Bigger Tax Bill Around the Corner – Business Owners Should Consider Deferred Comp

I had a client retire last year from a business that he bought 30 years ago. As many business owners do, he worried about how he would replace the cash flow from his business. Fortunately for him, he had funded his 401k, and he was able to pick up a large lump sum from the sale of his shares in the business. But his biggest source of income for the next stage of his life came from a Non-Qualified Deferred Comp (NQDC) program that his CPA recommended 15 years previously. This portion was to pay him $300,000 per year for the next 20 years.

As you can imagine, this made his CPA look like a genius. It also helped him defer a chunk of his income and the taxes associated with it for 15 years. Is this strategy appropriate for all business owners? Not necessarily, but many should explore the option. Deferred Comp comes in different styles and may not be suited for everyone.

Many different types of industries can adopt NQDC programs, but if you are a business owner they are most suitable for C corporations. In S corporations or unincorporated entities, business owners generally cannot defer taxes on their shares of the business income but can set up NQDC plans for their employees.

Qualified plans such as 401(k)s and SEPs have limitations set by the government. NQDC has no limit to the amount of income deferred. These plans are also easier and less expensive to maintain than qualified plans and can even be offered on a discriminatory basis. The business owner also has the flexibility to control the timing and receipt of benefits.

These plans are great tools for the business owner who would like to transfer their business to their children one day. The business owner’s children may not be able to pay their parents for the business, but the NQDC plan can give the owner that income stream to allow for an easier transfer.

These plans can have their drawbacks. If a plan is “unfunded” or informally funded it means that the employer has not officially set aside money to cover plan benefits. As a business owner your NQDC assets could be subject to creditors.

Plans can be “funded” to help protect the security of the assets with the use of trusts and/or life insurance. Funding can change the aspect of the taxation and vesting requirements and may subject the plan to ERISA requirements.

These plans may be a great way to defer income to a later time or help fund a business transfer to the next generation as the plan has been set up correctly. To ensure the plan is set up correctly, make sure to get good advice.