“Compensation Options For Key Employees”		«BACK
	by Dennis L. Monroe
	from November/December 2006 Franchise Times
	download .pdf

This issue, in large part, is caused by the large number of hourly workers in many franchise businesses, turnover and other employment issues that may make traditional contributor plans unmanageable.  Additionally, even if the employer navigates the administrative issues, the key employees may face benefit contribution limitations under the highly compensated employee rules.    

In light of the issues with qualified plans, employers, in many cases, will look to compensate key employees with non-qualified plans.  If the non-qualified plan is funded, unfortunately the funded dollars are not tax deductible until the money is paid to the key employee.

The insurance industry has come up with a number of different techniques to fund compensation plans that will result in tax free growth.  However, the fundamental issue of getting a current tax deduction when funding occurs is not adequately addressed. 
Here are three possibilities that may help in your compensation planning for key individuals:

1. Directors’ Plan

The Directors’ Plan involves making key employees directors of the company, or if there is a legal concern, simply members of the Advisory Board.  This approach gives the director (advisor) an effective way to utilize a one person 401(k) plan.  This is a retirement savings option that became available with the passage of the Economic Growth and Tax Relief Act of 2001.  Any business entity is eligible, including a sole proprietorship.  The director and the business of being a director are usually conducted as a sole proprietorship. 

It is well established that a director and, if carefully structured, an advisor, is not treated as an employee of the company even though he or she may be an employee of the company for his or her day-to-day work.  The payment of these fees is designated as self-employment income. 

Once the person has received the director or advisory fees, the person can then create a one person 401(k) plan.  The maximum deductible contribution is the lesser of 100% of the self-employed compensation or $44,000.  In trying to maximize retirement benefits, the question will come up as to what amounts would be reasonable for director or advisor fees?  This is a difficult question, but substantial director or advisor fees are common and certainly a payment in the neighborhood of $2,000 to $4,000 per meeting should be reasonable.  It is important that meaningful functions are carried out by the Board and active participation occurs. 

In summary, the Directors’ Plan is a plan that can be considered as a way to supercharge  retirement planning for key individuals.

2. Restricted Endorsement Bonus Arrangement (“REBA”)

A restricted endorsement bonus arrangement (“REBA”) is an easy plan to administer.  It is tax-deductible and creates golden handcuffs for the key employee. 

            A REBA is an arrangement in which the employer pays a bonus to the executive in the form of premiums for a life insurance policy.  The executive will be the insured and owner of the policy and have the right to name the beneficiaries.  A vesting schedule is set up that will be applied to the bonus, and the executive’s access to the cash value of the life insurance policy will be restricted until the executive is fully vested.
            The executive actually owns the policy, but there is a restricted endorsement which allows the company to be repaid.  This all seems great, but the amount that is used by the employee to fund the life insurance policy is after tax dollars, so what the employer normally elects to do is to gross up the amount that is paid to the employee so taxes are covered and the net out of pocket for the employee is zero.  This grossed up payment provides the employer with a full deduction for the amounts paid to the employee. 
            At retirement or the completion of the vesting, the endorsement, which the employer has held, is released and the executive is then able to use the cash value in any way he or she desires, including loans and withdrawals.  If the executive leaves the company before the plan is fully vested, any unvested portion of the bonus is generally paid back to the employer.  In most cases, this unvested portion should be tied to the cash value of the policies.  The employee merely uses the cash value to pay back the employer.  There are specific rules as to taxability to the employee and deductibility for the employer as a benefit (cash value) vests which may have an impact on the structure of the plan. 
            Obviously there is an insurance cost to this approach, but it does provide a full deductibility to the employer on initial payments.  Further, the amount, while it is taxable to the executive, can be arranged so the executive has no out of pocket costs.  Also, there is some security to the employer that if the executive leaves prior to the desired time, there can be some payback to the company.

• A Separate Management Company

The final idea is the use of a separate unrelated management company owned by certain key employees.  This approach involves key employees establishing a separate company owned by them that will perform management services for the operating companies of the former employer.  The former employees, who are not owners of an operating company, can then utilize this new company to create their own retirement program.  This program could be simply a 401(k) or a traditional deferred benefit retirement plan.  In either case, the tax deductible dollars are very attractive.
The operating company pays to the new management company a management fee which hopefully takes into account the extra amount for the retirement benefits.  The operating company gets a deduction for the management fee, and the management company takes this into income, but gets a deduction for salaries paid to all employees and retirement contributions.  This approach has a number of IRS issues, but can be effective.  Consulting with a tax advisor is key to implementing this option because of certain affiliate service company rules that are very technical and can cause disqualification of a qualified plan. 

The above examples are three available options to compensate key employees of a franchise business.  Hopefully they provide you with some new, unique and helpful ideas. 

Dennis L. Monroe is a partner and the chairman of Krass Monroe, P.A., a law firm specializing in multi-unit franchise finance, mergers and acquisitions, and taxation.  Krass Monroe, P.A. is located at 8000 Norman Center Drive, Suite 1000, Minneapolis, MN 55437-1178; (952) 885-5999.  For previously published articles, and other Krass Monroe information, please refer to our Web site at www.krassmonroe.com.