Ownership Of A Producer's Book: A Better Way

 OWNERSHIP OF A PRODUCER'S BOOK:

A BETTER WAY

Some agencies choose to offer key producers an 'ownership' interest in the producer's book of business as part of that producer's overall compensation package. Other agencies would like to, but consider the cost too high.

A simple way to reduce the cost is to improve the way it is taxed. If the agreement specifies actual 'ownership' which must be bought back when the producer leaves the agency, then the repurchase of the book will take the agency 15 years to deduct. If the agreement has the exact same financial value to the producer but the agreement is in terms of deferred compensation, the agency will be able to deduct the payments at the time they are paid to the producer.

In other words, a minor change in the agreement can enable the agency to reduce taxes now, rather than spread the benefit over 15 years.

Deferred compensation is much more flexible than typical retirement plans such as a 401k or profit-sharing plan.

• Amount: The benefit amount is extremely flexible, with no pre-determined upper limit.
• Vesting/Forfeiture: Vesting and forfeiture have no predetermined rules. For instance, you can design a 'golden handcuff' plan that the producer forfeits if he or she goes to work for a competitor.
• Non-Compete: A non-compete agreement with a producer who has already been hired is generally not enforceable unless the producer receives adequate consideration in exchange for signing. The deferred compensation plan can be that consideration.
• Death/Disability: The plan can include special benefits for death or disability.

COST SHARING

If the producer wants a higher benefit (or you wish to offset part of the cost), you can reduce current commissions in exchange for the future benefit.

To estimate the value of a reduction in a producer's commissions for a property/casualty insurance agency, let's assume the producer's commissions are reduced by 5% per year, and that the time value of money is 10% per year. The following table shows you how much that reduction in commissions is worth in terms of a multiple of 'book':

In other words, a reduction in commissions from 30% to 25% for 15 years is worth a multiple of 1.59 times the 'book.'

Put another way, a $5-per-year reduction in commissions for 15 years is worth $159 in deferred compensation after 15 years, assuming a 10%-per-year interest rate.

Since a producer's book usually grows over time, a lot of that book is likely to have been deferred for only a few years. This is a crucial factor in evaluating the costs and benefits of a deferred compensation plan.

Since one of the benefits of deferred compensation is reduced taxes, let's review the tax effects. Taxation of deferred compensation comes at two times: First, when the producer is fully vested and the money is non-forfeitable (generally at retirement); and second, when the money is actually paid (generally over a five- to seven-year period).

At Retirement: The entire deferred compensation amount becomes subject to social security and medicare taxes at retirement. Since social security taxes cut off at certain levels, you may end up owing very little social security tax. This is especially valuable if you retire at the year's end and have already paid the maximum social security tax for that year. Both the company and the employee benefit.

The Medicare tax does not have an upper limit, but the tax is small (1.45% for the employee and for the employer).

When paid: The amount paid is taxable income to the employee and deductible compensation expense to the employer at the time it is paid. The income does not reduce the employee's Social Security benefit when it is received.

As everyone knows, Congress never makes things simple when complicated will do just as well. Fortunately, Congress hasn't spent much time with deferred compensation, so it is much simpler. This is because it is 'Non-Qualified.'

'Non-Qualified' means that it does not fit the definition of a 'Qualified' plan. Typical examples of a Qualified plan include a 401K, profit-sharing plan, etc. Qualified plans are subject to many rules and restrictions, such as those found in ERISA. One of these rules is that they must be nondiscriminatory, which usually means you must offer the same package to basically all your employees. Many other rules also apply, such as how much can be contributed.

A Non-Qualified plan is much simpler, with far fewer rules to follow. But to be non-qualified it MUST be discriminatory. You must limit it to a group of management or highly compensated employees.

To avoid a number of unpleasant issues, such as immediate taxation to the employee and possible inadvertent classification as a 'qualified' plan, the plan must be technically 'unfunded.'

'Unfunded' does not mean that the company cannot set aside money to pay for the future obligation. But it does mean that if the company chooses to do so, any money set aside must remain available to the general creditors of the company in the event of bankruptcy.

A 'Rabbi Trust' is sometimes used to restrict further the way set-aside money can be used. Basically, a Rabbi Trust ensures that the set-aside money can only be used to pay for the deferred compensation obligation, unless, of course, the company goes bankrupt. In the event of bankruptcy, the money in the Rabbi Trust becomes available to the general creditors of the company.

Remember, the company does not get a tax deduction for deferred compensation until the money is actually paid to the producer. Any money set aside must be done with after-tax dollars.

The producer must not receive 'Constructive Receipt' or 'Economic Benefit.'

Constructive Receipt means that there must be some chance that the money might not get paid. This is usually met by specifying certain conditions under which it could be forfeited.

Economic Benefit means that the future recipient cannot somehow get that future economic benefit today. For instance, you cannot use the expectation of the future benefit as collateral for a loan today.

The money actually paid in a given year, plus the amount deferred for that year, must represent a 'reasonable' total. 'Reasonable' can be hard to define, but this is not likely to be an issue for a producer who is not also an owner.

Deferred compensation for the owners is a great tool for improving the future sale of a company, especially if you have a 'C' corporation.