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Does it make sense for sub S shareholders to have nonqualified deferre


Guest DMK

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My understanding is that shareholders of a sub S corporation essentially cannot establish a nonqualified deferred compensation plan for just themselves due to the pass-through taxation rules that apply to sub S corporations (i.e., that the shareholders would be currently taxed on the deferred amounts anyway). Can anyone confirm that this is the case?

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Whether it makes sense or not depends upon the relative ownership percentages, retirement income needs and compensation objectives for the shareholder-employees. In aggregate, the deferred compensation is not deductible when earned. It is deducted when paid. Thus, the corporation loses the deduction and all the shareholders pick up more income. However, if the employee who is covered by the deferred compensation plan is something less than a 100 percent shareholder, there may still be value.

In addition, non-elective deferred compensation plans are sometimes established to recognize past, uncompensated service. This creates a liability that reduces the value of the business for purposes of sale to other parties. It also can create a tax-deductible stream to a former shareholder-employee that may be advantageous to the buyer.

So - there are still planning circumstances that may make such arrangements meaningful, even in a pass-through entity.

Caution - remember the FICA exposure when planning such arrangements. It is not just the timing of the income taxes at risk, but the exposure for FICA, etc.

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Guest wmacdonald

I have found that for the large shareholders, it doesn't make since, however there is a trust, that is used for sub S corporations. The trust has a patent, and qualifies under ERISA. The trust would work as follows; the key employee defers $100,000 into the trust, and the corporation takes a deduction. The employee picks up the deferral in income, and deposits the net amount to the trust, i.e $60,000 (assumes 40% tax bracket). The trust, which is owned by the employees, and is outside of creditor reach, borrows $40,000 to make the employee whole. The $100,000 is invested in a life insurance contract that allows mutual fund investments, to avoid tax on the accumulation. When the employee terminates for any reason, the loan is repaid. When you run the math on this concept, it turns out to be better than a normal deferred compensation plan because you have a tax basis.

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Sorry, I don't get it. The employee "defers" $100,000 to the trust but has income of $100,000, which leaves the employee with $60,000 after taxes. Where is the deferral? Then the employee transfers $60,000 to the trust. The trust has $60,000.

The trust borrows $40,000 (from whom?) to make employee whole, which I presume means that the employee trust account has $100,000 ($60,000 from the employee and $40,000 loan proceeds). Where does the trust get money to pay interest on the loan, and later to pay principal of the the loan? From the insurance policy? Seems like that would seriously reduce the return on the policy. Seems like all that is happening is that the employee is getting tax deferral on investment earnings on $60,000 and the net (after loan interest) investment earnings on the $40,000. Seems like that could be done by going directly to the insurance policy without the trust and without any salary deferral.

And the discussion assumes the the scheme works from a regulatory point of view, which I am not even touching.

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Guest wmacdonald

You ask some very good questions. The corporation pays the interest, which is LIBOR plus 1,by making an additional contribution to the trust (grosses executive up etc). Because the trust funds ($100,000 in my example) are wrapped in a insurance contract, the employee gets a deferral of income(like they would using an annuity). Upon retirement, the executive can pull money out of the trust (policy) first from his/her basis etc.

The loan comes from a third party bank. If you run the math, the leverage from this concept produces a attractive return. This is not for everyone, however it does work for sub S and partnerships, which have always been a challenge. Hope this helps.

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Guest Bill Armstrong

Thanks for the responses. Another approach in the Sub S environment, albeit a small niche, seems to be the NIMCRUT. Anyone had any success with this approach?

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Guest BobParks

I am puzzled about the deduction of the interest by the Corporation. If I remember correctly the Corporation deduction must first be an ordinary and necessary business expense. Since an S can not provide "qualified type" benefits for more than 2% shareholders how does the interest expense for "nonqualified type" benefits become ordinary and necessary?

Again if I remember correctly, the income and expenses of an S must conform to the individual taxpayer rules. What type of interest then is the interest on a loan to provide "nonqualified type" benefits to shareholders? Personal, Business, Investment?

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Bob - An S Corporation can provide certain "qualified" benefits to more than 2% shareholders. It is just that the tax attributes of "fringe benefits" are limited to the attributes for self-employed persons (partners), not common-law employees. See IRC Section 1372.

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Guest BobParks

Hi Becky,

There does not seem to be a phrase that describes things so I used "qualified type".

If the S Corporation could not deduct NQDC benefits, is the interest on these benefits deductible?

Doesn't the Corporation deduction have to fit into one of the types of interest classifications for the shareholders personal tax filings?

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The interest is not deductable. Page one of the wall street journal 2-21-2001 relates the finding of the Federal court in Ohio whereby the IRS attacked such an insurance arrangement and won against American Electric Power. The judge called the whole thing "a sham in substance".

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Guest wmacdonald

Under the concept that I discribed, the "interest" payments are made to the trust, and taxed to the employee. You then go through the gross up etc. This concept, if you look at the numbers is a good way for someone to accumulate a retirement fund etc.

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Guest wmacdonald
Originally posted by alanm

The interest is not deductable. Page one of the wall street journal 2-21-2001 relates the finding of the Federal court in Ohio whereby the IRS  attacked such an insurance arrangement and won against American Electric Power. The judge called the whole thing "a sham in substance".  

The American Electric Power case was leveraged COLI. The IRS is currently winning these cases, I knew it would only be a matter of time. I never thought they were good ways of funding benefits etc. The concept I discribed is not this arrangement.
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Guest BobParks

Hello Bill,

My confusion continues.

How do we "gross up" an S corporation shareholder?

Thanks

Bob

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