Timing of Incentive Compensation Deductions

Before implementing an incentive compensation plan, most employers consider first human resource, shareholder dilution and financial accounting issues, then turn to the tax consequences. If an employer decides to grant stock options, it analyzes whether to forego a potential deduction by granting incentive stock options. If an employer considers granting restricted stock or other property, it usually takes into account the potential for a reduced (but accelerated) deduction should the employee make a Sec. 83(b) election.

Another issue is whether to provide the incentive compensation currently in the form of stock (subject to return if certain goals are not met) or simply to promise the stock will be paid when those goals are met. By receiving the stock currently, an employee generally receives some sort of certification that he owns the stock, a dividend stream and voting rights, even though he generally cannot sell, alienate or otherwise dispose of the stock until it vests. By receiving the stock only after goals have been met, the employee has nothing more than the employer's promise that the incentive compensation will be paid once it is earned.

Delay in Deduction

Employers should be aware that designing a plan as an immediate transfer of unvested property might delay a deduction, without providing any additional significant benefit. In such events, the plan wastes the time value of tax money.

Under Sec. 83(a), property transferred subject to substantial risk of forfeiture is not taxable until the year in which the risk lapses (e.g., when the employee actually receives a vested interest in the property). Sec. 83(h) provides that the employer will not receive its deduction until the employer's year in which (or with which ends the year in which) the employee takes amounts into income.

Similarly, for nonqualified deferred compensation, when the employer promises to pay money or property in the future, the employee recognizes income under Sec. 451 when he actually or constructively receives the benefit. Under Sec. 404(a)(5), the employer's deduction generally is delayed until the employer's year in which (or with which ends the year in which) the employee takes amounts into income.

The 2 1/2-Month Rule

Temp. Regs. Sec. 1.404(b)-1T, Q&A-2, defines deferred compensation as a plan, method or arrangement deferring the receipt of compensation to the extent that an employee receives compensation "more than a brief period of time after the end of the employer's taxable year in which the services creating the right to such compensation" are performed. The IRS has set forth a 2 1/2-month rule, providing that compensation, received beyond 2 1/2 months after the end of the employer's tax year in which the related services are rendered, is presumed received under a plan deferring the receipt of compensation. Compensation paid within the 2 1/2-month time frame is considered current compensation.

Example 1: Employer R, using a November 30 year-end, grants its employees restricted stock that vests on the last day of R's fiscal year in 2005, if performance goals are met. Under Sec. 83(a), employees will take amounts into income on this grant for the tax year ending Dec. 31, 2005. However, Sec. 83(h) will delay R's deduction until its fiscal year ending in 2006.

Example 2: The facts are the same as in Example 1, except that R grants employees a phantom stock plan (rather than a restricted stock plan). The stock vests on the last day of R's fiscal year in 2005, but, because it is delivered more than 2 1/2 months after the close of such year, the payment constitutes deferred compensation. Again, employees will recognize income in 2006 and R's deduction will be delayed until Nov. 30, 2007.

However, if the stock is delivered on Jan. 15, 2006 (within 2 1/2 months after the close of R's year), the payment will be treated as current compensation. As such, it will be deductible in R's fiscal year ending Nov. 30, 2005 and includible in employees' 2006 income.

A change from a restricted stock plan to a phantom stock plan that pays out on vesting can be particularly advantageous if it is anticipated that Sec. 83(b) elections will not be used to incur earlier taxation and deduction under the restricted stock plan. Sometimes, a plan can be designed to delay shareholder dilution without causing an adverse financial accounting effect. While an employee will lose any potential voting rights associated with restricted shares, dividend equivalents can make the employee "whole" with respect to corporate earnings. Perhaps most importantly, the employer will not be penalized with a delayed deduction for providing incentive compensation in the form of restricted stock rather than phantom stock, even though the two forms of compensation are virtually identical from an economic standpoint.

From Judith E. Alden, J.D., Washington, DC