Is your business highly profitable and certain key employees are making a large salary, which causes them to be paying taxes at high tax rates, and they don’t currently need all that you are paying them to live on?
Here is a simple idea to consider. A deferred compensation arrangement. One of the popular and simple solutions is called a “Rabbi Trust.” The basic idea of any deferred compensation is to earn the money when in a high tax bracket, but not report the income until future years when that person is in a lower tax bracket, say when they retire?
If a nonqualified deferred compensation plan is “funded” (i.e., the funds are earmarked for the employee and aren’t subject to risk of forfeiture), the dollars set aside for the employee are taxed in the year they are earned. (Which defeats the main purpose of a deferred compensation plan if you ask me.) To get around that problem, the employer must make the plan to be “unfunded.” Unfortunately, that means the employee must rely on the mere promise that they will receive the funds. Now the employee doesn’t pay tax until they receive the funds in future years, but they risk getting nothing if the employer runs into financial troubles and can’t keep their promise to pay the future deferred compensation.
A ”Rabbi Trust” is the solution to having a nonqualified (unofficial) plan where the money is set aside, and the employee doesn’t pay tax until future years when they are in a lower tax bracket.
By the way, such a trust has nothing to do with religion, it’s just the name that stuck when the IRS granted this arrangement to a rabbi of a congregation many years ago.
The rabbi trust must be irrevocable and in writing. That means the employer cannot take back the funds, nor can they change any of the trust terms. It is important to know that using such a nonqualified rabbi trust, leaves the funds in that trust subject to the employer’s creditors should that employer get into financial trouble.
One final matter which might be a deal breaker to the employer. Using such an unqualified plan means the employer does NOT get a deduction in the year they put money into the rabbi trust. They must wait until they pay the deferred compensation before they can get a tax deduction.
Perhaps, at the start of a new year, this would be a good topic to sit down with your highly paid employees and discuss?
Have you heard? Psalms 16:6 says, “The lines have fallen to me in pleasant places. Yes, I have a good inheritance.”