A deferred compensation plan is an arrangement whereby an employee or owner defers some potion of their current income until a specified future date. Wages earned in one period are actually paid at a later date.

Life insurance can be used to fund a deferred compensation plan. The deferred amounts can be used to pay premiums on cash value life insurance. The cash value can then be available at retirement to supplement other income or, if the insured dies before retirement, the insured’s designated beneficiary would receive the insurance policy’s death benefit.

There are both qualified and nonqualified deferred compensation plans.

A qualified plan receives certain tax preferences under the Internal Revenue Code:

• the employer is entitled to a tax deduction for the amounts contributed to the plan;

• the benefits grow on a tax deferred basis until they are actually paid under the plan; and,

• distributions are generally eligible for rollover to an IRA or other qualified plan, thereby permitting further tax deferral.

Note: Employers should have an IRS ruling regarding the tax status of a qualified plan.

The disadvantages of a qualified plan include:

• nondiscrimination requirements prohibits an employer from providing benefits for highly compensated employees to the exclusion of other employees

• the amount of the employer’s contributions are limited

• regular reporting requirements

A nonqualified plan does not receive favorable tax treatment:

• the employer is not entitled to tax deductions until such time as the benefits are actually paid to the employee

• under the doctrine of constructive receipt the benefits are taxable to the employee at such time as the employee has the right to receive the benefits without regard to when the benefits are actually paid. The taxpayer does not actually have to take possession of the funds.

The advantages of a nonqualified plan are:

• the employer can pick and chose among the recipient employees without regard to years of service, salary level or any other criteria

• allows a business to provide benefits to officers, executives and other highly paid employees

• the amount of the employer’s contributions are not limited

• a nonqualified plan is less expensive to set-up than a qualified plan

• there are no significant filing or reporting requirements

Note: There are special timing rules related to FICA taxes and income taxes.

Other forms of funding deferred qualification plans include a “Rabbi Trust”, named because first IRS approved arrangement of this type was set up for a rabbi by his congregation, which involves an irrevocable grantor trust but subjects the trust assets to claims by the employer’s creditors; a “Taxable Trust”, which is protected from the employer’s creditors but taxes are paid on the income a the time the deferred contributions are made; and, bonds which allow the employer to coordinate the retirement with the maturity dates of the bonds.

Any agreements and insurance policies within a business must be integrated with the overall plan and objectives of the business. Careful consideration must be given to the selection of the plan which is right for your business and to the method of funding your plan.