Compensation planning for potential lower tax rates
Although the specific provisions and timing of tax reform remain uncertain, it seems likely that business tax rates will be lower in the future. Given this expectation, prudent planning for employers includes accelerating deductions into periods before the rates will drop, leading to a permanent tax savings from the rate differential. One area that companies should consider now are compensation arrangements. Because compensation leads to income to the individual employees who are also likely to see tax rates lower in the future, deferring income into future periods may also be a strategy worth exploring. The following are some compensation arrangements that employers should consider now to take advantage of the potential rate changes.
Annual bonus policies
Most bonuses are structured to be paid shortly after the employer’s year end. If certain requirements are met, though, those bonuses can be accrued and deducted on the prior year’s tax return. Because individual employees are cash basis taxpayers, this leads to the company deducting the compensation in the year before the employee reports the income. Therefore, a 2017 bonus that meets the requirements to be deducted by the employer in 2017 but is paid in early 2018 will potentially provide the employer with permanent tax savings from receiving the deduction in the period with higher tax rates without harming the employee because it will not be taxed to the employee until the future period. Employers who are not currently taking advantage of deducting their bonuses in the earlier year should consider changes to their annual bonus policy to allow them to take advantage of the deduction in 2017.
Deferred compensation plans
Typically, employees cannot choose to defer income to future periods unless they make an election in the tax year before the income is earned. Therefore, the time has passed for employees to choose to defer 2017 income. In addition, employers that have existing deferred compensation plans are confined by the rules of section 409A that provides restrictions on changing the payment timing from what is provided in the existing written agreement. However, employers that do not currently have any nonqualified deferred compensation agreements may wish to consider implementing new ones in 2017. Any income that has not yet been earned at the time the arrangement is entered can be deferred according to the terms set up in the new plan. In most cases, the employer does not receive a deduction from nonqualified deferred compensation until it is paid so this strategy primarily benefits key employees who would like to defer income into a future period to benefit from lower individual tax rates when they include the compensation in their taxable income.
Defined benefit retirement plans
Now is also a good time for owners of small businesses with the right employee demographics to consider a cash balance pension plan. These plans can allow older employees to defer very large amounts of income to be paid as a retirement benefit in future years. Unlike nonqualified deferred compensation, these are qualified plans so the employer gets a deduction in the year contributions are made to the plan so this strategy can benefit both the employer with a current deduction at the higher rates, while allowing employees to defer income to future years at lower rates. A detailed actuarial analysis is necessary to determine the specific advantages of this type of plan but they are often best suited for small employers with owners that are older than the majority of their employees.
A company’s compensation package for employees has business implications that should be considered in addition to tax consequences. Nonetheless, now is a good time to consider your compensation strategy with your advisors to determine whether impending tax reform can provide additional benefits beyond what may be achieved if the same policies are considered in future years. Compensation plans all have unique tax consequences so an experienced tax advisor should be involved with any changes an employer considers.