A partnership or LLC, for tax purposes, is essentially a conduit through which the income and deductions of the business flow directly to the owners. Income tax is imposed on each individual owner’s distributive share of the business’ income at the tax rate payable by each owner as an individual. The key point to note is that income tax is imposed whether or not that share is, in fact, distributed by the business to the owner.
The general taxation of partnerships or LLCs results in the absence of the tax deferral for owners, which is a major reason for the deferral of compensation. To summarize:
- No deduction is allowed to the partnership or LLC for any premiums paid on life insurance used to finance the nonqualified deferred compensation plan (the partnership or LLC is the beneficiary of the policy, and therefore, deductions are not allowed under Code section 264(a)).
- Amounts used to pay premiums remain part of the taxable income of the partnership or LLC, since they cannot be deducted by the partnership or LLC. This means that amounts used to pay premiums will be currently taxable to the owners. Each owner will pay, at his or her personal tax rate, tax on those amounts divided between the owners according to his or her distributive share.77 As a result, a deferred compensation plan makes little sense for owners, with the possible exception of minority owners (employer contributions used to fund the plan may exceed what the minority owners would otherwise be entitled to receive via their distributive share, and the tax brunt is born primarily by the majority owners). However, a deferred compensation plan may make sense for nonowner key employees of a partnership or LLC.
- Because the character of items of income is carried through from the partnership or LLC to its owners, when tax free life insurance proceeds are received by the partnership or LLC, it remains income tax free to the owners.
- A reduction in basis must be made by each owner for the amount of the (undistributed) premiums paid. Total premiums paid each year are allocated to each owner according to his or her distributive share.
- Each owner’s adjusted basis is increased when the partnership or LLC tax conduit distributes those life insurance proceeds.
To learn more about nonqualified deferred compensation’s visit here.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM