Deductibility of Nonqualified Deferred Compensation in Mergers and Acquisitions

Determining the tax treatment and timing of an employer corporation’s deduction for amounts paid under nonqualified deferred-compensation arrangements under Sec. 404 can be a daunting task, depending on the circumstances. Even if such arrangements have not triggered any of the pitfalls in Sec. 409A, there is some ambiguity surrounding the rules governing the deductibility of nonqualified deferred compensation (NQDC) in the context of mergers and acquisitions. Proper application of these rules is complicated and at times yields surprising results.

What Is Deferred Compensation?

According to Temp. Regs. Sec. 1.404(b)-1T, a deferred-compensation arrangement exists for purposes of Secs. 404(a), (b), and (d) when the employee receives compensation for services after the 2½-month period following the end of the employer corporation’s tax year in which such services were performed.

Example 1: The accrued nonqualified deferred-compensation liability of a calendar-year employer corporation on December 31, 2005, was $200,000. During 2006, the employer corporation accrued an additional $50,000 of NQDC. On February 15, 2007, the employer corporation paid the entire $250,000 to the employee. Only $200,000 is deferred compensation. Because the $50,000 was paid out within 2½ months of the end of 2006, the year during which the services were performed, it is not deferred compensation.

General Deductibility and Timing

An accrual-method employer may typically deduct compensation after it is earned and the liability is established, regardless of when the actual payment is made. However, under Sec. 404(a)(5), the employer’s deduction of NQDC must be delayed to match the employee’s recognition of income regardless of the employer’s method of accounting. Sec. 404(a)(5) provides for the employer’s deduction for NQDC “in the taxable year in which an amount attributable to the contribution is includible in the gross income of employees participating in the plan,” as long as separate accounts are maintained for each employee (and the NQDC is otherwise deductible).

Example 2: The facts are the same as in Example 1. The employer corporation may not deduct the accrued liability amount in the years in which it was accrued (years ended on or before December 31, 2006). Rather, the deduction of the entire $250,000 may be taken by the employer corporation only in the year ended December 31, 2007, when the employee receives the cash and recognizes income.

Regs. Sec. 1.404(a)-12(b)(1) further elaborates on the timing of the deduction under Sec. 404(a) for deferred compensation, saying it is allowed “only in the taxable year of the employer in which or with which ends the taxable year of an employee in which an amount attributable to such contribution is includible in his gross income as compensation.” There is some question as to whether this regulation applies to unfunded plans. However, the IRS’s position is that the “year in which ends the taxable year of an employee” language applies to Sec. 404(a)(5); see, e.g., Temp. Regs. Sec. 1-404(b)-1T, Q&A-1, and Letter Ruling 8939002.

The employer may therefore claim the nonqualified deferred-compensation deduction only during the employer’s tax year that includes the last day of the employee’s tax year in which the payment was made.

Example 3: On January 15, 2007, an employer corporation with a tax year end of January 31 paid $100,000 of NQDC that had been accrued in prior tax years. The employee will report income of $100,000 on his December 31, 2007, income tax return. The employer corporation may not deduct the $100,000 on its tax return for the year ended January 31, 2007. Rather, it must wait until the year ending January 31, 2008, to deduct the $100,000; that is the fiscal year that includes December 31, 2007 (the last day of the employee’s tax year).

Taxable Asset Acquisitions

In the context of an acquisition treated for tax purposes as a taxable asset acquisition (e.g., qualified stock purchase with a Sec. 338 election), the assumption by the acquirer of the employer (i.e., the target) corporation’s unfunded nonqualified deferred-compensation liabilities may result in less-than-desirable tax consequences. The payments by the acquirer to former employees of the employer corporation will generally be treated as additional purchase price for the assets purchased from the employer corporation and will increase the acquirer’s basis in the assets. The employer corporation would add the amount of the liability assumed by the acquirer to its sales proceeds, and the employer corporation (rather than the acquirer) would be entitled to a deduction for the payments made to its former employees under the deferred-compensation plan, as it effectively paid the acquirer to assume the liabilities.

