Question: I am planning to retire and give stock in my business to my children in the next few years. While I am not expecting any payments in return, I want to continue my salary following my retirement. Can the business continue to pay salary to me after I retire?
Answer: If you retire and are no longer rendering services for your company, you cannot continue to receive a salary. If a tax audit occurs, the IRS will not respect the salary payments to you and will recharacterize your continuing payments from the company as a dividend or gift, neither of which is likely a desirable consequence. You should instead consider having the company adopt a non-qualified deferred compensation plan so you can continue to receive post-retirement payments from the company in a tax-effective manner.
Non-qualified deferred compensations plans can be adopted by a company to provide continuing payments to or on behalf of employees upon retirement or other employment termination such as death or disability. These plans are similar to conventional qualified retirement plans such as 401(k) plans and other pension and profit sharing plans which are intended to provide a source of income to workers during retirement. Qualified retirement plans must offer participation to a fair cross section of the company’s employees and may not discriminate in favor of owners or highly-compensated employees. Non-qualified deferred compensation plans, on the other hand, can be offered on a selective basis to any one or more employees without regard to ownership or level of compensation. Unlike qualified retirement plans where funds must be held in a segregated trust, non-qualified deferred compensation plans typically are not funded and participants are paid directly from the company upon employment termination. The tax treatment is perhaps the most striking difference as an employer maintaining a qualified retirement plan is entitled to a tax deduction when plan contributions are paid to a segregated trust and plan participants are not taxed on the segregated funds until they receive payments upon retirement or other employment termination. This favorable tax treatment is unavailable to nonqualified retirement plan sponsors which can only receive tax deductions when amounts are paid to the participants, whether upon retirement or another payment event.
One significant tax benefit for nonqualified plan sponsors and participants lies in the manner in which plan payments are subject to payroll taxes. Pursuant to a special timing rule, both the sponsoring employer and the participating employee are taxed on deferred compensation benefits when the benefits are promised, not when payments are actually received. While at first blush, the accelerated payroll tax reporting would seem to be disadvantageous, the opportunity to report payroll taxes at an earlier time usually represents an overall tax benefit to both the employer and the plan participant, particularly a participant who earn more than the Social Security wage base. Consider the following example:
ABC Company adopts a non-qualified deferred compensation plan in 2020 for its sole owner, Barry, who earns $150,000 per year in salary. The plan promises Barry a benefit of $100,000 per year for ten years beginning in the 2022 calendar year when Barry will retire. Without the special timing rule, both Barry and ABC Company would report and pay payroll taxes on the $100,000 of deferred compensation payments each year when payments are made. At 2020 tax rates, this means that the full $100,000 will be taxable for payroll tax purposes at the 7.65% rate resulting in annual payroll taxes of $7,650 imposed on both Barry and ABC Company. Over a ten-year period, Barry and ABC Company will collectively pay in excess of $150,000 in payroll taxes on the deferred compensation. Pursuant to the special timing rule, however, Barry and ABC Company will each pay approximately $11,000 in payroll taxes in the year the plan is adopted with no payroll tax imposition in the future. This tax savings results because salary payments are taxed to both the employer and the employee at the 7.65% rate, up to the Social Security wage base ($137,700 in 2020), with additional salary payments taxed to both the employer and the employee at the 1.45% rate. The upfront tax cost incurred in 2020 is more than offset by the tax savings that are realized when the deferred compensation payments are made.
To qualify for the special timing rule, the plan must be adopted at least one year prior to the time deferred compensation payments begin. An appropriate plan document should be created to set forth the company’s obligations to the employee. With proper planning, you can gift your stock to your children and continue to receive a salary taxable in a favorable tax manner through a deferred compensation plan.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to Bruce Bell.