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Business Succession Through Deferred Compensation

Business Succession Through Deferred Compensation

Name: Knox McLaughlin Gornall & Sennett, P.C.
Address: 120 W. 10th St., Erie, PA, 16501, US
Telephone: 800-939-9886
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Posted on December 06, 2024

Author: Nadia A. Havard

Originally published in November 2024

This article has not been updated for current law since the date of its posting on the website. This article is not intended to provide any legal advice. Please seek advice of your professional council.

Any U.S. federal and state tax advice contained in this communication is not intended or written by the Knox Law Firm to be used, and cannot be used by you, for the purpose of: (i) avoiding penalties under the Internal Revenue Code that may be imposed upon you, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

Deferred Compensation in Business Succession: Overview

As it has recently become clear, the workforce throughout the globe is undergoing the evolution. Artificial intelligence (AI) and other technology has an impact on individual jobs and productivity. It also affects the relationship between an employee and an employer. AI started playing an important role in defining the benefits that an employee can receive through its carrier. (2024 Newport/PLANSPONSOR NQDC Trends Survey Report, p. 4).

The most recent report published by Newport (an ASCENSUS company) predicts the AI evolution will cause global GDP to rise by $7 trillion over a 10-year period. Moreover, about two-thirds (2/3) of US occupations could be impacted by AI. (2024 Newport/PLANSPONSOR NQDC Trends Survey Report, p. 4 citing Goldman Sachs Research).

The same report also focuses on nonqualified deferred compensation (NQDC) and reveals some paradox as to how NQDC is viewed and used by employers. Based on the Newport/Plansponsor 2024 Survey of 268 small to large size companies (including C corporations, S corporations, partnerships and LLCs) from 46 different industries in the US, the most use of NQDC is to ATTRACT and RETAIN key employees and the least use is to INCREASE or PROVIDE EQUITY OWNERSHIP. (2024 Newport/PLANSPONSOR NQDC Trends Survey Report, P. 10, 70, 71)

Furthermore, when employers are asked whether NQDC is effective in ATTRACTING and RETAINING key employees (as a reminder, the preferential use of NQDC by employers), the success rate is only 41%. (2024 Newport/PLANSPONSOR NQDC Trends Survey Report, p. 12, 13)

At the same time, the research showed that key employees highly VALUED the NQDC benefit but did NOT UNDERSTAND it. This may be attributable, among other things, to complexity of NQDC structures. (2024 Newport/PLANSPONSOR NQDC Trends Survey Report, p. 12, 13)

Finally, based on the Newport/Plansposnor 2024 Survey, 99% of the employers use cash or other forms of liquidity to fund NQDC and only 1% use equity. (2024 Newport/PLANSPONSOR NQDC Trends Survey Report, p. 36)

The overutilization of cash and underutilization of equity in NQDC may raise a question as to whether NQDC funded with equity are overlooked in achieving the company goals like attraction and retention of key employees, and on a larger scale, paving the way for a successful business succession.

Impact of the Deferred Compensation on Business Succession

Numerous articles and books have been written regarding business succession, what it means, and the best way to accomplish it. The underlying premise is to find the balance between the goals of the company, the owners, and the company employees in a way that will let all three players get ahead of the game rather than being slowed down, or worse, destroyed or ruined.

Let us first talk about the companies.