However, because the regulations under Sec. 404 call for matching the deduction with the year that contains the last day of the employee’s tax year in which they report income for the payment, the employer corporation would need to remain in existence through the end of the calendar year in which the acquirer made the last of the deferred-compensation payments in order to get the full benefit of the deductions. If the employer corporation goes out of existence prior to the last day of the former employee’s tax year, the deduction would be forgone under a literal reading of Regs. Sec. 1.404(a)-12(b)(1).

As previously discussed, there is some ambiguity in the regulations with respect to the timing of payments under an unfunded deferred-compensation arrangement. Specifically, is Regs. Sec. 1.404(a)-12(b)(1) intended to cover only funded plans, with unfunded nonqualified deferred-compensation plans covered by Regs. Sec. 1.404(a)-12(b)(2)? Or does Regs. Sec. 1.404(a)-12(b)(2) cover only unfunded pensions and death benefits, and Regs. Sec. 1.404(a)-12(b)(1) covers all other nonqualified funded and unfunded plans? Sec. 404(a)(5) itself contains no language restricting the deduction to the year in which the employee’s tax year ends.

Considering the language quandary and that the regulations under Sec. 404(a) do not specifically address the employer corporation going out of existence or the filing of a final tax return, it may be possible to argue that the deduction should be permitted by the employer corporation on its final return. This treatment would be consistent with the general principle of matching deductions with the income to which they relate. However, due to the uncertain tax treatment, planning ahead to keep the employer corporation in existence through the end of the year may be the optimal strategy.

Example 4: The facts are the same as in Example 1, except that there was no additional accrual of $50,000 during the year ended December 31, 2006, and on February 28, 2007, the employer corporation sells all of its assets to the acquirer for cash and the assumption of its liabilities. There is no deferred-compensation liability remaining on February 28, 2007, for the acquirer to assume. The employer corporation remains in existence through December 31, 2007, and may deduct the entire $200,000 as a deferred-compensation deduction on its final corporate income tax return for the year ended December 31, 2007.

Example 5: The facts are the same as in Example 4, except that the taxable asset acquisition occurs on January 31, 2007. The acquirer assumes the $200,000 liability and then makes the $200,000 payment to the former employee on February 15, 2007. The employer corporation may deduct the entire $200,000 as a deferred-compensation deduction on its final corporate income tax return for the year ended December 31, 2007.

Stock Acquisitions

For stock acquisitions not treated as asset acquisitions for tax purposes, whether taxable or nontaxable, the application of Sec. 404(a)(5) to the deductibility of unfunded NQDC is more straightforward. With some stock acquisitions, the employer corporation remains in existence. In this case, payments made by the employer corporation that constitute NQDC will be deducted on the employer corporation’s income tax return for the year that includes the end of the employee’s tax year in which such payment was made.

In other situations, the employer corporation is merged out of existence subsequent to the stock acquisition, generally in a tax-free merger or liquidation. In this case, the successor entity “steps into the shoes” of the employer corporation with respect to all tax attributes, including any nonqualified deferred-compensation liabilities and tax deductions. The tax deductibility of NQDC will essentially be the same as in the former situation, with payments made by the employer or successor corporation being deducted in the successor corporation’s income tax return for the year that includes the end of the employee’s tax year in which such payment was made.

Example 6: The facts are the same as in Example 5, except that rather than a taxable asset acquisition, all the employer corporation’s stock is acquired for cash by a partnership. The employer corporation remains in existence and makes the payment. The employer corporation may deduct the entire $200,000 as a deferred-compensation deduction in its income tax return for the year ended December 31, 2007.

Consolidated Returns

Consolidated return regulations affect the timing of the deduction for deferred compensation if the employer corporation is moving to or from a consolidated group. Typically, a short-period return is required for the period prior to joining a consolidated group or the period after leaving a consolidated group. If the employer corporation moves from one consolidated group to another, Regs. Sec. 1.404(a)-12(b)(1) provides that the deferred-compensation deduction is properly reflected in the consolidated return that includes the end of the employee’s tax year in which the deferred-compensation payment was made.

