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017 – The Art Of Key Person Compensation – Rick Kozlowski

October 5, 2015 by JoshPatrick Leave a Comment


Today we tackle the challenge of key person compensation planning.  Sometimes we call this a retention bonus and sometimes a stay bonus.  The purpose is the same…..to help you key people get personal value when your business increases in value.

Our guest today is Rick Kozlowski an attorney practicing in Burlington, VT.  He helps private businesses successfully transition many legal issues they face while running and selling their business.  Rick is going to help us understand what legal strategies are available to create a win/win legal relationship with the truly important people in your company.

You’ll learn:

  • Why a supplemental plan is different than a 401(k) plan.
  • Why it’s important to fund a supplemental plan with cash.
  • What a Rabbi trust is why it helps your key people know their money is protected.
  • Why this plan needs to be tied to company performance.

Transcript:

Narrator:         Welcome to the Sustainable Business Radio Show on podcast where you’ll learn not only how to create a sustainable business but you’ll also learn the secrets of creating extraordinary value within your business and your life. The Sustainable Business is all about creating great outcomes.

Here’s your host, certified financial planner, student, entrepreneur and private business expert, Josh Patrick.

Josh:                Today’s podcast features Rick Kozlowski. Rick is one of my favorite attorney’s in Vermont. He’s a partner at Lisman & Leckerling. He specializes in estate planning and tax issues facing private business owners. Rick has worked with me on several projects where we’ve helped owners successfully leave their businesses, buy businesses and develop interesting compensation plans for their senior managers. Today’s conversation is going to focus in on supplemental retirement plans for senior management and whether having one in your business is something you should consider. Let’s get right to it and find out what Rick thinks.

Rick, let’s talk about compensation plans for a while. How are you today?

Rick:                Good. How are you? Thanks for having me. I appreciate it.

Josh:                Oh, my pleasure. This is a bit of a complicated area so let’s do our best to limit the jargon and try to speak in English so folks can understand what we want to talk about.

Rick:                I’ll try to do that.

Josh:                Not a problem for you, but it is a problem for me.

Rick:                I’ll do the best I can.

Josh:                Okay. Let’s start off. Why would an employer want to do a supplemental plan for their key people?

Rick:                Well, maybe the thing to do is to differentiate first between a supplemental plan and maybe the sort of garden variety retirement plans that a lot of companies have like 401K-type plans. This type of plan is extra. It’s a non-qualified plan. It doesn’t have a lot of the tax benefits maybe that a qualified plan does but what you get is simplicity and the ability to tailor the plan for your key people any way you want to do it within certain limits that we’ll talk about in a little while. The reason to set it up is to incentivize key people to stay with the company, to work hard and to try to make the company a success so it’s an add-on to your normal type of qualified plan. It’s really creating a carrot for these people to work hard and make everything a success.

Josh:                Do you see that these plans do what they’re designed to do or is that depending on how well they’re designed?

Rick:                I think it depends on how well they’re designed because intentions are great but the proof’s in the pudding. And so, when you sit down and you think about “How would I get my key people to maybe roll a little harder or stay a little longer and try to make a go of it?” You’ve got to tailor it to the people you’ve got – the group of people, the people they are, what they would find important.

I’ve seen plans before that looked great on paper but if you sat down with the people who were involved in the plan, they might say to you, “You know, this plan really doesn’t do much for me. It’s too far in the future. It’s too unrealistic. The goals are too high” – whatever it is that sort of ruins it for them will ruin it for the owner because all the time and effort put into the plan is wasted. You really want to integrate the people who are going to be in the plan and make sure that when all is said and done, they find it to be valuable. And so, they do the things you’re trying to get them to do which is to work hard, stay long and make the company successful.

Josh:                If I’m an employer and I’m thinking about putting together one of these supplemental plans for key people, what should I be thinking about before I even come in and talk to you?

Rick:                Again, I would look at the people you’re trying to incentivize because that’s critical. How old are they? What makes them tick? What is it that I can do for them that will get them to work hard and be part of the company? And so, you’d look at the type of benefit you want to give them. Normally, it’s measured in terms of money. But how you set up the benefit is critical. Is it set up to reward longevity? Is it set up to reward success of the company? Is it set up to reward somebody individually for what they do regardless of how the company does? Or is it a combination of factors like that?

And so, there’s probably 1,000 different combinations of how you can design a plan. But the key is to design it so that if I’m the employee, if you’re sitting in the employee’s chair, you’ll look at this plan and go “Wow! This is great. If I really work hard and stay with the company, I’ll do very well on top of my other compensation that I get.” So, if I was an owner of a company and I was going to see a planner or an attorney, I would think about those things before I walk in so that I could talk to that person who’d help design the plan about the things that make my employees tick.

Josh:                What kind of things can happen in a plan that go into design that causes damage to the plan that’s really inadvertent that you’ve seen?

