Nonqualified deferred compensation agreements.

Small closely held businesses operating as C corporations (not including personal service corporations) often overlook the tax saving benefits of nonqualified deferred compensation arrangements. To determine whether these arrangements are best suited to a C corporation, a CPA must be aware of the corporation's tax rate and the potential future costs of improperly using the low 15% rate (up to $50,000) during the corporation's less profitable or early-development years.

Closely held corporations often minimize their taxes by paying yearend bonuses to shareholder-owners. Although the strategy is time-honored and generally makes sense, when it is done incorrectly the IRS can determine the bonuses are unreasonable compensation, resulting in double taxation. The approach generally is favored because it can lessen the chances for double taxation in other occurrences, such as liquidations and unreasonable accumulations of retained earnings.

By using a nonqualified deferred compensation plan, a C corporation can

* Defer to a future year the actual payout to the shareholder-owners.

* Pay the tax on the deferred amount at the current lowest corporate tax rate (15%). There is no deduction for the deferral until it actually is paid. Likewise, the income is not reportable by the shareholder-owners until it is received.

* Take the deduction in the year the compensation is paid, preferably at a time when the higher corporate rates (25% to 39%) apply.

* Lower the threat of unreasonable compensation.

* Preserve current cash flow.

Generally, the Federal Insurance Contributions Act (FICA) and Medicare taxes must be paid on the deferred amount. However, the amount would include the Medicare tax only if the bonus was paid out after the shareholder-owners reached the FICA limit. FICA and Medicare taxes would not have to be paid when distributions were made from the plan.

To benefit from nonqualified deferred compensation plans, C corporation shareholder-owners should

* Discuss the possibilities and practicality with their tax and accounting advisers.

* Consult an attorney about the legal requirements.

* Determine the formats and types of available plans.

* Project the potential corporate and personal taxes for a reasonable future period.

* Activate the plan when appropriate, but not before the documentation is prepared.

Observations: When considering the use of nonqualified deferred compensation plans, C corporation principals should be aware of the following:

* They are formal written contracts that are negotiated between the corporation and the individual. They set forth the terms and conditions, such as the amounts deferred and the time they are distributed. They always should be approved by the board of directors.

* They do not require approval by any government agency. The plans do not have to meet the discrimination rules qualified plans must meet, and the selections of people for inclusion can be arbitrary.

* These plans generally should be unfunded so they do not tie up money; however, a more conservative approach is to invest the deferred payments to provide for future obligations.

* The total compensation including the deferred portion should generally stay within the boundaries of reasonability.

--Stanley Person, CPA, partner of Person & Co., New York City.