The Companies

Data for March of 2023 from the Bureau of Labor Statistics complied statistics on the status of businesses as viable on-going concerns. It showed that about 23.2% of businesses that opened on or after March 2022 failed within a year. (published by Mountain West News Bureau)
“According to the U.S. Bureau of Labor Statistics (BLS), approximately 20% of new businesses fail during the first two years of being open, 45% during the first five years, and 65% during the first 10 years. Only 25% of new businesses make it to 15 years or more.” (https://www.bls.gov/opub/ted/2024/1-year-survival-rates-for-new-business-establishments-by-year-and-location.htm - interactive chart)
It is clear that having a great idea for a business does not automatically lead to business success. Although the data focused on companies’ viability, it also provides hindsight in the context of business succession. New ownership and new management might have great ideas but no practical application. Given that new companies need to establish themselves first before they succeed unlike existing companies, the rate of failure experienced by new companies is not a stranger to the rate of failure due to inadequate business succession. “Without an effective plan for succession, more than 85 percent of family businesses fail by the third generation and over 95 percent fail beyond that.” (“Why Business Succession Plans Fail and How to Beat the Odds” by Brad Franc.
Whether we are talking about the rate of survival by new companies or failures in business succession, it is obvious, that human decision-making is a driving force. What if we try to approach business succession from a slightly different angle and redefine it? (Warren Buffet once compared family succession to “choosing the 2020 Olympic team by picking the eldest son of the gold-medal winner in the 2000 Olympics”. ((Id.)
The authors of the book titled “Think Like a Freak” give a great example how one can succeed by redefining the problem. According to the authors, one contestant from Japan doubled the number of hot dogs consumed during the competition by redefining the problem. Instead of asking the question “How do I eat more hot dogs?” the contestant asked the question “How do I make hot dogs easier to eat?” (Think Like a Freak by Steven D. Levitt and Stephen J. Dubner, 2014, at p. 61).
We can find another real life example of great success gleaned from redefining the problem. Karuna (biotech company) was created in 2009. “On Dec. 22 [2023] Bristol Myers said it would purchase Karuna for $14 billion. The Boston-based biotech was built around an experimental drug called “KarXT,” a component of which Eli Lilly tried to develop in the 1990s but ultimately gave up on. Clinical trials have since found treatment with KarXT significantly reduces schizophrenia symptoms.” (https://www.biopharmadive.com/news/schizophrenia-pharma-karuna-cerevel-deal-bidders/704522/)
So, why are we focusing on the rate of failure of companies and the need to find a creative solution to business succession by redefining the problem? Because we want to find an alternative or, at least, a viable supplement to the existing tools used in business succession.
Since business succession truly boils down to identifying owner’s goals and the goals for the company and finding the means to achieve both, let us look at these components one at a time.
When one says, “we want to achieve the company goals”, one usually implies “we want to find those will be leading the company to achieve these goals”. Why does the question shifts to the underlying ownership and the management? As we all know, companies are run by people, whether it will be the owners or key employees who will ensure company’s success or failure. Depending on the next generation of owners or key employees and their ideas, the company might continue its current business model and management style, or revamp itself. The owners’ and key employee’s aspirations will also determine whether the company will expand in the near future or, instead, will gradually evolve over longer period of time with focus on long-term growth and more protracted timeline. Therefore, when we are talking about the company goals in business succession, we really mean who will be the next generation to run the company as their ideas, aspirations and business judgement will shape the company future.
One of the striking examples of business succession is given in the book “Think Like a Freak”. “The data show it’s generally better to bring in an outside manager” to pass the family business on. “Family firms in Japan have a long-standing solution to this problem: they find a new CEO from outside the family and legally adopt him. That is why nearly 100 percent of adoptees in Japan are adult males”. (“Think Like a Freak” by Steven D. Levitt and Stephen J. Dubner, 2014, at p.1, footnote). Not every owner of the family business in the United States will be willing to legally adopt an unrelated person just to have the business stay in the family. But, family businesses in the United States are willing to engage whether through quisi-ownership or monetary reward non-family members to keep the family businesses moving forward.

The Owners

Another party to the business succession are the owners. When one talks about the owner’s goals, the underlying question is “at what speed the business succession should proceed”. When is the owner ready to give up control and leave the company? Is it at certain age or at certain financial milestone for the company? How much does the owner want to stay involved with the company?

The most traditional ways to pass the ownership in the company by owners will be via sale, gift, redemption or a combination of these tools. We will briefly tackle one option at a time.

