive, the deferred compensation plan allows the executive to achieve some tax relief and add to his or her retirement income.  However, there are reasons other than these traditional motivations that may be in the mind of the business owner considering a deferred compensation plan.  Let's consider some of them.

In the closely held organization -- an organization to which the majority of agents are likely to gain entrée -- there are many reasons for installing a deferred compensation plan.  Some of these reasons arise out of the nature of a closely held company.  In these organizations, a deferred compensation plan may be established for any or all of the following reasons:

As a substitute for a qualified plan
To help ensure that successor family owners have an experienced management team, or
As a substitute for an ownership stake in the organization

Let's consider these reasons.

Qualified Plan Substitute

Qualified plans enable the business to meet a range of objectives.  However, they tend to be prohibitively expensive for some organizations and somewhat inflexible, because of ERISA safeguards.  Furthermore, some employers may feel little or no obligation to help provide for the retirement security of their employees.  Despite those issues, these business organizations may want to provide retirement benefits for some of their employees -- particularly for their senior executives.

Nonqualified deferred compensation plans permit the employer to give selected employees -- including its owners in some cases -- extremely generous retirement benefits.  Since no government approval is necessary (DOL notice may be required, however), these plans are almost always discriminatory and usually provide benefits for no more than a handful of senior executives.  The possible adverse reaction from other, not-included employees is usually avoided since there is no requirement of notice to these employees, and they frequently are unaware of the existence of these plans.

Ensuring Successor Owners of an Experienced Management Team

Greater longevity, advances in reproductive medicine and the increasing prevalence of multiple marriages have all resulted in the commonness of childbirth into the parents' 40s and 50s.  Healthy children have even been born to parents in their 60s.  While these late-in-life births have consequences that extend well beyond the issue of business succession that, too, may be seriously affected.  

Family businesses often remain in the family provided there is sufficient capital along with a family member interested in managing the business when the current owner steps down.  But, what happens when there are minor children who may eventually have an interest in working in the family business but who have years of education ahead of them before that can occur?  

The answer may lie in ensuring the continuation of an experienced management team to run the business during that interim period.  The question, of course, is how to ensure the team's continuation.  Picture the situation from the non-family member's perspective.  

Jim Walters and Marcy Witt joined Family Electronics, Inc. several years ago largely because of its owner, Dudley Peters.  Dudley was one of those business owners that most employees only hear about and never experience firsthand.  He eagerly shared business information and responsibility with his staff.  He promoted them as far as their talents allowed and always treated them with respect, even when they made mistakes.  And, when the business became profitable, he made sure that his employees enjoyed some of that success by ensuring they had larger paychecks.  As vice presidents of the firm and Dudley's friends, Jim and Marcy were among the first to learn that he was ill and would have to step down.

Dudley's oldest child, Sean, is currently seventeen years old and has expressed a desire to take over firm ownership.  To Jim and Marcy, Sean has all of the characteristics of an employee's nightmare: he is uneducated, untested and may soon be their boss.  Fortunately for Jim and Marcy, they are both highly thought of in the industry and will soon be offered the opportunity to head up business operations for other companies.  For Dudley, Sean and Family Electronics, Inc., the loss of these two seasoned executives may very well mean that the company will no longer be a family business.  Instead of family retention, the business may have to be sold or liquidated.

Another answer may result from the use of a salary continuation deferred compensation plan designed to ensure that Jim and Marcy remain with Family Electronics while Sean obtains the necessary education and training to assume active management and ownership.  A salary continuation plan often envisions the payment of retirement benefits upon the executive's reaching normal retirement age -- age 65, for example.  However, age 65 isn't a "magic" age.  

Suppose that Jim and Marcy are deemed critical to the business' ability to continue into the future and that they are both age 40.  Further assume that it is reasonable to assume that Sean would be ready to assume active ownership of the business after 10 years -- four years of college and 6 years of business training at the company.  A salary continuation plan could be designed that would give Jim and Marcy a salary continuation benefit of 50 percent of their final salary for a period of 15 years, provided they remained at Family Electronics for 10 years.  During this time, Sean could be groomed to take his father's place at the head of the company.

 Substitute for an Ownership Stake

For many executives, the opportunity to gain an equity position -- to own some or all of the business -- is much sought after.  Conversely, owners of closely held corporations often choose to limit ownership to a very few individuals and, if stock shares are granted, to limit those shares to a small minority ownership.  This tends to keep control of the entity in the hands of current owners.  

Key executives, mindful of the decided lack of control granted by minority ownership often see a minority interest in a close corporation as having little value.  Normally stock shares in close corporations have restrictions on their sale.  Furthermore, even without these typical restrictions, the market for minority interests in close corporations is virtually non-existent.     

For this reason, businesses are turning more frequently to nonqualified deferred compensation as an alternative to granting a key executive an ownership interest in the company.  The plan is completely selective and may meet both the financial and psychological needs of the executive.