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How to Insure Your Income: Chapter 9 - Tax Issues

Because deferred compensation plans work primarily as a device for avoiding taxes, the IRS plays a bigger role here than it does in a simple insurance arrangement.

Taxation of deferred compensation involves four categories of tax liability:

  • income tax to the employee;
  • income tax to the corporation;
  • federal estate taxation;
  • other tax considerations.

The first two of these categories are the most important.

Employee income tax is generally not a consideration during the period of time that the income is deferred. An actual salary reduction plan whereby you defer receipt of current income usually results in no current federal tax liability.

Benefits received as a result of the disability of the key executive also are subject to ordinary income tax as received.

If benefits are received due to the death of the employee prior to retirement, part of the benefit will not be taxable and part will be taxable. The first $5,000 of benefits paid may be excluded from taxation to the beneficiary, provided the deceased had a substantial risk of forfeiture per the deferred compensation agreement.

Amounts received in excess of $5,000 are taxable to the beneficiary as receipt earned compensation. (This is different from the money paid under a life insurance contract -- which is not taxable.)

The corporate tax liability is somewhat different than the individual situation. Generally, the corporation will receive a tax deduction for the deferred compensation amount paid to the employee at retirement, disability or death. To achieve this deduction, the deferred compensation plan must represent a reasonable amount and must serve a legitimate or valid business purpose.

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