Sec. 1032 in Structuring Deferred Compensation Plans

In an effort to foster employee participation in corporate performance, many corporations offer a variety of compensation packages to encourage investment in company stock. In addition to stock options, stock grants and phantom stock plans, many employers offer company stock as an investment option under their deferred compensation plans. In fact, some employers require that deferred compensation be invested in company stock, because it can result in favorable financial accounting treatment. When setting up deferred compensation plans, employers must consider the potential impact of the Sec. 1032(a) nonrecognition rules to achieve the maximum tax benefit for such arrangements.

Background

Under Sec. 1032(a), generally, a corporation recognizes no gain or loss when it transfers its stock for property, regardless of whether such stock is newly issued or sold out of treasury stock. For this purpose, a transfer includes any transaction that would otherwise give rise to the recognition of gain or loss on the transfer of property (e.g., a transfer of property as compensation for the performance of services under Sec. 83).

Sec. 1032(a) applies only to a corporation's transfer of its own stock. Thus, a transfer of the parent's stock by a subsidiary does not fall within the scope of the nonrecognition rules. If a subsidiary actually purchases stock of its parent (i.e., directly from the parent or on the open market), the stock would have a basis equal to the purchase price and gain or loss would be recognized on its disposal.

In Rev. Rul. 74-503, the IRS held that a corporation has no basis in its own stock. Thus, if a corporation transfers its stock to a subsidiary as a contribution to capital, the subsidiary will have a zero carryover basis in the parent stock. This "zero basis" issue has caused considerable controversy, particularly in the area of taxable corporate acquisitions. Before the Service issued regulations specifically addressing this issue, a literal application of the zero-basis rules would cause a taxable gain equal to the value of the parent stock when a subsidiary transferred stock of its parent in a taxable transaction. This gain would not result if the stock were transferred directly by the parent, because the gain would be covered by Sec. 1032(a).

The zero-basis issue has also caused concern for transfers of parent stock by a subsidiary under a nonqualified deferred compensation plan. If a subsidiary maintains a plan for its employees' benefit, a zero-basis issue could arise if the deferred compensation liability were settled in parent stock and the parent contributed (or was deemed to contribute) its stock to the subsidiary. Absent regulations to the contrary, this situation would arguably generate a taxable gain at the subsidiary level on the transfer of parent stock in satisfaction of the deferred compensation liability. For purposes of measuring this gain, the subsidiary would have a zero basis in the parent stock.

Sec. 1032 Final Regs.

The IRS issued Regs. Sec. 1.1032-3, effective for transactions after May 16, 2000, addressing the application of the zero-basis issue to taxable dispositions of parent stock by a subsidiary. These regulations modified proposed regulations issued in 1998. To address the application of the zero-basis issue, the regulations adopt a hypothetical fact pattern that eliminates the issue for certain transfers of parent stock. Under this scenario, the parent is deemed to contribute cash to the subsidiary equal to the value of the parent stock actually transferred to the subsidiary. The subsidiary is then deemed to purchase the parent stock from the parent with this cash. As a result, the subsidiary has a basis in the parent stock "purchased" equal to the value of the stock on that date. The parent recognizes no gain on the deemed sale of stock to the subsidiary under the Sec. 1032(a) nonrecognition rules, and adjusts its basis in the subsidiary stock for the deemed capital contribution accordingly. If the subsidiary immediately disposes of the parent stock, there is no gain or loss to the subsidiary, because the basis and stock's fair market value (FMV) are equal. Thus, the zero-basis issue is circumvented.

To apply this hypothetical cash-purchase scenario to subsidiary transfers of parent stock, Regs. Sec. 1.1032-3(c)(2) requires the subsidiary to immediately dispose of the parent stock. Thus, for the subsidiary to get full basis in the parent stock and avoid the gain caused by the zero-basis issue, the subsidiary may not hold the parent stock for any period of time before the taxable transfer.

Application to Deferred Compensation Plans

Many corporations maintain deferred compensation plans for the benefit of their employees. These plans generally allow employees to defer compensation for income tax purposes until it is paid at a later date. Although corporations can establish the deferred compensation liability as a mere promise to make a future payment, these plans are typically established in conjunction with a so-called "rabbi trust." A rabbi trust permits the corporation to set aside assets for the eventual payment of the deferred compensation liability, but these assets are subject to the claims of the corporation's general creditors while held in trust. For income tax purposes, the assets held by the rabbi trust are deemed held by the corporation.

If the corporation allows or requires that the deferred compensation liability be settled with parent stock, it must consider the impact of Sec. 1032. Although the transfer of property is normally a taxable event, a transfer of a corporation's own stock in exchange for property is covered by Sec. 1032(a). Therefore, if a corporation distributes its own stock in satisfaction of the deferred compensation liability, it does not recognize gain or loss on the stock transfer. This is true regardless of whether the corporation transfers newly issued stock at the time of payment or treasury stock purchased at the time of the original deferral and held in a rabbi trust.

Example 1: Corporation D establishes a deferred compensation plan for the benefit of employee T. The plan allows T to defer a portion of his salary each year. The plan requires that T invest the deferred compensation in D stock through a rabbi trust, for distribution to T on his retirement.

In the example, T would not recognize the compensation for income tax purposes in the year of deferral. Instead, he would recognize as compensation the FMV of D stock distributed at retirement. D would be entitled to a compensation deduction under Sec. 83 for the full FMV of the stock transferred and reported to T as taxable compensation.