Sale of Stock

A shareholder owns 100% of the Best Company Ever, Inc. The owner sells stock, more likely in exchange for some form of down payment (usually, cash) and a secured installment judgement note. Since it is a sale, rather than a gift, more likely a key employee (whether a family or non-family member) or an unrelated third party will be the buyer. The immediate challenge is for the buyer to come up with financing, which, depending on the buyer, might be a problem.

Gift of Stock

Alternatively, the company transition can occur via gift of stock. In a typical scenario, a shareholder gifts his or her stock in the company either outright or to a trust set up for the benefit of a family member (e.g. a child or a grandchild, or a multi generation trust). Since the stock is gifted, the shareholder will need to file a gift tax return to disclose the transfer, and more likely, will use his/her federal lifetime gift tax exemption. (For 2024 the federal lifetime gift tax exemption is $13.61 million).

The transfer of business via gift of stock and use of the federal lifetime gift tax exemption may jeopardize the overall estate plan if there are other assets owned by the donor that he or she may want to leave to those who did not receive closely held stock. In some, but rare cases, the shareholder may want to reward key employees by gifting to them stock in the company, whether as a token of appreciation or, on a larger scale, as the means for transferring business. If such key employee is unrelated to the owner, the gift will be a deemed compensation to the employee under the Internal Revenue Code Sec. 102(c) (the Code). Such gift will be subject to payroll tax withholding and income tax in the hands of the employee. If, on the other hand, the key employee is related to the owner, the tax consequences of the gift will depend, among other things, on the motive of the donor. (The familial relationship does not automatically take the gift outside the income taxation in the hands of the key employee. “Taxation of a Gift or Inheritance from an Employer”, by Douglas a. Kahn, Tax Lawyer, Vo. 64, No. 2, p. 273)

Redemption of Stock

Finally, some companies use redemption as means of business succession. For example, the Best Company Ever, Inc., has a couple of shareholders. One of the shareholders is ready to retire and feels comfortable for the remaining shareholders to continue running the company. The first issue is whether the company has enough liquidity or has the ability to generate enough liquidity over the years to redeem the stock. The corporate redemption obligation will likely impact the on-going cash flow needs for operations. Cash accumulations by the company (such as a C corporation) in contemplation of redemption are likely subject to accumulated earnings tax (20% in 2024).

A Different Option

All three options (Sale, Gift and Redemption) focus MOSTLY on the CURRENT OWNER (i.e. the ease of stock transfer). What if we redefine the problem with MORE focus on the NEW OWNERS. Instead of asking the question “How does the owner transfer stock to the next generation of owners?” we will ask instead “How to get the new generation of owners be ready (in terms of decision-making and financially) to receive stock?” Since we are focusing on READINESS OF NEW OWNERS rather than MEANS OF TRANSFER BY THE CURRENT OWNERS, we may want to explore nonqualified deferred compensation (NQDC).

Nonqualified Deferred Compensation

First, let us differentiate qualified from nonqualified plans. In general, qualified plans (like 401(k)) are more regulated, more restrictive, but have the best tax outcome for an employer, its employees and underlying investments held by such qualified plans (i.e. immediate deduction to the employer, tax deferral to the employees, and income tax-free growth of the underlying investments). On the other hand, nonqualified plans (like stock options) are less regulated, less restrictive, but have more immediate, but still good, tax characteristics (i.e. deduction to the employer is tied up to the income recognition by the employee with shorter period for income tax deferral for the underlying investments).

Even in light of less attractive tax structure, the nonqualified deferred compensation (NQDC) may have some hidden value in business succession. NQDC usually REDUCES THE VALUE OF THE COMPANY FOR SALE/REDEMPTION PURPOSES and also PROVIDES A TEST PERIOD FOR KEY EMPLOYEES TO QUALIFY AS FUTURE OWNERS.

In general, a nonqualified deferred compensation plan or arrangement amounts to a contract between a company and key employee(s) where the company “promises to pay [the key employee] a predetermined amount of money [or stock] in the future’. (Retirement Planning and Employee Benefits, by James f. Dalton and Michael A. Dalton, 19^th edition, p. 692).

