When you set up a deferred compensation arrangement between you and your company, you agree to provide current services in exchange for a future payday. But there’s a chance you won’t live to collect the deferred comp.

Strategy: Name your favorite charity as a contingent beneficiary. Therefore, if your designated beneficiary—say, your spouse—predeceases you, the money goes to the charitable organization.

In a new private letter ruling, the IRS has ruled that a company can deduct the deferred compensation payments in this situation. (IRS Letter Ruling 200905016)

Here’s the whole story: The tax treatment of a deferred comp agreement depends on whether the plan is “funded” or not. With an unfunded plan, the company promises to pay the employee money at some future date (e.g., upon retirement). Done properly, the employee owes no tax—and the company gets no deduction—until the compensation is paid.

The rules for funded plans are more complex. In this case, the deferred compensation is set aside and specifically earmarked for the employee. If the employee has access to the funds (known as “constructive receipt”), these amounts are currently taxable—even if the employee doesn’t tap into them. Alternatively, the employee must pay current tax if he or she has an absolute future right to receive the funds. 

However, current tax may be avoided by using a forfeiture provision. The employee agrees to forfeit the funds if he or she leaves the company prematurely.

Other special planning techniques such as a “rabbi trust” may be used. With a rabbi trust, funds are generally not currently taxable because they are exposed to creditors.

In the new ruling, a company established a deferred comp plan for a select group of highly paid employees. Each employee was allowed to designate one or more beneficiaries to receive part or all of the funds upon death.

One employee designated his spouse as the primary beneficiary. However, in the event that the spouse disclaimed the deferred compensation or did not survive him by 45 days, a charity was named as the secondary beneficiary.     

Tax result: The IRS ruled that the company could deduct the payments. However, it did not offer any opinion on when the deduction was allowed.

Also, the IRS implied that the charity would not be taxed on the transfer, but it did not state whether deferred compensation is treated as “income in respect of a decedent” (IRD). IRD may be taxable to the estate or another taxpayer acquiring the right to receive a bequest or inheritance.

Tip: Consider this new ruling in light of your overall estate planning objectives.