What is deferred compensation?

Deferred compensation is an arrangement where a portion of compensation is paid at a future date rather than when earned, often used for tax planning or retirement purposes. For professional service firm owners, deferred compensation can shift income to lower tax years.

Key characteristics

• Payment is delayed to the future

• May defer tax liability

• Various arrangement types

• Subject to specific rules

• Risk of forfeiture varies

• Section 409A compliance required

Why it matters for professional service firms

Deferred compensation can shift income to years with lower tax rates. However, complex rules (Section 409A) govern arrangements with severe penalties for non-compliance. Professional service firm owners considering deferred compensation should work with tax professionals.

Real-world example

Patricia's income varied significantly: $450,000 in peak years, $180,000 in slower years. Deferred compensation arrangement: defer $100,000 from peak year to a future lower-income year. Tax savings: $100,000 taxed at 24% instead of 35%, saved $11,000. Required a proper Section 409A-compliant plan document and irrevocable election before the year began.