When to Take the Deferred Compensation Tax Deduction
Timing your business's tax deduction for deferred compensation depends on when the employee reports income and the plan's specific design.
Deferred compensation is an arrangement where an employee earns compensation in one year but receives the payment in a future year. For employers, this structure dictates when they can take a tax deduction for that compensation. The timing rules are precise and depend on the type of plan and adherence to regulatory requirements.
The General Rule for Deduction Timing
The concept for deducting deferred compensation is a matching principle. An employer cannot take a tax deduction in the year an employee earns future compensation. The deduction is permitted only in the tax year that includes the end of the employee’s tax year in which the compensation is included in their gross income.
This principle is codified in the Internal Revenue Code. For example, if a company awards an executive a $100,000 bonus in 2025 but the agreement states it will be paid out in 2028, the company cannot deduct that $100,000 on its 2025 tax return. The deduction must be deferred until the 2028 tax year, which is the same year the executive receives the funds and reports the amount as taxable income.
This rule effectively places the employer on a cash basis for deducting this expense, even if the business otherwise uses the accrual method of accounting. While the liability may be recorded on the company’s books when earned, the tax deduction is delayed until payment.
Types of Deferred Compensation Plans and Deduction Rules
The deduction timing rule applies differently depending on whether the deferred compensation plan is “qualified” or “nonqualified.” These categories are distinguished by their adherence to government regulations, which dictates their tax treatment.
Qualified plans, such as 401(k)s and pension plans, must comply with the requirements of the Employee Retirement Income Security Act (ERISA). For these plans, an employer can deduct contributions in the year they are made to the plan’s trust. This is an exception to the matching principle, as the employer gets an immediate deduction even though the employee is not taxed on the funds until withdrawal during retirement.
Nonqualified deferred compensation (NQDC) plans are not subject to the same ERISA rules as qualified plans and are often used to provide supplemental benefits to executives. For these plans, the general deduction timing rule, which links the deduction to the employee’s income inclusion, is strictly applied.
Most NQDC plans are “unfunded,” meaning the employer’s promise to pay is not secured by assets set aside from the claims of general creditors. This status is what allows the employee to defer taxation. If a plan were “funded” to protect assets for the employee, the employee would face immediate taxation, which is why funded NQDC plans are rare.
Key Requirements for Nonqualified Plans
To successfully delay taxation and align the employer’s deduction with the payout, a nonqualified deferred compensation plan must comply with the tax code. These rules establish a framework for when deferred compensation can be paid.
Compensation deferred under an NQDC plan can only be paid upon one of the following triggers:
- The employee’s separation from service
- Disability
- Death
- A specified time or fixed schedule set at the time of deferral
- A change in the company’s control
- An unforeseeable emergency
The plan document must state which of these events will trigger payment.
The acceleration of payments is prohibited, and an employer cannot pay deferred amounts earlier than specified by the plan’s terms. An employee’s election to defer compensation must be made before the year services are performed. For example, an election to defer a 2026 bonus must be made by the end of 2025.
Failure to adhere to these requirements has consequences for the employee. If a plan violates the rules, all deferred amounts become immediately taxable to the employee, even if not yet paid. In addition to regular income tax, the employee faces a 20% penalty tax plus interest.
Special Considerations for Public Companies
Publicly held corporations face an additional constraint on deducting executive compensation. The tax code imposes a cap on the deduction a public company can take for compensation paid to its highest-paid executives. This rule is not about when a deduction can be taken, but if it can be taken for amounts over a certain threshold.
The law limits the annual tax deduction to $1 million for compensation paid to any “covered employee.” Under current law, a covered employee includes the CEO, CFO, and the next three highest-compensated officers. A change introduced by the Tax Cuts and Jobs Act of 2017 is the “once a covered employee, always a covered employee” rule. This means once an individual is designated as such for any year after 2016, the limit applies to all future compensation paid to them by that company, even after they leave.
The American Rescue Plan Act of 2021 expanded the definition of covered employees, effective for tax years beginning after December 31, 2026. This change adds the next five highest-compensated employees to the list. Unlike the permanent designation for top officers, this additional group is determined annually, meaning public companies will have at least ten employees subject to the limit each year.
This limitation impacts deferred compensation strategy. For example, if a CEO receives a $2 million deferred bonus, the company can only deduct $1 million. Public companies must therefore carefully plan the timing of executive payouts to manage this permanent deduction loss.