Are SERP Benefits a Solution for Small Business?

A Selective Executive Retirement Plan (SERP) is the solution to a problem faced by many smaller corporations:  difficulty in hiring and keeping key executives and an inadequate qualified retirement plan benefits payable to key executives and owners.

Most businesses that are successful have at least one key employee who is responsible for the growth and profitability of a business.  When a smaller company would suffer financially from the loss of a key employee, a business owner can protect the company with a SERP for any key employees.  

In today’s competitive market, salary alone is often not enough to retain key employees.  Therefore, benefits, such as a SERP, can be key in remaining competitive with large corporations.  When determining how important the use of a SERP may be in “sweetening the pot” of benefits, some key questions related to the reduction in earnings, disruption of management, replacement costs, credit problems, confidence problems, and competition can assist in deciding if that particular employee would warrant a SERP.

Related: See Source of SERP Benefit Information >

Often, key employees who make over $270,000 per year are penalized due to caps placed on qualified retirement plans.  A SERP can offer customized benefits to these employees that are over and above those provided to all employees.  This non-qualified arrangement between a company and these selected key employees do not require any deferred compensation from the employee, but rather instill confidence in the employee that at retirement, an additional benefit will be available, or at death, a survivor benefit will be given to the family.

SERP Benefits

Custom-tailored benefits can be a bonus in attracting and keeping key employees.  A SERP provides these benefits in a non-qualified arrangement.  Not only does the corporation have flexibility in choosing who participates in the plan, but also in the benefit amounts and length.  Two key employees can receive two totally different benefit packages under a SERP.  Some SERP benefits include:  

  • Retirement Benefits – The main reason to offer a SERP to a key employee is to provide a supplementary retirement benefit for those who remain with the corporation until they retire.  This retirement benefit can include how large the promised benefit will be when it will begin, and the length it will be payable, all decided by the corporation.
  • Pre-Retirement Death Benefits – If the key employee dies before retirement, a survivor benefit is paid out to the beneficiary.  
  • Post-Retirement Death Benefits – If the key employee retires and dies before all retirement benefits are paid, the rest of the benefits will be paid to the beneficiary.

All of the listed benefits, both pre- and post-retirement, are an incentive to a key employee to remain with the company.  Since these benefit dollars equate to the money they would otherwise have to spend on their own retirement security, if they terminate employment, they would be making a substantial sacrifice.

SERP Funding

If SERP benefits are to avoid taxation until received, they must be made as an unfunded and unsecured promise by the company to pay the benefits from the general business assets.  A corporation may still purchase assets to meet any future obligations created by the SERP.  By creating a SERP for key employees, a corporation is creating a future liability for any promised benefits.  A perfect way to gather the funds needed to meet these obligations is to purchase life insurance on each SERP employee.

When the life insurance is owned by and payable to the corporation, favorable tax leverage is created.

  • Any salary continuation benefits paid by the corporation are tax deductible.
  • When employer-owned life insurance requirements are met and any key employee under the plan dies, the life insurance proceeds are received income tax-free by the corporation.  

By using a corporate-owned life insurance policy, a company is able to fully recover any costs associated with the SERP, including the cost of the life insurance premium.

SERP Mechanics

An example of how a SERP can work for a small corporation for selected key employees:

  • First, after satisfying the notice and consent requirements for any life insurance contracts owned by the company, the business then purchases enough life insurance on the employee to fund any after-tax costs related to the promised benefits and to also recover any premiums paid that are nondeductible.
  • Next, the company pays the life insurance policy premiums and is named as beneficiary.  At this point, no money is paid or expected from the key employee.  Only the company and life insurance company is involved in any payments.  The key employee is named as the insured, and the company is the owner and beneficiary.
  • The company makes an agreement with the key employee with regards to salary, continued employment, and any other agreements pertaining to benefits.
  • Then, if the key employee remains with the company until retirement, the promised tax-deductible retirement benefit is paid by the business from its current cash flow, loans, withdrawals from the cash value of the policy, or a combination of all.  It should be noted that any withdrawals or loans on the policy will reduce the policy’s death benefit and cash value.
  • The key employee receives these benefits as taxable income and is reported to the IRS as such.
  • If the business maintains the policy until the death of the key employee after retirement, the death benefits are received tax-free from the insurance company and the company recoups all costs.
  • If the key employee dies before retirement, the death benefits are received free of regular income tax to the business and the income tax-free death benefit can be used to pay the promised tax-deductible survivor benefits to the key employee’s beneficiaries.

By structuring a SERP to include life insurance, a small corporation or business can attract, keep, and maintain key employees who will be loyal to the company until retirement.  In addition, the business can ultimately recoup any money paid out on a SERP.  This equates to a “win-win” for both the small business and its employees.

As with any complex insurance plan, consulting a qualified financial advisor to discuss, plan, and execute any SERP a small corporation may be contemplating is advisable.

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