A fringe benefit primer for the closely held C corporation.

• Author: Altieri, Mark P.
• Position: Part 1

EXECUTIVE SUMMARY

* There are many situations in which payment of additional salary and bonus to a key employee is warranted; the employee and tax adviser should carefully analyze the possibilities.

* Interest-free loans may be used in the compensatory context, despite restrictions and imputed interest under Sec. 7872.

* An employer-provided health plan can benefit both an employer and employee when premiums are deductible and proceeds are nontaxable.

This two-part article surveys basic techniques for selectively compensating key employees of closely held C corporations on a tax-favored basis, and the benefits and pitfalls of such strategies. Part I examines salaries and bonuses, interest-free loans and health and disability insurance.

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A tax adviser to a closely held business should attempt to structure compensation and benefits packages that achieve favorable tax results for both the business and the affected employee. Certain employee benefits (generally, those specifically provided by statute) are excludible from an employee's gross income, while being fully deductible by the corporation when paid or accrued. Otherwise, the benefits should be arranged so as to create a "tax wash" between the company and the employee (i.e., if a benefited employee must include all or part of a benefit in gross income, the company should receive a full deduction when it pays or accrues the cost). The tax adviser should avoid circumstances in which a benefit program could result in full inclusion in an employee's income, with no offsetting deduction by the company (e.g., an actual or constructive dividend).

This article surveys the techniques for selectively compensating key employees of closely held C corporations on a tax-favored basis and the benefits and pitfalls. The methods are designed to help the shareholder-key employee satisfy his or her desire for benefits not granted proportionately or equivalently to other employees. Only methods of compensating key employees not subject to statutory nondiscrimination rules (or subject to less restrictive rules) are discussed. (1) Part I, below, examines salaries and bonuses, interest-free loans and health and disability insurance. Part II, in the November 2004 issue, will discuss group life insurance, split-dollar life insurance and nonqualified deferred compensation.

Certain of the benefits are not generally available (or sensible) for conduit entities, such as S corporations and partnerships. For example, a partnership would not need to deduct compensation to partners, as distributive shares have essentially the same effect. Similarly, S corporations are well known for undercompensating shareholder-employees, so as to avoid Social Security and payroll taxes. Nonqualified deferred-compensation arrangements generally make little sense for the owners of S corporations and partnerships--any income retained by the entity to informally fund a deferred obligation will flow through and be taxed to owners currently.

Current Compensation

The ultimate way to benefit a key employee in a closely held C corporation is to provide him or her with additional current compensation, through increased salary and/or a bonus. For income tax purposes, however, this technique generally only results in a tax wash, because the employee must include the full amount in income, with the company getting a corresponding deduction (to the extent the reasonable compensation test, discussed below, is met). It also results in additional employment and payroll taxes.

However, many situations can dictate payment of additional compensation to a key employee. For example, the employee may have net operating losses (NOLs), tax credits or charitable deductions that could absorb additional income. Or, the employee may have incurred unusually high deductible losses or expenses for the tax year in question that, because of the Sec. 172(d) limits on NOLs, cannot be carried over to other years.

If the only question is whether to receive additional taxable compensation currently or defer it, the employee and his or her tax adviser should closely analyze the possibilities. They should determine whether the employee would be in a better position on an after-tax basis if the proposed amounts were currently received and the after-tax proceeds invested, or deferred through a nonqualified deferral arrangement (discussed below). Any advice to defer or currently receive additional compensation should take into account factors such as the employee's age, marital status, attitude toward retirement planning and his or her ability to make constructive use of additional current compensation. (2)

The effects of the corporation's wealth retention, in lieu of paying additional compensation, should also be considered. The use of a C corporation employer as an income-splitting tool should not be overlooked in cases in which the business expects to generate a small amount of income. If the entity is not a professional corporation (subject to flat 35% tax) and is not at risk for incurring the Sec. 531 accumulated earnings tax, it should consider the benefit of retaining wealth in a low marginally taxed C corporation owned by a high marginally taxed shareholder-employee. Although the lower-taxed corporate retained earnings may someday be subject to double taxation, the present-value...