Sometimes I wonder if CFOs and HR Directors talk with each other. Occasionally I run into a CFO who is implementing a tax strategy using employee benefits, and he or she is clueless as to whether the benefits are actually valued by the employee. (I assume that's how Clark Griswold ended up with a subscription to "Jelly of the Month Club" in "National Lampoon's Christmas Vacation.")
At the same time, I sometimes encounter an HR Director who designs a benefit package purely based on employee demand. The reality is that plan benefit designs must be all-inclusive of tax, financial and incentive issues. A benefit plan should benefit both employer and employee.
It's difficult to achieve a balance when a key issue — tax law — is unpredictable. In the last several years Congress has peppered us with both tax breaks and tax increases, often in the same year. Consider the fact that the PPACA, which represents significant tax increases starting in 2013, was passed less than eight months before the 2010 TRA, which extended tax breaks. How can an employer factor tax issues into a benefit package when future tax rules are in question?
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These days only gamblers and fools are confident enough to predict future tax policy. But there still are some tax principles that can be factored into employee benefit design.
- Tax deductions are valuable. The overwhelming number of U.S. business are flow-through businesses (S Corps, LLCs, etc). Accordingly, the owners of these businesses are very conscious of maximizing current tax deductions. They need something to offset the flow through nature of their business income. There has been a significant interest in plans that allow a current tax deduction yet retain a form of golden handcuff or restriction. An example would be an executive bonus plan, in which the employer provides the employee with a cash-value life insurance policy but requires the employee to agree to a return of cost if the employee leaves before a specified date.
- Tax diversification is effective. Much like investment diversification, a case can be made for spreading tax effects among multiple years. A popular example is a deferred compensation plan for key employees. Even though the employer is forgoing a current income tax deduction, this can be an effective tax strategy because it moves the deduction to a year when it may be more valuable. In the last few years, business tax incentives were added by Congress as a way to stimulate the economy, and many of these incentives are scheduled to expire. By deferring a deduction, an employer actually may come out ahead because the deduction can be used to offset exposed income in the future. Further, not only does the employee defer taking the compensation into income currently, but also gets the advantage of having the compensation count currently for FICA purposes. Employees who participate in these plans typically exceed the income cap on FICA, and so the income counts for FICA without requiring additional contributions.
- Tax tricks are treacherous. Consider the marketing names ascribed to many aggressive benefit plans that have been offered in the last several years: 419(a)(f) (6), 412(e)3, Permanent Section 79. These all refer to tax benefits that allegedly can be garnered by adopting such benefit programs. In many situations, the promised tax benefits ended up being a source of litigation between the company and the IRS. The IRS recently has demonstrated an impressive track record in winning these cases. What's the logic in trying to save tax pennies while risking business dollars?
- It's not just about benefits Notwithstanding my concern about the ways CFOs can misuse benefits, the simple fact is employee benefits are one of the most effective, and safe, tax-planning tools available to businesses. Consider an employee stock ownership plan (ESOP). An ESOP is simply a qualified retirement plan. But tax-wise, it's so much more. In the proper circumstances, it's a way for business owners to defer, or even avoid, capital gains on the sales of their businesses; a way to deduct both principal and interest on money borrowed to buy out the owner; and a way to avoid income tax on future corporate profits.
Maybe if we can get the CFO and the HR Director in the same room they can both make money (through motivated, productive employees), and save money (through reduced taxes). What a concept.
Want to factor taxes into your benefits design? Ask yourself these questions:
How important are taxes to the parties involved? In some cases, both employer and employee are focused on a benefit issue that eclipses tax considerations.
- Who needs the tax benefits the most? Sometimes the company is in a low tax bracket while the employee is being hit with high taxes.
- When are the tax benefits needed? Good tax planning involves the diversifying of types and timing of taxes.
- Taxes notwithstanding, is there value to the benefit? Taxes and benefits are not a zero-sum game. Balance the financial advantage gained to the employer with the perceived value received by the employee.
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