Example 7: The facts are the same as in Example 6, except the stock of the em-ployer corporation is acquired by a calendar-year corporation that is a member of a consolidated group. The employer corporation becomes a member of the consolidated group on February 1, 2007, and must file a final short-period return for the period January 1–31, 2007. The deduction for the $200,000 payment made on February 15, 2007, is properly reflected in the consolidated group’s income tax return for the year ended December 31, 2007, because it includes the last day of the employee’s tax year.

Example 8: The facts are the same as in Example 7, except the payment is made on January 15, 2007, by the employer corporation prior to the acquisition. The deduction for the $200,000 payment on January 15, 2007, is properly reflected in the consolidated group’s income tax return for the year ended December 31, 2007, because it includes the last day of the employee’s tax year. The payment is not deducted in the employer corporation’s final short-period income tax return even though it includes the date of payment.

Example 9: The facts are the same as in Example 7, except the payment is made by the employer corporation prior to the acquisition on December 15, 2006. The deduction for the $200,000 payment on December 15, 2006, is properly reflected in the employer corporation’s income tax return for the year ended December 31, 2006, because it includes the last day of the employee’s tax year.

Conclusion

The tax rules regarding nonqualified deferred-compensation arrangements are riddled with complexity. Special attention must be paid to the deferred-compensation rules under Sec. 404(a)(5) in the context of mergers and acquisitions, especially when combined with the consolidated tax return rules, to ensure that the structure of the transaction results in the desired tax consequences with respect to the timing of the deduction and who may claim it. The tax adviser also must consider other provisions that may limit a deduction, including Secs. 162(m) and 280G. Planning opportunities may exist for the employer corporation or acquirer to place the deferred-compensation deduction in the most desirable tax return by either accelerating or deferring the timing of the actual payment to the employee.

From Kevin Powers, CPA, and Melissa Reinbold, CPA, Oak Brook, IL

Tracking Tax Basis in an S Corp. ESOP

Employee stock ownership plans (ESOPs) currently cover 10 million employees in the U.S. participating in approximately 11,000 plans, according to the ESOP Association. With the number of plans expected to increase, the need for tax accounting and recordkeeping for ESOPs is becoming more prevalent and complex. Although much has been written about the general workings of these plans, the tax benefits to the company, and the potential for increased employee loyalty by implementing an ESOP, this item focuses on another ESOP issue: how to track the employee’s tax basis in his or her ESOP stock.

A participating employee in an ESOP receives company stock as an employee benefit, which he or she accumulates over time and which serves as a form of retirement savings. An employee is not taxed on the current accumulation of wealth in company stock, only when the stock or funds are withdrawn from the ESOP, similar to a 401(k) plan. Distributions may be paid in a lump sum or in substantially periodic payments. The plan documents will specify if the distribution of ESOP benefits may be paid in cash or company stock. When an employee leaves the company, an agreement traditionally obligates the employer to buy back the distributed stock at fair market value (FMV). Unless the ESOP is part of a publicly traded company, an annual valuation is required to determine the price of their shares.

On a lump-sum distribution of employer securities, an employee will defer any tax relating to net unrealized appreciation (NUA) under Sec. 402(e)(4)(B) until the underlying securities are disposed of. Alternatively, the employee may elect to be taxed currently on any NUA on the tax return in which the lump-sum distribution is reported. Employees receiving lump-sum distributions in 2010 who are not required to immediately sell back the employer stock may want to consider making the election (due to the impending tax rate change for capital gains). Regs. Sec. 1.402(a)-1(b)(2)(i) defines NUA as the excess of the employer securities’ FMV at the distribution date over their cost or other basis to the qualified plan’s trustee. The individual is taxed on NUA at long-term capital gains rates, regardless of the ESOP’s holding period for the shares distributed and the individual’s holding period once the securities are distributed. If the employer securities are not rolled over tax free to a qualified plan, an employee must recognize as ordinary income his or her basis in the shares received.

Four methods are provided in Regs. Sec. 1.402(a)-1(b)(2)(ii) for determining the cost or other basis in the employer securities. If a security was earmarked for an employee’s account at the time it was released to the account of the employee, such cost or other basis will be used. When employer securities were purchased during the tax year, or other period not exceeding 12 months, and allocated to more than one employee, the average cost can be used as the security cost. The final two remaining options relate to employer securities that were not tracked or allocated to individual employee accounts.