Rick:                Again I think, to sort of reiterate, if you fail to make the incentive real, the plan is going to be ruined from the get go. I’m a firm believer in communicating with the employees that are involved, maybe even getting their input early on but certainly when you’ve got a plan in mind, it’s sitting down with them and seeing what kind of reaction you get. Other problems that can crop up are the things like over-promising. So, it’s great to say “Hey, I’d like to give my employees each $1 million when they retire and that’s my plan.” Well, that’s great but if you can’t afford it, not only have you created a problem for yourself but the promise isn’t really real. So, you’ve got to really sit down and think ahead, “What is it that these people can earn and can I afford it – can the company afford it when the time comes to pay the benefit?”

I’ve also seen owners sometimes over-include people or under-include people. And by that, I mean, they look at their executive pool, so to speak, and they think of the people they want involved in the plan. And they put too many in so that there’s too much benefit to pay out at the end and it really waters the whole thing down. Or they leave out some key people who end up maybe even disgruntled because they weren’t part of the pool. So, it takes a lot of thought, I think, on the part of a business or to look at their key people and decide “who’s going to be in it? What am I going to promise them?” because if I make a mistake on either one of those, it can ruin the plan. I think those are the key components, maybe, of planning.

Josh:                There’s always a choice that owners have to make when they put these plans together and that is whether they’re going to fund the plan or they’re not going to fund the plan. Can you talk about that a little bit?

Rick:                Sure. Remember, these aren’t qualified plans. This money isn’t being set aside permanently in a trust like a 401K or some other type of plan where if you start funding the plan, the money is out of the company and gone. These are really promises to the employee. And so, it isn’t necessary that you actually segregate assets and fund the plan. You can make a promise to pay an employee something if they stay for a certain amount of time or if the company does a certain sales target or whatever it might be.

But I think it’s important to fund the plan as you go for a couple of reasons. (1) It makes the plan real to the employee. So if you say, “This is how your benefit is going to grow over the next 10, 20, 30 years or whatever the plan is, you can show the employee that you’ve set aside assets for that payment so when the time comes the company will be able to keep the promise that it’s making to you. That makes the plan real to the employee. And as I said at the beginning of the show here, the more real it is to the employee, the better the plan is.

Now, when you set funds aside for a non-qualified plan, it’s a little bit of a misnomer because those assets even though you may have put them in a special account – we can talk about Rabbi trust, if you want, but if put them into a special account for the employee, they remain part of the company’s assets. So, if I’m a creditor, if there’s an issue with bankruptcy or something like that, those assets that were promised to the employee are fair game for creditors of the company. So, even though you may be funding it currently, and trying to make it real to the employee, they need to know and it would say so on the plan document that these assets are not protected from that type of claim.

The other thing that funding does is it keeps the plan on track because if you’re not funding currently and if you’re just sort of kicking the can down the road, in 10 or 15 years you could have a whole bunch of unfunded promises at a time when the company might not have the wherewithal to make those payments. I think funding is important. It does a bunch of positive things and not funding can do a bunch of negative things.

I mentioned a Rabbi trust. A Rabbi trust is a special type of account that you set up to segregate assets for an employee. The company’s not supposed to touch them. But again, they still remain part of the company’s general assets and are available to creditors if there is a problem. You know, I think that that problem with creditors, if you’ve got a company that’s clipping a lot and is successful, really isn’t a big downside for an employee. I think employees like to see the money in the account, even knowing that if everything goes poorly they may not get the money. That’s probably a lesser consideration for them most of the time.

Josh:                That makes sense. So, there’s a bit of expense that goes with these in complexity. And part of that complexity is a code section called 409A. Can you talk about that a little bit and what with that means?

Rick:                The bane of many attorneys, 409A. It was implemented in the Enron era when some of these bigger companies obviously had serious problems and executives who had inside information knew they had serious problems and started to accelerate their deferred compensation, paying themselves while their houses were burning down around them. What happened in the end of that was that the average employee, who had their retirement plan and stocks of these companies and whose job was tied to the success of these companies, lost everything and the execs went on to other mansion or wherever they were and counted the money they got out of the company before everything went south. 409A was designed to stop that. It’s a very complicated code section.

I had the pleasure of reading the regulations a while back. I think they’re 50 or 60 single-spaced pages long – very, very complicated. And then the problem is 409A covers a lot of different types of deferred comp plans, almost all of which wouldn’t have the Enron-type spin to them. And so, they sort of threw the baby out with the bath water and that they just covered everything rather than try to make it specific to the type of plans that were actually the problem. And so, 409A essentially stops you from abusing the plan. That’s the whole idea. That’s what it’s designed to do and it does that by creating some pretty severe penalties for failure to comply. It’s something you’ve got to watch out for whenever you’re thinking about doing any kind of supplemental retirement plan or deferred-type compensation plan.

Josh:                And you need somebody who actually understands that code section and can write a document that supports it?

