Special Retirement Benefits For S Corp Owners And Executives

For the S corporation owner

As discussed, S corporation owners have to pay tax on the company’s earnings even if they don’t distribute the earnings to themselves. For this reason, traditional tax savings solutions, such as deferred compensation, won’t work for S corp owners. It makes no sense for them to defer taxes on their own wages and then pay income taxes on those same dollars as S corporation earnings.

An attractive pre-tax solution for an S corporation owner is a qualified plan. The contribution is deductible but not currently taxed to the owner. However, because they are for employees in general, the plans impose limits on both who must be covered and for how much.

Further, these are tax-deferred plans, not tax-free plans. The trade-off for a current tax deferral is paying tax on the accumulated amount (at ordinary income tax rates) during retirement. In essence, a qualified plan is a box the owner can fill up with deductions. Once the box is full, it’s time to think outside the box to see what other benefits are available. The S owner bonus plan may be such a benefit. (See chart.)

Like the executive bonus plan proposed above for executives, an S owner bonus plan can be a tax-effective retirement and death benefit strategy. With this plan, the business pays for a personally owned contract or policy.

Typically, the vehicle would be a permanent life insurance policy, funded at a high premium level. This would provide both death and retirement benefits on a tax-efficient basis. The premium on the policy is either taxed as compensation (W-2) or as an S corporation dividend (K-1).

The advantage of characterizing the premium as a dividend is that it is not subject to employment taxes such as Medicare. Keep in mind, however, that if there are multiple owners, the premium must be part of the allocable share of dividends to all the owners.

Either way, the S corp owner pays income tax on the premium. Assuming the policy is not a modified endowment contract, the cash values will grow tax-deferred and can be paid out tax-free. If the owner dies, the death benefits are income tax-free. If the owner retires, he or she can take tax-free withdrawals up to basis and then switch to loans against the cash value.

Consider the advantages of this plan to the S corporation owner.

o The plan offers income tax diversification. With a qualified plan, contributions are tax-deferred but taxable in full in the future. With the S owner bonus plan, using a permanent life insurance policy, the premium is taxed currently but avoids tax on growth in the future. It’s like paying tax on the seed but not on the harvest.

o The plan can be self-completing if life insurance is the chosen funding vehicle. Depending on the policy used, the premium may be waived in the event of disability. If the S corp owner retires, cash values may be available for retirement income. And, of course, when the owner dies, a death benefit would be paid.

o The S owner bonus plus plan involves distributed profit. The policy is an individually owned asset, unencumbered by the business.