Over the years in the small business arena, when retirement is mentioned, the discussion usually focuses on programs like 401k, Profit sharing, SEP’S, and Simple Plans.
They are all very good plans and every business should offer one of them to their employees for the purpose of having a benefit plan where employees can save for their retirements.
However, not every employer wants to take on the burden of funding retirement for their employees for many reasons. The reasons range from a lack of cash flow, employee groups who would rather take the money home.
In situations where the employer feels they would like to use their company to create a benefit for themselves, and not the employees, they should look into an executive compensation plan called the CEEP (Corporate Executive Equity Plan). The CEEP is a hybrid of a few types of benefit plans used for the higher paid group in companies and for the owners.
The term “non-qualified “, refers to a plan that normally is not used for the masses, but used for a selected group of people. As an example: Employer A can decide that they want to put a plan in for employee B, C but not employees D-Z. In most cases the plan itself would not be tax-deductible as a “plan”, however, it can be tax deductible under certain conditions.
How the CEEP works!
Mr. Jones owner of the Big Dip Donut shop decides that he wants to allocate $25,000 a year into a retirement plan for himself and no other employees of the company. For the most part, he can’t have a qualified retirement plan without offering it to the employees. Even a “Simple Plan”, which is the easiest to implement would have drawbacks.
The CEEP would work like this:
The company would compensate Mr. Jones, $25,000 to deposit into a plan. A cash rich insurance policy would be applied for and owned by Mr. Jones. Because Mr. Jones increases his compensation; he would pay taxes on the amount bonused to him.
The Big Dip Donut shop would take a deduction on the compensation, using 30% overall tax bracket, the company gets a deduction, netting a cost of $17,500 cost. This would be the same if the company made a contribution to a pension plan.
Mr. Jones, however, picks up the tax. In this case however, the company will loan Mr. Jones the tax liability of $7,500 a year. Because of this loan, The Big Donut Shop will charge Mr. Jones 3% (Federal Adjusted Long-Term Rate), on the loan each year. They will accrue this cost on the books.
So far, Mr. Jones has not paid anything out of pocket, and The Big Dip Donut Shop has not paid more than $25,000. All is good.
As time continues, Mr. Jones will have access to all the cash values over and above the loaned amount and the accrued interest value.
At retirement a few things will happen:
Let’s look at the summary:
Employer: Funded $675,000 gross, net cost $472,500
Loaned $202,500 (tax liability to Mr. Jones)
Interest Cost accrued: $112,003
Net cost of loans: $ 314,503
Forgiven Loan: $220,152
Employee:
Mr. Jones wants to retire and use the assets.
Options:
- Mr. Jones wants the policy; to do that he will take a withdrawal, tax free of $314,503, and pay back the company in whole. The company could now use that money to buy Mr. Jones another benefit. Let’s say a retirement income of $44,929 for 10 years. The net cost to the company would be $314,503.
- The company can forgive the loan and discharge the debt which will be taxable to Mr. Jones. This is a cost of $220,152 as it can take a tax deduction. Mr. Jones would withdraw tax-free the $220,152 to pay the new tax liability. He would then own the policy with no lien on it. The value would be about $793,429 after the withdrawal. The death benefit would be worth $2,306,317.
- Mr. Jones could do #2, but then create a tax-free income for 18 year for $67,500. This would be the equivalent of $96,429. The benefit would be worth over $1,215,000
Summary:
Mr. Jones had his company contribute a net cost of $692,652 which includes the compensation, taxes and interest accrued. All funded by the company over 28 years.
Mr. Jones has no out of pocket costs as it was funded by the company. He ends up with $793,429 of cash with a $2,306,317 death benefit and can turn the cash into a tax-free income worth over $1,215,00, which is equivalent to a $1,735,714 gross benefit.
If Mr. Jones decided to set up a qualified retirement program, he would get a full deduction for the $25,000 however, he would have to include all of his employees which would limit the wealth he could create for himself.
For business owners who want to create wealth for themselves outside of their company, the CEEP programs creates the flexibility of tax deductions, tax recovery, and tax-free income which can’t be created in any other program.
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