Schneider Downs has assisted several auto dealers recently with the implementation of incentive compensation plans utilizing deferred compensation arrangements (“DCA”). These types of plans allow key employees to share in the growth of the company without actually owning equity.
As an example, a dealer could establish a plan whereby the general manager will receive a bonus each year based on the increase in net operating income over the previous year. The general manager would then have the option of foregoing the cash and instead, investing the bonus in the DCA. The DCA is measured in terms of units and each would be valued at some percentage of the dealership’s value, based on the number of outstanding units. The valuation formula should be determined at the inception of the plan. It would typically be the book value of the company plus other normalizing adjustments and may include an estimation of blue sky. Blue sky could be determined based on a normalized earnings history.
The plan should include a vesting schedule. The employee is typically 100% vested in his or her share of the DCA in the event of death, disability, retirement or sale of the dealership. If the employee terminates for any other reason, only the vested portion becomes due. This amount is typically paid over a period of years and is tied to a non-compete arrangement.
This type of incentive compensation plan provides several benefits:
- Just like any incentive compensation plan, it rewards key employees for a good job, including meeting specifically-defined goals.
- It helps retain key employees because, upon termination for other than death, disability, retirement or sale of the dealership, the non-vested share is forfeited. Key employees with unvested benefits will be reluctant to leave the dealership.
- It allows employees to share in the growth of the business without actually receiving a share of the company. For example, if a unit is worth $4.00 at the end of year one, a $20,000 bonus will buy 5,000 units. If the company grows in value by 25% the following year, the same 5,000 units will now be worth $25,000. So the employee benefits even before the second-year bonus is determined.
- The dealer is able to reward and retain key employees without a cash outlay. This aspect is important for dealers who are reinvesting in the dealership. The ultimate cash outlay could be financed with an annuity or insurance policy.
- The key employee is able to defer the income tax on the bonuses until he actually receives the cash at the triggering date. The dealership will get a tax deduction at the time of payment and the employee will recognize ordinary income. There is no capital gain treatment because stock DCA’s are not a capital asset like corporate stock.
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