Rev. Rul. 2003-27 states that the stock of an S corporation held by an ESOP is subject to the same basis adjustments under Sec. 1367(a) as stock held by any other S shareholder. The stock’s NUA is determined using the ESOP’s adjusted basis in the stock. However, the basis of a share of stock to the plan for purposes of determining NUA does not control its basis in the hands of the distributee. The distributee’s basis will be the same for each share of stock received.

Third-party administrators (TPAs) who traditionally provide benefit plan services for ESOPs will track the allocation of shares to each participant’s account in the respective plan and generally the original cost basis of the shares. However, TPAs do not generally track the basis under Sec. 1366(a)(1) for an ESOP-owned S corporation, and therefore the responsibility generally falls to the S corporation’s tax advisers. Under Sec. 1366(a)(1), an S shareholder must take into account all items of income, loss, deduction, or credit and allocate the items on a pro-rata basis to each share of the corporation. It is the corporation’s responsibility to request the TPA to track this for all participants in its ESOP plan, including providing the TPA with a Schedule K-1, Shareholder’s Share of Current Year Income, Deductions, Credits, etc., each year to allocate the appropriate share of income or loss. TPAs will determine if they have adequate knowledge of Sec. 1366(a)(1) to properly track the stock basis. If an employee with a significant ownership in the plan retires or is distributed stock, the tax ramifications are much easier to compute when information has been tracked since the plan’s inception. If the plan allows for only cash distributions, there should be no need to track basis under Sec. 1366(a)(1). (See Exhibit)

The following example illustrates how the stock basis in employer securities would be computed for an individual employee and the tax impact when the securities are distributed.

Example: Z, a calendar-year S corporation, maintains Plan B, an ESOP. Plan B holds 100 shares of Z stock purchased on January 1, 2006, for $20,000 with employer contributions. Plan B’s pro-rata share of Z’s taxable income for tax year 2006 is $5,000, or $50 per share; for tax year 2007 it is $1,000, or $10 per share. There are no Sec. 1366(a)(1) adjustments other than for taxable income.

A is an employee of Z and an eligible participant in Plan B. Five shares are maintained in Plan B for A’s benefit from January 1, 2006, to December 31, 2007. On the latter date, Plan B distributes to A five shares of Z stock, which is required to be repurchased under a fair-valuation formula in accordance with Sec. 409(h). On December 31, 2007, the FMV of the five shares is $1,500. As shown in the exhibit above, in the year of distribution, the FMV of A’s shares is $1,500, their basis is $1,300, and A’s NUA is $200.

A could elect under Sec. 402(e)(4)(B) to forgo the deferral of tax on the NUA and pay tax on the NUA of employer securities distributed. If the employer securities are not repurchased under Notice 98-24, the IRS holds that any gain on the subsequent sale of stock not rolled over is taxed as long-term capital gain to the extent of the original NUA, regardless of the sale date. In determining whether to make the election, factors to consider include current long-term capital gain tax rates versus ordinary rates, speculation on future tax rates, cashflow to pay the tax due, and speculation on the stock performance over time. In addition, unless the distributed stock is rolled over to an eligible retirement plan in accordance with Sec. 402(c), $1,300 of ordinary income will be recognized in the year of distribution.

This example is simplified and does not take into account employee and employer contributions. If the employee contributes cash or property, the calculation will differ and the NUA will need to be allocated among employee and employer contributions in the plan.

Many employees are unaware of the tax implications and consequences when receiving ESOP distributions. With proper recordkeeping and basis tracking, the ESOP, the company, and the TPA will be able to readily provide the employee with adequate information to determine the tax consequences of plan distributions. This will allow employees to make informed decisions about taking a lump-sum distribution, rolling over the proceeds to another qualified retirement plan, and other considerations. With employees continuously entering and exiting a retirement plan, it is essential to keep records up to date to ensure that the proper basis and records are maintained on each employee’s behalf.

From Kristy L. Rempalski, CPA, and Matthew C. Osterhaven, CPA, Grand Rapids, MI