Closely held C corporations: using deferred compensation to capture the 15% bracket.

• Author: Duran, Michael W.

Ccorporations not classified as personal service corporations enjoy a low 15% bracket on the first $50,000 of taxable income. Compared to a shareholder-employee in the 28% bracket or higher, this rate results in a significant current savings on income retained by the corporation. This current savings, however, comes at a substantial future cost in the form of double taxation on the retained income, either through liquidating distributions, dividends or possible IRS attack on accumulated earnings. To avoid this future double taxation, many closely held C corporations routinely opt to forgo the current benefit of the 15% bracket and engage in that time-honored ritual of annually bonusing-out the corporation's profit.

While this traditional bonusing-out approach is effective in preventing double taxation, it can result in a significantly greater current outlay for Federal taxes, thus straining the corporation's year-end cash flow. Recent developments in the area of deferred compensation draw attention to an alternative strategy that may allow the corporation to benefit currently from the low 15% bracket while preserving the retained income for future deductible payout.

The basic strategy is simple: rather than pay out the year-end bonus to obtain a current deduction, the bonus is deferred for future payout under a deferred compensation agreement between the corporation and the shareholder-employee. Properly implemented, this simple strategy will not only spare the corporation a heavy immediate payroll tax liability, but may also reduce the overall tax liability on the income.

The following example illustrates the potential benefits of the deferred-bonus strategy.

Example: CHC corporation has a fiscal year-end of April 30. Xis CHC's sole share-holder and principal executive. Just prior to year-end, CHC and its advisers project taxable income for the year to range from $40,000 to $50,000. To avoid future double taxation of this income, CHC will pay a $40,000 year-end bonus to X (any remaining profit will be eliminated through a modest profit-sharing contribution).

For the bonus to be deducted by CHC this year, Sec. 267(a) (2) requires that it be immediately taxable to X. Accordingly, the bonus is included in CHC's April payroll and, under Section 13273 of the Revenue Reconciliation Act of 1993, Federal income tax withholding on the bonus is fixed at 28%, or $11,200. In addition, because CHC's year-end falls early in the calendar year, X's...