Examples of NQDC arrangements in business succession include, but not limited to, Nonqualified Stock Options (NSO), Restricted Stock Plans (RSP), and Supplemental Executive Retirement Plan (SERP).

Nonqualified Stock Option is a right given to a key employee to purchase the company’s stock at a stated exercise price. For example, on January 1, 2025, the key employee is given the right to buy 10 shares of company stock at $10 per share. The right becomes enforceable (vests) for 2 shares of stock per year. The right to purchase all 10 shares can be exercised in 5 years from the date of the grant. The company grows and on January 1, 2030, one share of stock is worth $30. The key employee can buy all 10 shares on January 1, 2030 for $100 (10x$10) rather than $300 (10x$30). The key employee has W-2 income of $200 for 2030 ($300 (the fair market value of stock on the date of exercise)-$100 (the purchase price).

Restricted Stock Plans are when the company pays the key employee with company stock that is non-transferrable for some time and is subject to substantial risk of forfeiture. For example, on January 1, 2025, the key employee is granted 10 shares of restricted stock worth $10,000. The restrictions (i.e. vesting) will lift in 5 years. The key employee can elect to pay income tax for 2025 on $10,000 under Code Sec. 83(b). The company grows and on January 1, 2030, when the restrictions are lifted, the stock is worth $30,000. The key employee recognizes income on $30,000 for 2030 (unless elected under Code. Sec. 83(b) to pay tax on $10,000 in 2025).

Supplemental Executive Retirement Plans are designed to provide a former owner additional benefits post sale/retirement. For example, the company enters into an employment agreement with the owner prior to the sale of stock by the owner for $300,000 and promises to pay $100,000 in 10 equal annual installments after the owner retires or to his heirs beginning at the owner’s death. The entire $300,000 is subject to Medicare tax (1.45% in 2024). The $100,000 as paid will be subject to income tax. SERPs is also a company liability on its books.

