Nonqualified deferred compensation is a useful tool that can be helpful in ensuring the continuation of family businesses.
Nonqualified deferred compensation ("NQDC") techniques have long been viewed as flexible, "customizable" methods of dealing with specific issues of compensation in businesses. They are particularly well-suited for corporate executives to achieve goals of business growth, and they can be tailored in many respects to the time and method of reaching those goals.
By contrast, qualified retirement plans, although they enjoy greater tax advantages, must cover a broad range of employees and provide fairly consistent benefits to management and rank-and-file employees. For that reason, qualified plans have been found less useful as a means of achieving the goal of encouraging management performance.
Care must be taken to ensure that NQDC arrangements do not trigger penalties and premature income taxation under Section 409A of the Internal Revenue Code. So the ground has shifted somewhat, and greater care is needed in setting up deferred compensation incentive programs. But even within these new constraints, nonqualified deferred compensation has valuable aspects that can help in ensuring the continuation of family businesses.
1. Use in Family Businesses
NQDC has long been used to provide cash incentives for achieving corporate goals, and this is true in businesses of all types and sizes. There is a use for such arrangements in family businesses that can help to maintain control within the family while retaining the services of non-family management. In many family-owned businesses, there are executives and other valuable employees whose help is vital to the success of the business. It's not unusual for such people to want some stake in the business beyond the paycheck, specifically an ownership interest in the business. That isn't always a result to be avoided, especially if no one in the next generation of the family wants to or is able to lead the business: an eventual transfer to loyal employees may be a useful and profitable exit strategy for the family.
But what if that hasn't been determined yet, or suppose there are capable family members working alongside the non-family executives? How can those executives be rewarded and provided with incentives in the form of, or at least similar to, ownership of the family business, when the desire and expectation of the family is that ownership remain within the family group? This is where NQDC may be a substitute. There are several forms that such deferred compensation may take.
One is the straightforward incentive payment based on the results of the business operations, usually payable shortly after the end of the fiscal year. Another type, closer to actual stock ownership, would be a phantom stock plan (nowadays given the more attractive name of a stock appreciation right plan). This type of plan is an attempt to mirror the growth of the value of the business. A valuation may be made of the business each year, and this result, or one reached by a similar method, may be used to build up an account on the books of the business. No actual bank or other asset account is set up; it is just a bookkeeping entry. This highlights an important point about nonqualified plans: there is no separate tax-deferred fund set up that is dedicated to the provision of benefits, unlike that required in the qualified plan world. It is possible to set aside funding for such benefits, but except in special circumstances, the amounts set aside will remain subject to the claims of creditors of the employer. Moreover, the tax consequences of funding an NQDC will be less advantageous than those applicable to qualified plans.
NQDC plans can be flexible to suit the business’ goals. The plan may go on for a number of years, with the "payoff" occurring when the business is sold or the employment terminates, or after the expiration of a period of years. It may be necessary, if a large enough amount has built up, for the payment to be stretched out over a further period of years, in which case care must be taken to ensure compliance with Code Section 409A. It is possible, unlike the case in qualified plans, to have a "bad boy" clause (whatever the gender of the employee), providing that if the employee is terminated for cause, the deferred compensation account is eliminated. But in that case, it is important to have a clear definition of termination for cause.
Despite Code Section 409A, there is a wide range of types of NQDC available to permit family businesses to provide ownership-like incentives to non-family employees without giving them actual ownership. As suggested above, selling or transferring a business outside the family might eventually be the decision made, but until then, NQDC can be the means of retaining ownership within the family along with the services of valuable employees and their loyalty.
2. Benefits for Retiring Owners
Another use for NQDC may be to provide a source of retirement payments to members of the family after they have decided to pass on ownership and control to the next generation. In fact NQDC might be a means of facilitating such transfers by ensuring the older generation a source of income when it has given up active involvement in the business. Again, any such arrangements are subject to the requirements of Code Section 409A. And it is important that such deferred compensation not be treated as a disguised part of the payment for sale of the stock, if that occurs, to the succeeding generation, and that it not cover so extensive a group as to fall within the rules for qualified plans.
Careful planning is needed based on the particular facts of each family. But one of the impediments to transferring control of a business from the older generation is often the need to maintain an income stream. By providing for a stream of payments over a period of years, as a reward for long service to the business, the younger generation can remove that stumbling block to giving up control. We have seen this in practice, with business owners reluctant to give up the weekly or monthly paycheck. Even if they have adequate assets, it is often difficult to give up that regular payment. By substituting an NQDC payment, a level of assurance can be provided to the older generation that might help them give up the reins of ownership and control.
Family businesses and their succession plans are a source of puzzles that need to be worked out with careful regard to the goals and concerns of the various generations of family members. Considerations of tax law, estate and gift planning, fairness in family arrangements and psychological issues create stumbling blocks to the success of such businesses. Among many tools that can be helpful, NQDC is one that should be considered as a means of dealing with conflicting goals and solving family goals.