Rick:                Yeah. Well, it is hard. And so, one way to do it, I think that is – especially for companies who may be in the mid-range size or even smaller, if they want to do something like this, they don’t want to have a 40-page document that addresses all the 409A issues. But because those plans are really not susceptible to abuse in the common sense, what you can do in the plan is refer to 409A, require the plan to adhere to 409A, allow the plan to be amended – if you inadvertently violate it. And so, if you build in some safeguards that way, it really isn’t necessary, I think, to address every single issue that the regulations might raise. It’s sort of a shortcut way of making the plan 409A-compliant without getting into all of the details and the nitty-gritty of how that section works. I think 409A is manageable. It’s just a thorn in everybody’s side.

Josh:                I mean, they’re obviously complicated and there has to be a lot of forethought that goes with it. What would it cost an employer to put one of these in place as far as fees go?

Rick:                You know, it depends and lawyers always say that so I’ll say that – it depends. But, if you have a small group of key executives and you have a really concrete idea of the way you want the plan to work and it isn’t going to take a lot of time by your planner to massage the plan, or fix the plan, or talk to employees and put in a lot of hours in design. The actual documentation of it is, I don’t think terribly expensive. And so, you can do a simple plan like this for probably under $5,000, maybe. The more people involved and the more complicated the plan and the more complicated your formulas, the drafting becomes harder. You have to spend more time with the owner, making sure they understand what they’re promising; especially what the maximum exposure is under the plan to paying people. You want to make sure again you don’t over-promise. And so, a lot of times the design can get complicated and then you can spend quite a bit more putting a plan together.

Josh:                When you’re putting these plans together, you sort of have a choice. Do you make it really simple and easily understandable or do you make it complicated and a bit harder to understand? I happen to be on the side of simple and I would suspect you are too. Why would that be true?

Rick:                Well, I think you and I actually face a similar plan that we worked on a while ago is if you make it so complicated – for example, if you have some sort of formula that’s tied to the EBITDA of the company and you have a lot of different variables, factors and things that go into calculating “what it is that this executive would get – this key person would get?” If they can’t figure it out, then it doesn’t mean a lot to them. So, if they work for a couple of years and they sit down with the plan, they go, “Gee, I wonder how I’m doing.” And then they scratch their head. And after an hour, can’t figure out what is that they’re getting, I don’t see how that creates an incentive for them.

And so, even though you may want to include some of those complexities in the plan, I think you have to—I think in the plan we did, Josh, we actually did an executive summary that sort of tried to get rid of the numbers and talked about the concept so that they understood how things would operate and that we would be able to make a calculation if they wanted to take a look at what they had – trying to keep it so that they would actually feel like they were getting something of value for working and staying with the company. And so, I’m a fan of simple too. I think that if you keep it simple, it’s a better carrot for the people who are chasing it.

Josh:                Do you think it’s important for the company to report on a periodic basis to the executives how their plan is doing?

Rick:                I think so. This isn’t meant to be a secret. It isn’t meant to be “We have a plan. We want you to work hard but that’s the end of the story. And so, go back to your desks and let’s go.” I mean, I think, letting them know how it’s going – whether it’s for good or for bad, will keep the plan on track and will keep people hopefully moving in the right direction. And so, I think, owners should share that result with them – not every month, certainly, and maybe not even every quarter, but maybe annually anyway, saying “Here’s how we’re doing. Here’s how that plan formula’s working. Here’s where you are with maybe vesting. Here’s where you are with what you would get if you retired in 10 years or whatever the plan is designed to do.” I think that it keeps everything real. And as I’ve said, I think that’s the key to the plan.

Josh:                Yeah, I think that is absolutely true. Well, we’ve only scratched the surface of this and we’re pretty close to be out of time for the day. I love these ideas of supplement plans. I hope some of our listeners do also. If they want more information, how do we get a hold of you?

Rick:                Probably the easiest way is by e-mail. I’m great with e-mail. The phones a little tougher. My e-mail is rkoz@lisman.com. So, I you have a question about any of the things we talked about or maybe something that we didn’t, just shoot me an e-mail and I’ll try to get back to you.

Josh:                Yeah, I’m going to encourage anybody who’s listening to contact Rick if they’re interested in learning more about supplemental retirement plans. He is one of the few attorney’s who actually makes complicated stuff and simplifies it for you.

Rick, I really appreciate you spending these few minutes with us this afternoon. Thank you so much.

Rick:                I appreciate it. Thanks for the invite.

Josh:                You’ve been listening to the Sustainable Business Podcast where we talk about what you need to do with your business if it was to be here 100 years from now. If you like what you heard and want more information, please contact me at 802‑846‑1264 ext 2 or visit us on our website at www.stage2solution.com or you can send me an e-mail at jpatrick@stage2solution.com.

This is Josh Patrick and thanks for listening. I hope to see you soon for another edition of The Sustainable Business.

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