Salary continuation plans are essentially deferred compensation arrangements between employee and employer; they stipulate that extra benefits will be provided to the employee after retirement, disability, and/or death, provided the employee complies with the terms of the agreement. The agreement may require the employee to work for a stated period of time, or it may contain a “noncompete” clause obligating the employee not to compete directly with the employer over a period of time in a specific geographic location.
The benefits provided by these kinds of plans are often expressed as a percentage of salary starting at retirement (e.g., retirement benefits of 30% of salary for 10 years), and are based on length of service. This type of plan can supplement other retirement plans.
Salary continuation plans can be constructed so they are nonqualified (not tax-deductible). These plans avoid the restrictions and administrative burdens of qualified (tax-deductible) plans. With this approach, a company is free to choose participants and benefit levels. To avoid many of the restrictions of the Employee Retirement Income Security Act of 1974 (ERISA), however, a nonqualified plan must be restricted to a select group of managers or highly paid employees.
In contrast to a qualified plan, benefits under a salary continuation plan depend solely on the financial strength of the corporation, and there is no requirement that funding be guaranteed. Thus, in the event of bankruptcy, the employee would have the same rights as a general creditor in collecting benefits.
Among the advantages of salary continuation plans are the following:
- Provision of a retirement plan for key employees. This feature is especially important for companies that cannot afford a tax-qualified plan for all eligible employees.
- Retention of key employees. Salary continuation may help retain employees and be more cost-effective than offering higher salaries.
- Allowance for a more competitive compensation package. When recruiting a mature executive, a salary continuation plan can be an alternative to a higher salary or increased retirement benefits.
- Provision of a necessary or desirable early retirement. It’s often the case that part of the attraction of a salary continuation plan is its appeal to a key employee who might want to retire earlier than usual.
- Protection of some benefits in a merger situation. With so many mergers and acquisitions taking place, having a salary continuation plan in place may provide more secure retirement funding for key executives.
The cost of a salary continuation plan is directly related to the benefits provided. Employer contributions to the plan are deductible in the year in which the payments are included in the employee’s gross income. A fund reserve can also be created to help meet these obligations. However, the employee cannot have a specific claim on any fund or reserve.
Many companies find it advantageous to recover the costs of the plan by including a death benefit. In this case, an employer purchases cash value life insurance on the employee. The company is both the owner and beneficiary of the policy. The size of the policy is determined by the value of money (the interest rate), the benefits, and mortality considerations.
Assuming actual mortality rates are consistent with those anticipated, the company can potentially recover all premiums and benefit costs, plus interest, on the money expended. Premium costs are not deductible, but policy proceeds are generally received tax free by the corporation. Policy proceeds may, however, be subject to the alternative minimum tax (AMT). Benefits paid to the employee’s heirs are tax deductible for the corporation.
It is important to note that the Internal Revenue Service (IRS) often has regulatory changes in the offing that could affect salary continuation plans. As a result, it’s always best to check that you’re in step with the latest tax regulations.
When properly used, salary continuation plans can be valuable tools to attract, reward, and retain key employees. Their flexibility may make them cost-effective for a company of any size.