Because D would transfer its own stock in satisfaction of the deferred compensation liability, it would not recognize gain or loss, under Sec. 1032, on the transfer. This treatment would benefit D if the stock were to appreciate in value, because it could take a deduction for the increase in the stock's value, even though the increase would not be taxable income.

If a corporation does not structure a deferred compensation plan properly, it might have to recognize gain on the transfer of the parent stock.

Example 2: The facts are the same as in Example 1, except D is a subsidiary of Parent P, a publicly traded corporation, and the deferred compensation is to be invested in P stock. D maintains its own plan for T's benefit and purchases P stock directly on the open market through a rabbi trust that it maintains.

In this scenario, T would not recognize the compensation for income tax purposes in the year of deferral. Instead, he would recognize as compensation the FMV of the D stock distributed at retirement. D would be entitled to a compensation deduction under Sec. 83 for the full FMV of the stock transferred and reported to T as taxable compensation.

Because D transfers P stock in satisfaction of the deferred compensation liability, it would recognize gain or loss on this transfer, which does not fall under Sec. 1032. This treatment would be detrimental to D if the stock were to appreciate in value, because the deduction allowed for the increase in the stock's value would be offset by a gain on the stock transfer.

The Sec. 1032 final regulations offer the best scenario for structuring deferred compensation plans when a subsidiary is involved. This scenario is illustrated in Example 10 of Regs. Sec. 1.1032-3(e). The regulations specifically provide that the parent stock can be transferred to an employee of the subsidiary in satisfaction of a deferred compensation liability without the subsidiary recognizing any gain on the transaction. However, to achieve this result, the subsidiary must receive the stock from the parent and immediately transfer it to the employee. This immediacy requirement avoids a gain under the zero-basis rules discussed previously.

The final regulations require that a subsidiary maintain, at the parent level, a rabbi trust established under the plan. This can be done even though the plan itself is maintained at the subsidiary level for the benefit of its employees. When the plan calls for a transfer of parent stock to an employee of a subsidiary, the parent contributes the stock to the subsidiary, which immediately transfers it to the employee. As long as the stock is immediately transferred, the gain under the zero-basis rules is avoided.

Example 3: Corporation D, a subsidiary of Parent P, establishes a deferred compensation plan for the benefit of Employee T, an employee of D. The plan allows T to defer a portion of his salary each year. The plan requires that D invest the deferred compensation in P stock through a rabbi trust, and the P stock will be distributed to T on his retirement. P establishes and maintains the trust and funds it with P stock when T defers income. On T's retirement, P contributes the stock in the rabbi trust to D , which distributes the stock to T immediately.

In Example 3, T again would not recognize the compensation for income tax purposes in the year of deferral. Instead, he would recognize as compensation the FMV of the P stock distributed at retirement. D would be entitled to a compensation deduction under Sec. 83 for the full FMV of the stock transferred and reported to T as taxable compensation.

Because D transfers the P stock to T immediately, the transaction is subject to the hypothetical cash-purchase rule set forth in Regs. Sec. 1.1032-3. Thus, P would be deemed to have contributed cash to D in an amount equal to the value of the P stock, and D would be deemed to have used this cash to purchase the stock from P. P recognizes no gain or loss on the hypothetical sale of its stock to D, under Sec. 1032. Likewise, D recognizes no gain or loss on the transfer of P stock to T, because its basis in the stock "purchased" is equal to the value of the stock transferred.

Example 4: The facts are the same as in Example 3, except D holds the P stock (either directly or through a rabbi trust) for some period of time before transferring it to T.

In this situation, the worst possible tax consequence would result. D would recognize a gain equal to the full value of P stock transferred to T. By failing to meet the immediacy requirement, there would be no hypothetical cash purchase of P stock by D. D would have a zero basis in the P stock under the carryover-basis rule.

To avoid the application of the zero-basis rules on the transfer of P stock, D would have to maintain the rabbi trust at the parent level. Thus, the determination of which corporation (parent or subsidiary) is the grantor and owner of the trust is of great significance. To address this issue directly and eliminate any confusion as to the grantor's status, the IRS issued Notice 2000-56. The Service felt this guidance was necessary because taxpayers could have reasonably anticipated that rabbi trust arrangements could not be structured without causing subsidiaries to be treated as trust grantors and owners.

Notice 2000-56 provides that a parent will be treated as the grantor of a rabbi trust if it meets two conditions: (1) the parent stock held within the rabbi trust is subject to the claims of the parent's creditors; and (2) any parent stock not transferred to the subsidiary's employees reverts to the parent on termination of the trust. For purposes of the first requirement, it is permissible for the rabbi trust assets also to be subject to the claims of the subsidiary's creditors. The notice provided a safe harbor, as long as existing plans were amended to meet these requirements on or before May 16, 2001. However, new rabbi trust arrangements should be structured with these requirements in mind.

Conclusion

Corporations that maintain deferred compensation plans and settle the liability to plan participants in the form of company stock can achieve a tax advantage. If the stock appreciates in value, the gain on the stock transferred escapes taxation, provided it comes under Sec. 1032(a). When a subsidiary maintains such a plan, it can obtain Sec. 1032 benefits if it structures the plan properly. Taxpayers and practitioners alike should conduct a thorough analysis of the Sec. 1032 regulations when structuring these plans, to ensure the maximum tax benefit is achieved.

From David A. Thornton, CPA, Columbus, OH