[The following article, written by Michael W. Duran, CPA, was published in the April 1996 edition of The Tax Advisor magazine. The Tax Advisor is the tax journal of the American Institute of Certified Public Accountants. The article has not been updated for any tax law changes since its publication.]
Closely held C corporations: using deferred compensation to capture the 15% bracket.
Author:Duran, Michael W. Date:Apr 1, 1996 Words:1145 Publication:The Tax Adviser ISSN:0039-9957
C corporations not classified as personal service corporations enjoy a low 15% bracket on the first $50,000 of taxable income. Compared to a shareholder-employee in the 28% bracket or higher, this rate results in a significant current savings on income retained by the corporation. This current savings, however, comes at a substantial future cost in the form of double taxation on the retained income, either through liquidating distributions, dividends or possible IRS attack on accumulated earnings. To avoid this future double taxation, many closely held C corporations routinely opt to forgo the current benefit of the 15% bracket and engage in that time-honored ritual of annually bonusing-out the corporation's profit.
While this traditional bonusing-out approach is effective in preventing double taxation, it can result in a significantly greater current outlay for Federal taxes, thus straining the corporation's year-end cash flow. Recent developments in the area of deferred compensation draw attention to an alternative strategy that may allow the corporation to benefit currently from the low 15% bracket while preserving the retained income for future deductible payout.
The basic strategy is simple: rather than pay out the year-end bonus to obtain a current deduction, the bonus is deferred for future payout under a deferred compensation agreement between the corporation and the shareholder-employee. Properly implemented, this simple strategy will not only spare the corporation a heavy immediate payroll tax liability, but may also reduce the overall tax liability on the income.
The following example illustrates the potential benefits of the deferred-bonus strategy.
Example: CHC corporation has a fiscal year-end of April 30. Xis CHC's sole share-holder and principal executive. Just prior to year-end, CHC and its advisers project taxable income for the year to range from $40,000 to $50,000. To avoid future double taxation of this income, CHC will pay a $40,000 year-end bonus to X (any remaining profit will be eliminated through a modest profit-sharing contribution).
For the bonus to be deducted by CHC this year, Sec. 267(a) (2) requires that it be immediately taxable to X. Accordingly, the bonus is included in CHC's April payroll and, under Section 13273 of the Revenue Reconciliation Act of 1993, Federal income tax withholding on the bonus is fixed at 28%, or $11,200. In addition, because CHC's year-end falls early in the calendar year, X's regular salary is still well under the Social Security maximum ($62,700 for 1996) and a full 15.3% in FICA taxes, or $6,120, is also due. The total current Federal tax outlay on the bonus is 43.3%, or $17,320.
Alternatively, under an existing deferred compensation agreement between X and CHC, X elects to defer the year-end bonus for payout in a future year. As a result, the bonus is not currently taxable to X and CHC will therefore pay Federal tax of 15% on the $40,000, or $6,000. FICA taxes will also be due on the bonus despite its deferral for income tax purposes (Sec. 3121(v) (2). However, Prop. Regs. Sec. 31.3121(v) (2)-1(e) (5) provides CHC with considerable flexibility in deciding when the bonus may be "taken into account" for FICA tax purposes. Accordingly, CHC chooses to treat the bonus as being paid in December, when X's regular salary will exceed the Social Security tax wage base. This reduces FICA tax on the bonus to the 2.9% Medicare tax, or $1,160 (although $4,960 more in FICA tax must now be paid on regular wages).
As a result of deferring X's bonus, CHC reduces its year-end Federal tax outlay by $11,320 ($17,320 - $6,000) and both defers and lessens the FICA tax impact of the bonus. In addition, there will be no further FICA tax on the deferred compensation when eventually paid to X, and this includes the payout of any accrued interest on the deferral (Sec. 3121(v) (2) (B)).
In implementing this deferred bonus strategy, the following guidelines should be followed:
* Reasonable compensation: The deferred bonus, when added to the shareholder-employee's regular salary, must represent reasonable compensation. Presumably, this analysis has already been made in paying out taxable bonuses, but the adoption of a formal deferred compensation agreement presents a good opportunity to review this area and guard against any IRS challenge.
* Documentation: The deferred compensation agreement should be in written form and formally adopted by board resolution. There should also be a separate election form on which the shareholder makes the annual election to defer any year-end bonus. The agreement and election statement may be concise, but should clearly spell out the terms for both deferral and eventual payout of the compensation. This presents an opportune time to review this strategy with the corporation's attorney to examine any nontax benefits or detriments of adopting the plan.
* Constructive receipt: Particularly in the context of a closely held corporation, the issue of constructive receipt is a predictable IRS challenge. It is therefore essential that the deferred compensation agreement, and the shareholder-employee's annual election, be signed before the related services are rendered and the amount of the bonus is ascertainable. Also, the right to receive the deferred compensation should be nontransferable and the plans should be unfunded (i.e., while it is prudent for the corporation to set aside and invest funds as necessary to meet its long-term obligations, any such accumulations must remain subject to the corporation's general creditors). Finally, it is critical that both the corporation and the shareholder-employee fully comply with the conditions and terms of the deferred compensation agreement. Accordingly, the terms for eventual payout should be carefully considered and strictly followed.
* ERISA compliance: Falling outside the often burdensome compliance requirements of ERISA may be critical to the decision to adopt a deferred compensation agreement. The type of arrangement contemplated above involves an individually negotiated and unfunded agreement(s) between the corporation and one or more of its employees. This contrasts with a true plan covering a particular class of employees and, therefore, falls outside the purview of ERISA and its compliance requirements.
Note: For a more detailed discussion of ERISA compliance issues as well as a through review of the deferred compensation area in general, see Altieri and Kirch, "Nonqualified Deferred Compensation Agreements," The Tax Adviser (Aug. 1995), p. 502, and "Nonqualified Plans Can Avoid Limits on Deferred Comp.," Taxation for Accountants (May 1995), p. 266.
The area of deferred compensation offers the tax adviser room for creativity in developing cost-effective and tax-wise strategies for his clients. For closely held corporations that routinely forgo the current benefit of the low 15% bracket in favor of paying out a currently taxable bonus to avoid future double taxation, a simple deferred compensation agreement may not only accomplish the same goal with considerably less strain on the company's year-end cash flow, but also reduce the overall taxes payable on the income.
COPYRIGHT 1996 American Institute of CPA's
Copyright 1996, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.