Case Study

A 60-year old owner of an S corporation would like to retire in 5 years at the age of 65. The owner would like an internal buyer (i.e. a key employee) to buy the company. The key employee is likely capable of running the company but does not make enough money to buy the stock. The company has some accumulated cash.
Step 1 - Deferred Comp Plan (issuance of stock options to a key employee). The Best Company Ever, Inc. has 10,000 shares of stock issued and outstanding. It is authorized to issue 1,000,000 shares. On January 1, 2025 each share is worth $100 (total $1,000,000). Shareholder 1 owns 10,000 shares of stock (100%). On January 1, 2025, the company grants nonqualified stock options (NSO) to the key employee to buy 10 shares of the company stock at the price of $100 in 5 years. Each year the right to buy 2 shares vests (i.e. graduated vesting schedule tied up to the company financial performance). Gradually (over 5 years) the key employee’s right to buy 10 shares (2 shares per year) vests with ultimate purchase in 5 years. During this time, the owner is evaluating how the key employee is making strategic decisions related to the company and whether indeed such key employee is the right fit to own the company.
Step 2 - Deferred Comp Plan (the company enters into SERP with the owner). On January 2, 2025, the owner enters into a SERP agreement with the company to receive $80,000 per year over the next 5 years beginning the year after the retirement from the Best Company Ever, Inc. On January 2, 2025 the company is worth $600,000 ($1,000,000 - $400,000 (SERP $80,000 x 5 years).
Step 3 - Corporate Redemption coupled with exercise of stock options by the key employee. On January 1, 2030, the company doubled in value (from $1,000,000 to $2,000,000). Because of SERP liability, $2,000,000 - $400,000 = $1,600,000, the share of stock is worth $160 ($1,600,000 / 10,000 shares). The key employee buys 10 shares at $100 (total of $1,000) and has taxable income of $600 ($160 x 10 = $1,600 (10 shares are worth $1,600). $1,600 - $1,000 (what the employee paid for) = $600 of income. Key employee purchased 10 shares of stock for $1,000 worth $1,600 and recognized income of $600.
If on January 1, 2025, the key employee was issued the restricted stock instead of NSO (10 shares at $100 per share and the key employee elected under Code Sec. 83(b) to include the entire amount ($1,000) as income for 2025 (income tax cost $370 at 37% income tax rate), then on January 1, 2030 when the restriction is lifted, the key employee does NOT need to come up with cash to purchase the stock. Nor will the key employee have $1,600 of income for 2030 either.
SIDEBAR #1: Presume the same facts as above, except that the company did not have either NQDC or SERP. In the sale scenario the key employee would have no income, but would need $2,000 to buy 10 shares in year 5 when the owner is ready to retire. In the gift scenario the key employee would have had $2,000 of taxable income if the owner gifted 10 shares in year 5. Finally, the redemption scenario would not have worked unless the key employee has already had at least 1 share of stock. (CAUTION – If the key employee was issued some shares of stock outside nonqualified deferred compensation arrangement, there would have been no testing period (5 years in our example) to determine whether the key employee can effectively run the company).
Now, let us get back to our case study. After the key employee purchased 10 shares, there are 10,010 shares outstanding (10,000 owned by the shareholder and 10 shares owned by the key employee). The company redeems the owners’ stock for $1,598,400 (10,000 shares out of 10,010 shares = 99.9%. $1,600,000 x 99.9% = $1,598,400) either in cash (if possible) or via a secured installment judgement note and pays $400,000 as SERP to the former owner over 5 years. The owner sold 10,000 shares with the capital gain of $1,598,400 (if basis were zero) and ordinary income at $80,000 per year for the next 5 years.
SIDEBAR #2: Again, presume the same facts as above, except the company did not have NQDC or SERP. In the sale scenario – the owner will have $2,000,000 of capital gain when the owner sells it stock to a key employee. Unless the key employee has $2mil in cash, the owner is likely to receive $2,000,000 over the years with the risk that the company will be mismanaged. In the gift scenario – the owner does not have capital gain, but needs to use $2mil of the lifetime gift tax exemption and the key employee has taxable income of $2mil. Finally, under the redemption scenario, the owner has $2,000,000 capital gain, probably the sales proceeds payable over time. CAUTION – there was no testing period (5 years in our example) to determine whether the key employee can effectively run the company.
So, to summarize the case study, if the Best Company Ever, Inc. issues stock options or NQDC plan with the payment in 5 years in addition to entering into SERP with the owner and in 5 years (when the stock options are exercised by the key employee) redeems the owner’s stock or the owner sells his stock to the key employee, the liquidity needs for redemption by the company or purchase by the key employee will be lower if the company would not have had SERP, and the owner would have had 5 years to evaluate whether the key employee is fit to own the company. (The stock value will likely be lower due to the liability on the corporate books for SEPR thus easing cash flow on the company or the key employee, depending on who is buying the owner out.)
From the shareholder’s perspective, the shareholder redeems all stock in year 5 (with capital gain treatment) and receives SERP payments for the next 5 years (with ordinary income treatment). Although the shareholder may have some ordinary income on SERP payments, such shareholder had 5 years to evaluate whether the key employee is ready to run the company. If, upon expiration of 5 years, the shareholder determines that the key employee is not the right person to succeed to the company, the shareholder can revisit the business succession plan.
From the future owner’s perspective (i.e. the key employee in our example), the key employee buys 10 shares in 5 years from the date of issuance (1/1/2025), provided the key employee meets the criteria for vesting (e.g. company financial performance, opening new markets, etc.), by using less cash and paying less income tax. Not only the key employee will have a chance to start thinking like a future owner (thus giving a chance to the current owner to assess and evaluate such decision-making), but ultimately, the key employee will use less liquidity with lower tax liability to succeed to the company.
Since not all key employees might possess all attributes needed to own the company, those who are needed for business success, can be rewarded and incentivized by Stock Appreciation Rights (SARs) and Phantom Stock Options. SARs and Phantom Stock Options are issued to non-owner key employees to incentivize them to stay with the company during and post transition. The business succession plan includes not only succession of the ownership, but also succession and continuity of the management. To accomplish this, both, equity NQDC and non-equity NQDC (like SARs and Phantom Stock) can be used to achieve the goals.

