As we all know, compensation is the number one expense in a franchise business. One of the trends in compensation, particularly in this sector, has been to keep base salaries fairly flat and then implement bonus programs based on performance and profitability. This trend has resulted in the proliferation of deferred compensation plans and other types of incentives, which call for various deferral arrangements.
Incentive programs can take various forms:
1. One form of incentive approach is purely a bonus arrangement whereby the bonus is tied to a certain level of performance and paid only after the end of the company’s fiscal year (once the bonus determination has been made). The bonus can be based on an overall corporate performance or individual unit level performance. Some companies, in trying to show alignment, actually use the combination of the unit level and corporate level for a bonus arrangement. This bonus approach is fairly common, and most franchise companies have some type of bonus arrangement.
2. Another incentive approach is a true deferred compensation arrangement where an earned bonus is deferred and not paid out for a number of years. In many cases, this type of arrangement has a vesting feature. The deferred amount is normally based on a level of performance, with the payout structure taking different forms. The forms are based on what happens to the money during the deferral period. The following are examples of this approach:
a. The first approach would be a savings account approach. Generally, the savings account is not funded currently; rather, the employee is assigned a theoretical savings account, which may appreciate over time.
b. A second approach would be to assign a portion of the company’s stock to the employee in a theoretical equity account. The employee’s deferred amount would appreciate as the company’s value appreciates. Obviously, this approach requires a periodic valuation of the company to establish the assigned value and growth rate of the company.
c. The third approach is where the deferred amount is theoretically invested in a combination of options a. and b. above.
Let me give you an example. A person may be entitled to a $20,000 bonus. $10,000 of the bonus is deferred. This deferred amount could be placed in a theoretical account that bears interest at a floating or fixed rate and is then paid out after a given period of time (for example, at the time of termination of employment, disability or death). Additionally, this account balance could be invested in a phantom ownership in the company. The growth of the account is tied to the growth of the company. A valuation of the company would be made on an annual basis, and the company’s growth factor is applied to the account balance. Under this approach it is possible for the account balance to decrease, although many deferred plans provide for a floor so the account balance cannot decrease. One of the key elements in using the phantom ownership approach is to use an economic value that is not subject to the owner’s discretion. An example may be using controllable profit versus a net profit number.
It is important to note that the 2004 tax law changes (which were intended to take away some potential abuses by highly paid executives) may apply to these deferred compensation plans.
There are several items to take note of regarding the new tax law changes. Most of the changes are definitional. For example:
• A plan provision that allows a pay out if there is a change in control of the company must provide for a very specific definition of change in control.
• The definition of disability is very restrictive; and
• The rules as to elections by employees for deferrals have been tightened.
What does all of this mean? It means that new and existing deferred compensation plans need to meet very specific IRS guidelines. Generally, these rules apply to amounts deferred after December 31, 2004 .
It is important to remember that most deferred compensation plans are unfunded; thus, the money for a period of time stays in the company. From a tax standpoint, deferred compensation is not deductible until the employee receives the compensation. However, the balance of the deferred compensation is available for growth.
As stated above, there are many variations of deferred compensation plans. Some plans even allow tax favored loans against the plans, which may allow employees to access their deferred compensation prior to termination from employment.
In summary, these plans are great employee incentives without immediately using company cash. However, due to the recent tax law changes, all existing plans must be reviewed and all new plans must be carefully drafted to ensure compliance.
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