The “Stay” Bonus as an Effective Business Succession Tool
According to the Exit Planning Institute, nearly two thirds of closely held business owners say they would like to transition the family business to a succeeding generation as their preferred exit option. While keeping the business in the family is a common objective of business owners, the sad reality is that roughly 70% of all second generation family businesses fail.
There are many reasons for this high failure rate including: failing to identify and groom a successor, not having a succession plan in place, not planning for the unforeseen, and not retaining key employees upon transition. Having a well thought out exit plan where successors are identified and groomed early, buy/sell agreements are in place, and unforeseen disasters such as death or disability are insured against can be the difference between falling into the successful 30% of family business transitions or the 70% that fail. Another important component of an effective exit plan is to involve and retain key employees during and after the business transition. Using a “stay bonus” to keep key employees upon a succession event can be an effective strategy to help ensure a successful transition to the next generation.
A stay or retention bonus is a simple concept and is commonly used during mergers or acquisitions of large companies. However, they are also applicable in the small family owned business arena as the impact of key employee loss or turnover can have a devastating effect on the business. In the small business context, the stay bonus is simply a contractual agreement between the business and select key employees that the company will pay a bonus if the employees stay for a period of time after a triggering event such as the retirement, death or disability of the business owner. By having the promise of a bonus at the end of the retention period, key employees may be more likely to remain with the company during transition, which may make the difference between future success and failure particularly if the transition was unplanned such as on the owner’s untimely death.
Designing and Funding the Stay Bonus
Generally stay bonuses are paid in a lump sum in cash within 2 ½ months after the close of the tax year in which the bonus is no longer subject to a substantial risk of forfeiture (i.e. it is vested). Payment within this timeframe is vital as it helps prevent the arrangement from being considered a deferred compensation plan subject to IRC Section 409A. Failure to pay the bonus before the end of this period may result in significant income tax consequences, penalties and interest. The bonus amount and the stay duration can be determined by the business owner or negotiated with the key employees. Common bonus amounts are anywhere from one to three years salary depending on the importance of the key employee.
One possible alternative to a cash bonus would be to provide key employees with some sort of equity compensation at the end of the stay period. However, stock or equity bonuses have advantages and disadvantages that must be weighed against cash compensation. Offering equity in the business alleviates the need for cash which may be tight in the event of an unexpected transition event. In addition, offering equity in the business may be a strong incentive for key employees to remain with the company for the long term. On the other hand, making key employees owners regardless of how small their ownership interest, creates certain legal rights for the new minority owners which may not fit with the overall succession plan of the business.
If cash bonuses are to be used, one potential way to informally fund the promised bonuses would be for the business to purchase a life insurance policy on the current owner’s life. The company would be the owner, premium payer, and beneficiary of the policy. To ensure that the death proceeds of an employer-owned policy retain favorable income tax characterization, it is essential to comply with the requirements of Internal Revenue Code Section 101(j). In the event of premature death of the owner, the death benefits from the life insurance policy can be used to fund the stay bonus payments to the key employees. If a permanent policy is purchased, any cash values in the policy may be used to help pay the promised stay bonuses upon retirement or buy/out prior to the owner’s death. Loans and withdrawals will decrease the cash value and death benefit. Tax-favored distributions assume that the life insurance policy is properly structured, is not a modified endowment contract (MEC), and distributions are made up to the cost basis and policy loans thereafter. If the policy has not performed as expected and to avoid a policy lapse, distributions may need to be reduced, stopped and/or premium payments may need to be resumed. Should the policy lapse or be surrendered prior to the death of the insured, there may be tax consequences.
Stay or retention bonuses may also be considered as part of an overall execute benefit plan for key employees. Any life insurance that the company owns on the key employee to fund key person death benefits, supplemental executive benefits, or a split dollar plan may also provide the funding for a stay bonus. Cash values from a key person policy could be used to pay promised stay bonuses. Of course, this reduces both the death benefit and cash value remaining in the policy.
Jerry Lopez is 56 and owns a successful surfboard manufacturing and distribution company, Lopez Surfboards. Lopez Surfboards has 25 employees including two of Jerry’s children Laird and Rochelle. Laird is the company’s national sales manager and is expected to take over the business from Jerry when he retires in about 10 years. Over the past 10 years, one of the key drivers of success for Lopez Surfboards is due to the two surfboard “shapers”
Kelly Irons and Andy Slater. Their surfboard designs are internationally recognized and the loss of Kelly or Andy would cause a significant drop in sales for Lopez Surfboards. While the shapers have worked with Jerry for many years, they aren’t as close to Laird. Even though there is a transition plan in place for Laird to ultimately succeed Jerry in the business, should Jerry die suddenly it is unknown if Andy and Kelly would leave the company. Consequently, a stay bonus agreement could be used to retain the shapers during the transition if Jerry were to die prematurely.
For this case, Lopez Surfboards would buy a permanent life insurance policy on Jerry’s life and would be the owner and beneficiary. In the event of Jerry’s death or upon his retirement in 10 years, Lopez Surfboards would offer a stay bonus to Kelly and Andy to remain with the company for one year after the tax year in which the key employees become eligible for the benefit. A cash bonus equal to two years salary would be paid by March 15th of the year after the transition event occurred. In the event of Jerry’s death, the bonuses could be paid from the death benefits payable to Lopez Surfboards. If Jerry lived to retirement and then sold the business to Laird, loans or withdrawals against the policy on Jerry’s life could be made by the company to help fully or partially fund the cash payments to Andy and Kelly.
When designing succession plans for small business owners, do not underestimate the possible impact of key employees departing when a transition event occurs. This is particularly true if the event is unforeseen such as the death of the business owner. Using a stay bonus agreement to retain those key employees can help ensure a successful transition to the next generation.
By James R. Allen Jr. CFP, CLU, ChFC. James is the Director of MetLife’s Advanced Sales Central