Most Typical Deferred Compensation Arrangements Used in Business Succession

SERP, Nonqualified Stock Options and Stock Appreciation Rights – Their Structure

“SERPS. SERPs are often unfunded, meaning the company retains control of the money until it needs to pay the benefit, offering flexibility in cash flow management. SERPs can be structured to provide incentives for the owner to stay through the business transition, aligning their interests with the long-term success of the company. They are also tax-deferred for the employee until benefits are received.

Nonqualified Stock Options. These plans provide key employees or successors with incentives tied to the future growth of the business. They are flexible and customizable to the business’s needs.

Stock Appreciation Rights (SARs) and Phantom Stock Plans. These plans provide key employees or successors with incentives tied to the future growth of the business without transferring equity. They are flexible and customizable to the business’s needs, encouraging key employees to stay during and after the succession process. Additionally, they do not dilute ownership but still reward participants based on company performance.

Funding of SERPs, SAR and Phantom Stock Options. Using life insurance to fund deferred compensation plans is an efficient strategy, as it ensures liquidity when payments become due, often during a succession or after the owner’s retirement or death. The life insurance proceeds are often income tax-free, and the cash value can be accessed by the company if needed, making it a flexible funding vehicle.

What is the rate of success of using non-qualified deferred compensation structures in business succession? The rate of success for using non-qualified deferred compensation (NQDC) structures in business succession depends on how well the plans are tailored to the needs of the business, its owners, and key employees. While there isn't a universally agreed-upon "success rate" in terms of exact percentages, businesses that implement NQDC plans effectively tend to experience smoother transitions, improved retention of key employees, and successful continuation of business operations. The key factors contributing to success include:

Alignment of Interests. NQDC structures, such as SERPs, salary continuation plans, and stock appreciation rights (SARs), are successful when they align the interests of both the business owners and the employees. By incentivizing key employees with future benefits, the company can ensure continuity during the succession, resulting in a higher chance of success. When employees see a clear financial reward for staying through the transition, the likelihood of successful succession increases significantly.
Talent Retention. One of the main reasons businesses implement NQDC structures in succession planning is to retain key employees or successors. Plans like phantom stock or NQSOs that tie compensation to future business performance can be very effective in retaining talent. Companies that effectively use these plans often experience high retention rates, leading to a smoother, more successful transition.
Customization and Flexibility. NQDC structures are successful when they are customized to fit the specific goals of the business and the personal financial goals of key stakeholders. A well-structured plan that accounts for tax considerations, long-term goals, and the succession timeline will have a much higher success rate. Plans that are flexible and adaptable to changing circumstances also contribute to the long-term success of the business transition.
Tax Efficiency. Many NQDC plans offer tax deferral benefits, which can be a strong incentive for both the company and the employee. Businesses that structure NQDC plans with tax efficiency in mind often experience higher success rates, as they are better able to manage cash flow and minimize tax liabilities during succession.
Funding Mechanisms. Success rates increase when NQDC plans are properly funded, especially when using vehicles like life insurance to guarantee payouts. Companies that have a solid funding strategy in place reduce the risk of financial shortfalls, ensuring that the deferred compensation obligations can be met when they come due, which supports a smoother succession.
Planning and Implementation. The rate of success is also closely tied to how early and thoroughly the business starts planning. Succession plans that integrate NQDC early in the process have a higher likelihood of success because they allow time for the plans to vest, for key employees to be motivated, and for tax benefits to accrue.” (AI ChatGPT)

Nonqualified Deferred Compensation Arrangements Income Tax Consequences

Income tax consequences on NQDC will depend on what type of NQDC is issued. In general, since it is a nonqualified arrangement, the income, for the most part, will be recognized when the deferral is over (i.e. upon exercise). With some exception, the income can be recognized upon granting the nonqualified compensation. (See above the discussion re issuance of restricted stock and election under Section 83(b) of the Code.)

