31. Deferred Compensation

A Deferred Compensation Plan permits a highly compensated employee to defer a part of his or her income until retirement. This deferral allows the employee to receive the compensation when he or she is in a lower tax bracket and, thus, permits the employee to actually keep more of his or her income.

A Deferred Compensation Plan is a contractual arrangement between an employee and an employer in which the employer agrees to defer either a portion of the employee's current income or an upcoming increase. The employee usually receives this deferred amount in monthly payments after retirement for an agreed upon period of time. A Deferred Compensation Plan generally provides that if the employee dies before receiving the full amount of his or her benefits, the remaining amount will be paid to the employee's beneficiary or estate. Most plans also include provisions for pre-retirement death benefit, and benefits to be paid if the employee becomes permanently and totally disabled.

A Deferred Compensation Plan is attractive for several reasons. First, the plan will aid in recruiting and retaining highly qualified, productive, key employees by permitting these employees to build up an additional source of retirement funds without adverse tax consequences. This is especially important in a relatively small company that leans heavily upon the talents of a few executives. Additionally, many plans provide that an employee forfeits all future benefit payments by voluntarily leaving that employer or by working for a competing company after retirement. Since the employee will lose all plan benefits leaving the employer, he or she will be more likely to remain with that employer.

A second attractive point is that a Deferred Compensation Plan may discriminate among the employees. The employer chooses which employees will participate in the plan and varies the amounts of compensation to be deferred among the participating employees. A Deferred Compensation Plan is also relatively easy to administer since it is not subject to nearly as many ERISA requirements as is a qualified plan that must cover all employees.

Thirdly, since the employer is usually the owner and beneficiary to any insurance policies purchased in connection with these plans, the employer may borrow against the cash values of the policies to meet business emergencies.

An ideal way for the employer to accumulate the funds needed to meet the obligations of a Deferred Compensation Plan is to purchase a life insurance policy on each employee involved in the plan. When deferred compensation benefits become payable to the employee, the employer can either pay the benefits out of available cash and be reimbursed by the death benefit at the employee's death, or the employer can borrow against the policy's cash value to meet it's obligations to the employee. By informally funding the plan with life insurance, the company is assured of completely recovering its costs, even where the employee dies or becomes disabled prior to retirement. Insurance assures that a guaranteed amount of income tax free death benefit will be paid to the company, and it also provides a method for the company to accumulate cash without becoming subject to the accumulated earnings tax.

TAX CONSEQUENCES OF A DEFERRED COMPENSATION PLAN UTILIZING LIFE INSURANCE

TO THE CORPORATION:

The employer does not receive a tax deduction for the premiums paid on the life insurance policies since the corporation is the beneficiary of those policies. The employer does receive an income tax deduction for an ordinary and necessary business expense in the years that the deferred compensation benefits are paid out to an employee. If the employer chooses to totally surrender the policy, the difference between the cash received and the premiums paid by the employer is taxed as ordinary income. If the employer does not surrender the policy, but rather keeps it in force, the employer receives the death benefit income tax free at the employee's death.

TO THE EMPLOYEE:

As long as the employee has no "incidents of ownership" in the life insurance policy, he or she receives no taxable income prior to retirement. After retirement, the employee is taxed on the deferred compensation benefits as they are received, at ordinary income rates.

Should the employee die before receiving the full amount of benefits, the remaining amount is usually paid to the employee's heirs. Any benefits paid to the employee's heirs or surviving spouse are taxed at ordinary income rates. Additionally, where the employee dies before receiving his or her full benefit amount, the present value of the benefits remaining to be paid is included in the employee's gross estate for the purpose of calculating the estate tax.

Tax reference verification 1-800-829-1040

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