Benefits for Key Management: Giving Some Employees More Without Breaking the Plan

The request usually arrives the same way. You have three or four people who are hard to replace, and you want to give them something better than everybody else gets. Not just a raise. Something that holds them, recognizes the years they have already put in, and lines their interests up with yours if the company is ever sold.

Treating some employees better than others is largely permitted. The complications come from where you do it. Qualified plans carry tax advantages, and in exchange they come with nondiscrimination rules that limit how much better you may treat your highly paid people. Non-qualified arrangements are far more flexible and can cover exactly the people you name, but they are unsecured promises sitting behind your general creditors, and they carry their own deferred compensation rules. Most design questions come down to which side of that line you are on.

One thing plainly, first. Plan design here is not solo work. It is a conversation among your business lawyer, benefits counsel and, where a plan has a funding or actuarial component, an actuary. Having spent nearly half my career as a corporate officer and in-house counsel, my part was to pin down what the owner was actually trying to buy, then make sure the thing promised was the thing written down.

Can I give three or four key people better benefits than everyone else?

Mostly yes, and the benefit you pick decides how hard it is. Compensation, bonuses, a vehicle, a club membership, extra paid time off, severance, a deferred bonus, a share of the proceeds of a future sale: all of those can go to the people you name. Equal treatment is not a general requirement of employment law. What you cannot do is draw the line in a way that tracks a protected characteristic, or write a plan with its own eligibility rules and then administer it differently from the document.

The restrictions cluster in the tax-favored benefits. Congress allows a deduction now, deferral of income to the employee and tax-free growth, on the condition that the plan is not simply a device for the owner and the top of the house. So the rules test coverage, participation and the benefits themselves, comparing what your highly compensated employees get against what everybody else gets. Who counts as highly compensated is set by ownership and by a compensation figure the Internal Revenue Service adjusts, so get the current number from your advisors.

What do nondiscrimination rules actually restrict?

In a retirement plan, several tests run every year. Coverage testing asks whether enough of your non-highly compensated employees benefit at all. Deferral and matching tests compare the rate at which your highly compensated people defer, and the match they receive, against the rest of the workforce. A top-heavy test looks at how much of the plan’s value sits with key employees. Failing one means taxable refunds to your highest-paid people, usually arriving after they have planned around the deferral, or a required contribution for everybody else.

There are legitimate designs that buy you out of some of that, and they are the reason benefits counsel and an actuary belong in the room. Safe harbor plans trade a required employer contribution, immediately vested, for relief from certain tests. Other designs can direct more of a contribution toward an older, higher-paid group. None of them is a loophole. Each carries conditions, and the conditions usually include contributions for the rest of your workforce in bad years as well as good ones.

Welfare benefits have their own rules and are easier to get wrong. A cafeteria plan, the arrangement that lets employees pay their share of premiums with pre-tax dollars, has its own tests. So does a self-insured medical plan, and so does group term life. If your health plan is fully insured, your flexibility on who gets what level of coverage is greater than owners assume. If you self-insure, favoring the highly paid can make the favorable part taxable to the people you were trying to reward. Either way the plan document governs: define the class, apply it the same way every time, and test it.

What is a top hat group, and what can a non-qualified plan promise?

The reason a non-qualified plan can ignore most of that is one exemption. The federal law governing employee benefit plans imposes participation, vesting, funding and fiduciary requirements on pension plans generally, and exempts an unfunded plan maintained for a select group of management or highly compensated employees. That is a top hat plan. There is no bright line for how small select has to be. The analysis weighs the size of the group against your workforce, the rank and pay of the people in it, and whether they could have negotiated their own arrangement.

Three officers in a company of a few hundred is plainly a select group. The trouble starts years later, after the plan has held one more good person at a time and the group has drifted into middle management. If the group is no longer select, the plan is not exempt, and it fails rules it never tried to satisfy. That surfaces in a dispute with a departed participant, or in diligence on a sale. So treat the list as a controlled document: a board or member decision to add anyone, a note of why that person qualifies, and the one-time filing with the Department of Labor that these plans owe.

Inside the exemption the menu is wide. A supplemental executive retirement arrangement promises a stated benefit at retirement. A deferred bonus plan credits an amount each year, vesting over time, payable on a named event. Phantom equity, also called phantom stock or appreciation rights, credits units that track the value of the business and pay cash on a sale or another named event. A long-term incentive can track a defined measure over several years, or track a transaction, which is what owners want once a sale is in view.

Now the limit, and it is not a technicality. A non-qualified promise is an unsecured promise of the company. If the company becomes insolvent, your key manager is a general creditor in line with everybody else. A rabbi trust, a trust holding assets earmarked for the plan but still reachable by creditors, protects against a change of heart or a change in control, not against insolvency. Making the benefit genuinely secure is what tax law treats as funding, and funding triggers immediate tax to the employee. The insecurity is the price of the deferral, and the participant should hear it when he signs.

Then the deferred compensation rules, where these plans fail. A deferral election has to be made before the year the services are performed, with a narrow exception for a newly eligible participant. The plan has to fix the time and form of payment in advance. Permitted payment events are a short list: separation from service, a specified date, a change in control, disability, death, an unforeseeable emergency. Acceleration is generally prohibited. A failure falls on the employee, as immediate income plus interest and an additional tax, so confirm the current rules before drafting and sign before the deferral period starts.

