How to Build and Transfer Business Value With a Non-Qualified Plan

Make sure the plan you choose fits your goals.

According to Investopedia, a non-qualified plan is “a type of tax-deferred, employer-sponsored retirement plan that falls outside of employee retirement income security act (ERISA) guidelines” and that is “designed to meet specialized retirement needs for key executives and other select employees.”

While this is a very straightforward definition, I’ll take it one step further: Non-qualified plans are not only a tax-deferred vehicle that provides an additional benefit to your key people, but also, practically speaking, they can be designed to create added value in your business AND are indispensable to the exit planning process.

Here are five reasons why this is true:

1. Motivation for top performers to increase profitability and productivity

The IRS limits non-qualified plans to a select group of people (management group or key-employee group) and, as such, can be used to focus management/key employees on improving business value. If properly designed, you can structure non-qualified plans to be performance-based, awarding them only to your best people when they surpass performance standards.

Examples are profitability through key performance standards(such as EBITDA, gross profit or cash flow) or productivity through key value standards(such as adding new customer accounts, improving systems and processes, and eliminating waste). In other words, you can leverage non-qualified plans to focus your top people on improving certain value drivers in your business that (to no surprise) drive up business value.

2. Flexibility in design gives you more options

Non-qualified plans are not subject to the same stringent funding, eligibility, vesting and fiduciary requirements of ERISA (Employee Retirement Income Security Act of 1974) that qualified plans are and, as such, provide business owners added flexibility in the design formulas, vesting schedules and distribution options they elect. This allows you tremendous creativity in how you design the plans, especially in design formulas and vesting schedules. It may look the same for the entire key-employee group or different for each plan participant.

3. Greater confidence at the negotiation table

Non-qualified plans provide you, the business owner, greater confidence as you move closer towards exiting your business. If you are selling your business to an outside third party, you will want to ensure you have done everything you can to motive your key employees to stay on with the business (and the new owner).

Moreover, you will want to make sure you have done everything you can to shift responsibility and leadership over to this group. Sophisticated buyers and their team of advisers understand this. They know they are not buying your balance sheet alone but, additionally, the employees who, in turn, run the systems that run the company.

By intentionally creating a vesting schedule that surpasses your planned exit date you will have greater confidence that your key people will remain with the business through a third-party sale. The last thing you want is for your key people to leave when you do.

Additionally, non-qualified plans benefit the new owner since the company’s best people will stay on and continue to grow the company (if the plan is performance-based). When the time comes for the new owner to distribute fully vested amounts from the plan (whether in the form of cash or stock), the employees will be taxed as ordinary income (in most cases) and the new owner will receive an offsetting tax deduction.

4. Can help reduce the tax bite in a transfer to key employees

Non-qualified plans can be a tremendous vehicle in an internal transfer to key employees. If you are planning on transferring ownership to insiders, you will want to carefully consider how you are designing the plan. Since your employee’s source of income is the same of yours, the business, there will inevitably be a double tax effect in the transaction. This can be a big problem.

How can a successful transfer happen when more than 50 percent winds up in the IRS’s coffer?

The key is to get all the money you need (or want) from the business without subjecting business cash flow to double taxation. If cash flow is subject to single tax, there is more cash available to pay you.

The primary question is, How much cash will you receive from the actual sale of stock and how much will you receive from tax-favored methods? You will want to design the plan so that you receive the lion’s share of cash from tax-favored methods since these tax-favored methods result in a tax deduction at the company level and a single tax at the owner level — in other words, they create one tax bite.

While there are many methods to transfer ownership in a manner that reduces the tax bite, one of the most common methods is the use of a non-qualified deferred compensation plan for the owner in the form of installment payments, since the business gets to deduct the deferred compensation payments to the owner. In other words, it needs to make one dollar to pay you one dollar. For this type of plan to work it must be in place at least five years before your exit or the IRS may tie the plan to the sale of stock.

5. Provide greater peace of mind in a family transfer

Non-qualified plans are especially helpful in family transitions from parents to children. In many cases, even though the child may be grown and fully capable of running the company, management may be loyal to the parent and not necessarily to the son or daughter.

To ensure a smoother transition that keeps the business within the family and preserves business legacy, a non-qualified plan that intentionally vests and rewards management several years after the transfer is complete will provide both parties confidence and peace of mind that the company’s key people will stay on with the next generation.

Bringing it all together

Business owners have a powerful tool in non-qualified plans. If properly designed, these plans can help you improve profitability and productivity, add leverage and give greater confidence in a third-party sale, improve tax efficiency if you transfer to insiders, and provide greater peace of mind in a family transfer.

Whichever plan you choose, you will want to make sure it fits your goals, objectives and business resources, and, ultimately, builds and transfers business value.

Source: bizjournals

​Patty Block, President and Founder of The Block Group, established her company to advocate for women-owned businesses, helping them position their companies for strategic growth. From improving cash flow…. ​to increasing staff productivity…. ​to scaling for growth, these periods of transition — and so many more — provide both challenges and opportunities. Managed effectively, change can become a productive force for growth. The Block Group harnesses that potential​, turning roadblocks into building blocks for women-owned businesses​.

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