A non-qualified deferred compensation plan is an effective compensation planning tool for business owners to reward key employees and themselves.
Two important requirements must be met for non-qualified deferred compensation to qualify for income tax deferral. First, the employee must formally elect to defer the compensation before services are performed and the income earned. The employee defers the earned income until the earlier of retirement or separation from employment. The employee has the unfettered right to take their deferred income at their discretion in the future, at which time it will be taxed as earned income and the employer can take a corresponding business expense deduction.
Secondly, there must be a substantial risk of forfeiture of the deferred income to the employee; there cannot be a guarantee or certainty of payment. If the deferred comp plan is unfunded by the employer, then by definition no employee income is recognized until received. If the plan is funded, then the employee’s right to receive or transfer deferred income cannot be guaranteed or it is considered constructively received and taxable.
The plan should be geared towards highly compensation employees to steer clear of federal pension regulation of the plan and allow discrimination of plan benefits in favor of the owner and key employees.
If the employer wants to informally fund the plan to reserve for future employee cash payouts, cash value life insurance is often the best investment choice since earning/growth inside the insurance policy would not be taxed to the employer during the deferral phase.
We have the expertise to help employers design the right deferred comp plan for your business and to help employees eligible for a deferred comp plan make the right income deferral planning decision.