Should I give a key manager real equity or something that behaves like it?

This is the decision owners treat as compensation and then regret as governance. Real ownership is not a larger bonus. It carries rights that come with the status rather than with your plan document: information and inspection rights, votes on whatever the organizing documents give owners a vote on, standing to bring claims about how the company is run, and a body of law on how minority owners have to be treated. So ask who is at the table in a future sale, whose consent is required, and who can demand the books in the middle of a negotiation.

The tax mechanics surprise people too. A grant of an existing interest for less than its value is generally compensation on receipt, and the election to be taxed on restricted property at grant has to be filed inside a short window and cannot be cured later. In a partnership or a limited liability company, a properly structured profits interest can be granted without immediate tax, but the manager becomes an owner for tax purposes. That means a K-1 rather than a W-2, income reported whether or not cash is distributed, and no withholding. A manager nobody warned is unhappy in April.

Phantom equity delivers the economics without any of that. Units are defined by a plan document, vested as you decide, valued by a stated formula, and paid in cash on named events. It is compensation when paid, ordinary income to the participant, with no step into ownership. Because it is entirely a creature of the document, the document has to answer what the parties will fight about: termination for cause, without cause, and resignation; what counts as a sale; how value is measured, by whom and as of when; and whether anything is paid if the business is worth less in five years.

None of this says never grant equity. Sometimes real ownership is exactly right. But grant it inside a complete set of documents: a buy-sell with a defined trigger on termination of employment, a valuation method, transfer restrictions, a drag-along so a minority cannot block a sale, and a clear statement that employment and ownership are separate.

How do these arrangements get funded, and what has to be papered?

Companies often informally fund a non-qualified promise with life insurance, and ownership of the policy is the thing to get right. The company is the applicant, the owner and the beneficiary of a policy on the key person’s life. The policy is a company asset, reachable by the company’s creditors, and the employee holds no interest in it. That is what keeps the arrangement unfunded for tax purposes, and it is why the policy is a financing decision rather than security for the promise. Where the employee owns the policy or takes an interest in it, you have paid compensation now.

Two practical points. The tax code conditions favorable treatment of employer-owned life insurance on notice to the insured and written consent before the policy is issued, and a consent signed afterward does not fix it. And the liability for the promise accrues on your books over the service period whether or not you set anything aside. A promise that was never accrued is a surprise in diligence, and surprises in diligence get priced.

Then the paper, which is where these arrangements come apart. What has to exist: the plan document; an award agreement signed by both sides; any deferral election forms, signed before the deferral period; the authorizing action of the board or the members; the formula with worked definitions of every term that drives it; a beneficiary designation; and the accrual on the books. One person should be able to hand that file to a lender, an auditor or a buyer without assembling it first.

The common failure is not technical. It is a conversation. An owner tells a key manager, in a good moment, that he will be taken care of if the company sells. Nothing is written. Years pass. Then the company sells, or the manager leaves, or the owner dies, and two honest people remember the same conversation differently with nothing in the minutes either way. Every version of that ends badly. If you are going to promise it, paper it in the same month you say it. If you are not willing to paper it, do not say it.

Frequently asked questions

Could I just pay my key people more instead of building a plan?

Often that is the right answer, and it is always the simplest one. Cash costs you nothing in administration, nothing in documentation risk, and nothing in future governance. What cash does not do is hold anybody. Current compensation gets spent, and it resets expectations every year. The reason to build an arrangement is to attach value to a future date or event, retirement, a stated number of years of service, or a sale, so that leaving early forfeits something real. If retention across a defined period is not actually your goal, pay the bonus and skip the plan.

Does a manager with phantom equity get to see the company’s financials?

Only to the extent the plan document says so, and that is one of the structure’s advantages. A real owner usually holds information and inspection rights by statute that you cannot fully contract away. A phantom participant holds whatever rights you granted. In practice you have to provide enough information for the formula to be credible, typically the measure the units track and an explanation of how it was computed, so define in the document what gets provided, how often, and what the participant may and may not ask for. Add a confidentiality obligation, and address what happens if the participant disputes the calculation, because that dispute is entirely foreseeable.

What happens to these arrangements if I sell the company?

That is a question to answer while you are drafting, not while you are negotiating. A buyer will want to know what triggers payment, who pays it, and whether the obligation comes along with the business. Non-qualified arrangements commonly pay out on a change in control, which means the purchase price has to account for them and the deferred compensation timing rules have to be respected on the way out. Define what counts as a change in control, whether an asset sale counts, whether payment is accelerated or assumed, and what happens to unvested units. Deals get repriced over promises nobody quantified, and a plan that cannot be valued cleanly tends to become a holdback.

Talk with Sheldon

I serve as outside general counsel to closely held companies in Missouri and Illinois, and building benefit structures that treat key management differently from the rest of the workforce was a large part of my work on the inside. We bring in benefits counsel and an actuary where a design needs them, and my own part is making sure that what you intend is what the documents actually say. If you are thinking about doing something for two or three key people, reach me through the contact page.

By Sheldon Korlin, Attorney, AEGIS Law