Nonqualified stock options (NSO) are not subject to tax when issued. Since the purchase price (i.e. exercise price) is fixed on the date of issuance, the employee knows how much liquidity he/she will need to purchase the stock. That will allow the employee to elect (to some degree) when to purchase the shares and recognize taxable income. The employee will be taxed on the difference between the fair market value of the stock on the date of exercise less the paid purchase price. Such income is taxed as ordinary income to the employee and is subject to payroll withholding tax as well. Upon exercise, the company can take deduction. If later the employee sells the stock, the difference between the fair market value on the date of sale and the fair market value on the date of option exercise will be taxed as either short or long term capital gain. (“The taxation of non-qualified stock options is subject to Section 83 of the Internal Revenue Code because stock options granted to employees are generally considered to be compensation for services. In addition, Section 409A of the Code may also apply to certain grants of non-qualified stock options.”

Restricted stock, as mentioned above, is nontransferable and subject to a substantial risk of forfeiture. When issued, the employee does not recognize ordinary income, unless elects under Section 83(b) to include the fair market value in the taxable income. The company will take a deduction when the employee recognizes ordinary income, depending whether the employee made Section 83(b) election. If no Section 83(b) election was made, the taxable event occurs when restrictions lapse (ie. the earlier of either when the stock becomes transferable or no longer subject to substantial risk of forfeiture.) Applicable restrictions will usually lapse over the period of three to five years. CAUTION, different rules will apply to related dividends since dividends can be deferred until restrictions lapse.

Phantom Stock, by nature, is tied up to actual stock value. Although no actual stock is issued, the phantom stock units have value equal to the fair market value of stock. The employee does not recognize any income when phantom stock is granted. However, as it vests, the employer must withhold taxes for FICA. The employee will recognize ordinary income, subject to withholding tax, when the phantom stock units are paid by the company to the employee. (These are so called “cash award”). The corporation will take a corresponding deduction for the taxable income recognized by the recipient.

Stock Appreciation Rights (SARs) will trigger ordinary income to the employee when SARs are excised rather than granted. The company will pay the difference (in cash) between the fair market value of stock when SARs were issued and the fair market value of stock when SARs are exercised. The company will take a corresponding deduction in the amount of taxable income recognized by the employee. (Rev. Rul. 82-121)

It is important to consider whether the issuing company is a C corporation or an S corporation. Since S corporations have more restrictions on the single class of stock and shareholder eligibility, issuance of deferred compensation should be reviewed by the counsel. Also, shareholder agreements imposing restrictions upon stock transfer were held not to qualified as restrictions subject to substantial risk of forfeiture. (See QinetiQ US Holdings, Inc. v. Com., 119 AFTR 2d 2017-330, 845 F3d 555 (CA4, 1/6/2017)

Planning to Avoid Pitfalls

What are the pitfalls of using non-qualified deferred compensation in business succession? “The use of non-qualified deferred compensation (NQDC) in business succession planning can be highly effective, but it also comes with several potential pitfalls that businesses must carefully navigate. Understanding these risks is crucial for ensuring a successful transition. Below are some of the key pitfalls.

