Not every business can afford to reward key employees with the largess of a Tyco or Enron. Yet rewarding key employees is very much a fact of life for many small business owners. Since planes, homes, boats, and forgiven loans are beyond the reach of most small business owners, a simple deferred compensation plan can do the job.

The tax code provides that compensation to an employee be considered taxable income to the employee and a tax-deductible expense to the corporation. Unfortunately, the code does not allow a business owner to defer compensation in such a manner that the employer can get a tax deduction while the employee escapes taxes.

If the employee has any rights of ownership, the employee is said to have constructive receipt, which in turn triggers income taxation. Therefore employers who set up deferred compensation plans must fund the plans with after-tax dollars. The employee has no ownership interest until the deferred compensation is paid, at which time the employee is taxed for the income received and the employer receives a corresponding tax deduction.

These plans can be used to provide supplemental retirement benefits and as a tool to provide extra rewards to key employees. Most commonly, a life insurance policy is used as a repository for the money.

Because these plans are not subject to the ERISA restrictions of most qualified pension and profit-sharing plans, the deferred compensation plan allows businesses to design a truly individualized plan to meet very specific compensation goals.

The plan starts with the employee agreeing to defer a percentage of his or her pre-tax salary or bonus. In return, the employer provides a supplemental disability or retirement income for the executive and his or her family.

Depending upon the specific goals and time horizon of the executive and the employer, the employer uses the executive’s deferred compensation money to purchase and pay premiums on a cash value life insurance policy for the executive.

The employer is the owner of the policy and names itself as the beneficiary. The executive is the insured.

The life insurance policy provides a tax-free death benefit to the employer as well as accumulates a tax-deferred cash account. Premium payments made by the employer are not tax deductible. At this time the cash value remains an asset of the corporation.

When the executive retires, becomes disabled, or at another specified date, he or she may begin receiving the deferred compensation from the employer. This payout is taxable income to the employee and represents a tax-deductible expense to the employer.

Upon the death of the employee, his or her heirs will receive a taxable income or a taxable lump sum depending upon the design of the plan.

The advantages of such a plan to the employer are that there are few ERISA requirements, it can be provided for select employees, and it can be used as a tool for recruiting and retaining key employees. The advantages to the employee are that deferred comp plans are not subject to qualified plan deposit restrictions, the money can be used to supplement other retirement income sources, and the income accumulates tax deferred until withdrawn.

Most important of all…such a plan will not make headlines on a police blotter!

Bruce Fenton is a financial consultant, a writer, and the president and founder of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.