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Play out tax angles on deferred comp

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in Small Business Tax,Small Business Tax Deduction Strategies

As a high-ranking official of your company, if not the top dog, you might want to set up a deferred compensation (“deferred comp”) arrangement so you can defer taxes.

Strategy: Assess the risk if your company is foundering. In a worse-case scenario, you might have to forfeit the deferred comp.

To add insult to injury, a taxpayer in a new case owed FICA tax on deferred comp he never actually received. (Balestra, Ct. Fed. Cl., 5/31/14)

Here’s the whole story: A nonqualified deferred comp plan may supplement other retirements of key employees. Essentially, the employee gives up compensation due for current services. If the plan is structured properly, no tax is due until the employee receives the compensation in the future—usually at retirement. If the employee is in a lower tax bracket at that time, he also reduces the tax in addition to delaying it.

The plan must be “unfunded” to secure these tax benefits, (i.e., the employer can’t set aside funds for the employee in a separate account). Essentially, the employee is relying on the employer’s promise to pay out the money. This could be a problem if the company goes bust.

Furthermore, under a special tax rule, the deferred comp is treated as wages for federal employment tax purposes at the later of the date when services are performed or a substantial risk of forfeiture no longer exists.

New case: A pilot for a prominent airline who retired in 2004 was entitled to nonqualified deferred compensation that would be due on his retirement date.

Under the IRS’ interpretation of the tax law, the full present value of the deferred comp should be counted for FICA tax purposes in the year of his retirement. However, the airline had started bankruptcy proceedings in 2002, two years before the pilot retired. Due to these proceedings, the airline’s obligation to pay the deferred comp to the pilot was discharged, even though he never received most of the money.

The Federal Court of Claims determined that the IRS assessment was valid. Therefore, the pilot isn’t entitled to a refund of the payroll taxes on deferred compensation that he never actually received.  

Tip: A future issue will discuss other deferred comp techniques.

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