If you are a business owner, and are starting to think about transitioning the business to a younger generation, you might want to consider whether a deferred compensation agreement would help you attain your goals.
Basically, a deferred compensation agreement is based upon the belief that a certain key employee is worth more to the company than the amount of their current compensation, and therefore the company agrees that in exchange for continued employment (at the under-valued compensation level), the company will continue to pay the employee a defined amount over an extended period of time, after the employee retires, or in the event of death or disability.
Deferred compensation is taxable as ordinary income to the employee and deductible by the employer when it is paid out (not when it is accrued). It may not be secured, so an employee who is nervous about the employer’s ability to pay, may not be too happy about that. There are methods of “informal” security, often involving a life insurance policy, which can be used.
There is a section of the tax code (409A) that governs deferred compensation plans, and provides penalties for non-compliance. Care should be taken to make sure that your plan conforms to the many requirements. This is not an area where you want to Do It Yourself. For example of some of the requirements.
Payments must not be under the control of the employee. They may be made only in the event of the following events:
• separation from service;
• change in control of the employer;
• a defined unforeseeable emergency;
• or a fixed dated defined in the plan.
Payments may not be accelerated.
Plans must be in writing and notice of the plan must be filed with the Department of Labor. There are severe penalties for plans that fail to meet the requirements.
If you think a deferred compensation plan might be interesting to you, I’d be happy to discuss it with you.