Deferred Compensation

The Small Business Owner and Deferred Compensation

by Barry Boscoe, CFP

Over the last five to ten years, there has been a reduction in qualified benefits for highly compensated employees, and an increase in the use of non-qualified deferred compensation plans. Today, it is unlikely that you will find a large corporation that does not use some sort of deferred compensation in its quest to attract and retain executives.
This phenomena is due to the fact that many highly paid executives, having attained compensation levels satisfactory to their lifestyles, are now burdened with unnecessary income adding to their already high income tax. The executive, having sufficient disposable income, would like to put additional compensation away for retirement. However, due to Internal Revenue Code limitations on qualified plan contributions, the highly paid employee is prevented from placing any additional funds in his/her qualified plan. This subjects the excess compensation to needless income taxation.
However, does a non-qualified deferred compensation plan have application for the small business owner? Deferred compensation provides a strategy of leaving income in the corporation. Depending on the structure of the business entity, the deferral of this income tax, at the owner’s level, can create quite a tax arbitrage. Arbitrage is the difference between the various taxpayers’ tax brackets. The corporate tax bracket is usually less than the owner’s tax bracket, therefore, leaving money in the corporation at a lower tax bracket lessens the overall cost of the program. In the ideal situation, where the corporation is in a 15 percent tax bracket and the business owner is in a 39.6 percent tax bracket, the arbitrage is as much as 25 percent in income tax savings. As in all cases, however, one should not let the tax tail wag the dog. There are other extenuating circumstances beyond the income tax benefits that one must review, due to the possible negative impact on the business owner.
Can corporate creditors get to the plan? In order to avoid immediate taxation on the Deferred Compensation Plan, the promise to pay benefits must be unsecured and any assets intended to fund the Plan must be subject to the creditors of the corporation. In a small business, where the likelihood of insolvency is greater, there is an undo risk on the loss of important supplemental retirement benefits in the event of a corporate bankruptcy.
How reasonable is the compensation being taken? The IRS can take a stand that deferred compensation benefits received reflect unreasonable compensation and thus treat the distribution as non-deductible dividends. In the past, the IRS has used this approach, arguing that there isn’t a valid business purpose for the Plan, since it only benefited the owner/employee and not the corporation. As in many cases, the IRS does not issue advance rulings on the tax consequences of Deferred Compensation Plans for sole or majority stockholders.
What is the possibility of the Alternative Minimum Tax (AMT)? The Alternative Minimum Tax is an alternative tax which was enacted to ensure that tax payers with substantial economic income, could not avoid all or a large part of their tax liability by using certain exclusions and deductions otherwise referred to as a preference item. Corporate-owned insurance is subject to the Alternative Minimum Tax. Cash value growth and death benefits that normally would be non-taxable if individually owned, may be taxed inside the corporate shell, thereby reducing the ultimate benefits to the corporation and thus ultimately to the executive/business owner.
What happens when the business is sold? In the event the business owner decides to sell the business, he/she will be relying on the successor management to pay out the promised benefits originally established under the Deferred Compensation Plan. The former business owner will have to assume the risk that the new owners will pay these promised benefits and that the new owners will successfully manage the business in the future in order to have the monies to pay out the promised benefits. Lastly, it may be more difficult to sell the business with a large Deferred Compensation Plan liability hanging over its head.
Can taxable income be made tax-free? All Deferred Compensation benefits are taxable when paid, thus creating a taxable retirement benefit. There are other alternatives to creating tax-free retirement income. Life insurance is one of those methods which would allow the business owner to receive potentially tax-free retirement income without the other risks discussed above.
Deferred Compensation may offer benefits to the business owner such as deferral, but the problems discussed above make such a Plan riskier and possibly less attractive. Therefore, small business owners might be better served to use executive bonus or split-dollar plans for supplemental retirement income. While these plans do not avoid at least some immediate income taxation, they give the business owner more security.