Compensation;

Tweet

It seems early to be thinking about annual bonuses, but this year you may need to do more thinking than usual. That's because of a quirk in the Tax Reform Act of 1986 that creates a window wherein companies can get a relatively high deduction for deferred compensation payments, while individuals will be taxed at the relatively low maximum rate of 28%.

Here's how it works: on July 1, 1987, the maximum corporate tax rate drops from 46% to 34%. For fiscal '87, corporations will pay a blended rate that is determined by their fiscal year-ends. Calendar-year corporations, for example, will be taxed at a maximum blended rate of 40%. The benefit from the quirk in the law, an individual would defer compensation from '87 to '88, and the company would pay the deferred compensation within two and a half months of the fiscal year-end. The company could then take a relatively high '87 deduction, while the employee would be taxed at the maximum '88 rate of 28%.

There's one catch to all this, notes Frank Nessel of the Johnson Cos., a consulting firm based in Newtown, Pa.: it doesn't work for shareholders with 5% or more of the voting stock or "related persons." That's because the corporation can deduct deferral payments to such people only in the year in which the individual reports the income. You can get around that problem, however, if your company's '87 fiscal year ends in '88. Then you can distribute the deferral in '88 before the fiscal year-end and take the corporate deduction in fiscal '87. The individual still benefits from the lower individual rate in '88.