Lack of Funding or Underfunding: One of the biggest risks in NQDC plans is failing to properly fund future compensation obligations. If the business does not set aside sufficient funds or use proper funding mechanisms, such as life insurance, it may face cash flow problems when it’s time to pay out deferred compensation. This can jeopardize the business during the succession process, leaving key employees without promised benefits. Solution: Implement a reliable funding strategy, such as using life insurance or other financial instruments, to ensure future obligations are met.
Tax Complications Pitfall: Unlike qualified plans, NQDC plans do not provide immediate tax benefits for the company or the employee. Additionally, the taxation of NQDC plans can be complex. Deferred compensation is taxed as ordinary income when received by the employee, which could result in higher tax liabilities if not properly planned. For businesses, the deductibility of NQDC payouts is deferred until the compensation is actually paid. Solution: Work with tax professionals to structure NQDC plans that minimize tax liabilities and optimize timing for both the business and employees.
Potential Loss of Key Employees Before Succession: If the deferred compensation plan does not have a well-structured vesting schedule or the benefits are not enticing enough, key employees may leave the company before the succession is complete. This could disrupt the business and its succession plan. Solution: Create attractive, well-timed vesting schedules that incentivize key employees to stay through the entire succession process.
Complexity and Legal Risks: NQDC plans are subject to strict legal rules, particularly under Internal Revenue Code Section 409A, which governs the timing of deferral elections and distributions. Failing to comply with these regulations can result in substantial penalties and unintended tax consequences for both the business and employees. Solution: Ensure compliance with all regulatory requirements, particularly Section 409A, by working with legal and financial experts who specialize in deferred compensation plans.
Lack of Employee Understanding and Buy-In: NQDC plans are often more complex than qualified plans, and key employees may not fully understand how the plan works or the benefits they stand to gain. This lack of clarity can lead to a lack of enthusiasm or participation in the plan, reducing its effectiveness as a retention tool. Solution: Provide clear, ongoing communication and education to employees about how the NQDC plan works, its benefits, and what they can expect to receive. This helps build buy-in and ensures that the plan achieves its goals.
Company Financial Instability: Because NQDC plans are typically unfunded liabilities, they are subject to the financial stability of the business. If the company encounters financial difficulties, it may be unable to meet its deferred compensation obligations, leading to broken promises to key employees and potential legal disputes. Solution: Maintain sound financial practices and consider funding strategies that provide security for NQDC obligations, such as purchasing corporate-owned life insurance (COLI) or establishing a reserve fund.
Timing Issues with Plan Payments: If the timing of NQDC payouts is not aligned with business cash flow or the needs of key employees, it could create financial strain for both the business and the individual. Payouts that occur too early or too late can reduce the effectiveness of the plan as a retention tool. Solution: Carefully plan the timing of deferred compensation payouts to align with business cash flow and the long-term goals of the succession plan, as well as employee retirement or career transition goals.
Lack of Flexibility in Changing Circumstances: Once established, NQDC plans can be rigid and difficult to modify without facing legal or tax penalties. If the business or its employees experience changing circumstances, it may be hard to adjust the plan to meet new needs without triggering negative consequences under Section 409A. Solution: Build as much flexibility into the plan as possible within the legal constraints, and work closely with legal counsel to ensure changes can be made if necessary without triggering penalties.
No Immediate Deduction for the Business: With NQDC plans, the business cannot deduct deferred compensation expenses until the compensation is paid to the employee. This delay in deductions can negatively affect the company’s tax strategy, particularly if the payout period coincides with higher tax rates. Solution: Plan payouts to align with favorable tax conditions for both the business and employees. Businesses should also manage cash flow and tax planning to account for the deferred deductions.
Risk of Misalignment with Succession Goals: If NQDC plans are not carefully aligned with the overall succession strategy, they may not serve the intended purpose of incentivizing the right people or ensuring a smooth transition. For example, if the NQDC plan disproportionately benefits certain employees who are not critical to the business's future, the plan may fail to support a successful succession. Solution: Integrate NQDC plans into the broader succession strategy to ensure that the compensation structure aligns with long-term business goals, the needs of key employees, and the objectives of the business owner.
Overly Complex Plan Design: If the NQDC plan is overly complex or cumbersome to administer, it can become difficult to manage, leading to errors or compliance failures. Complexity can also reduce employee understanding and engagement with the plan. Solution: Keep the plan as simple as possible while still meeting the business's needs. Ensure that administrative processes are in place to handle the plan’s complexities and that employees understand how the plan benefits them.” (AI ChatGPT)

Author: Nadia A. Havard

Originally published in November 2024