Many closely held businesses are structured as pass-through tax entities such as S-corporations or limited liability corporations (LLCs). This allows them to avoid the double taxation inherent in C-corporations, where income is first taxed at the corporate level, then taxed a second time when dividends are paid to owners. However, this structure means that owners of pass-through entities must address a more complex set of issues than C-corporation owners when deciding whether a non-qualified deferred compensation plan (NQDCP) could be of value to their organization.
Like any other business, pass-through entities can use NQDCPs as flexible, creative tools to attract, reward and retain nonowner key employees. Owners can choose who participates in these plans, as well as determine what benefits participants receive and when they receive them. They can also create custom vesting schedules for employer contributions that act as incentives for participants to stay with the organization.
While NQDCPs can provide valuable benefits for key employees, it usually doesn’t make sense for the owners of pass-through entities to participate in a plan. The primary reason is that NQDCP benefits are only tax-deductible when paid, not when contributions are made. Therefore, any money that pass-through entity owners defer into the NQDCP will result in an increase in K-1 income equal to that amount. This can be an even larger problem if there are multiple owners and the amount each one defers is disproportionate to their ownership interest.
Shown below is a summary of key NQDCP considerations for pass-through entity owners:
NQDCPs can be a valuable component of a pass-through entity’s recruiting and retention strategy. Wrightwood can help you analyze key plan design, funding, tax, and accounting issues prior to deciding whether to implement an NQDCP. They can also help you evaluate additional considerations that are specific to how these plans work at a pass-through entity. Please contact Wrightwood to learn how an NQDCP can be structured to be a long-term success for your organization and its most valuable employees.
