Compensation
Generally speaking compensation expense is allowed as a deduction under §162 (trade or business deductions) or §212 (production of income). Most large C corporations preparing tax provisions are on the accrual basis of accounting for tax purposes. Their employees, however, are on the cash basis of accounting (think W-2 wage reporting). Despite this mismatch, most of the compensation expense paid in wages and salaries during the year will match up.
Before 2005, deferred compensation that we care about for tax provision purposes fell to two code sections, §404(a)(5) for cash type compensation, and §83 for compensation paid with transfers of property.
Compensation that was a nonforfeitable liability earned in one tax year paid out in subsequent tax years is includable in the employee’s income in the year received (actual or constructively), and the corporation is allowed to take its deduction at the same time under §404(a)(5).
Stellar Corporation has employees that it would like to give bonuses to. The employees are notified in December of tax year 1 (2003) that they have earned a bonus for that year. This bonus is theirs, even if they decide to leave Stellar before the bonus is paid. Stellar Corporation accrues the bonus expense for books in tax year 1. The bonus is paid the first week of April in tax year 2 (2004).
Stellar Corporation has a deferred compensation plan (with a little “p”). The corporation is going to recognize its deduction when the employees recognize their income in year 2 (2004). Prior to 2005 Uncle Sam was essentially putting Stellar Corporation on cash basis in regards their deduction for deferred compensation, and with the guidance of a few regs out there hoping corporations would behave reasonably.
Someone’s always got to ruin a good thing, and Enron did not behave. What the executives did at Enron (among various nefarious activities) was to take deferred compensation plans (little “p”) with their executives and accelerated the payments to themselves quickly, before the company went bankrupt. Executives got their pay, and ordinary Americans carried the huge losses.
Well, Congress was livid. In a fit of highly focus anger, Congress enacted the American Jobs Creation Act of 2004 which contained a new code section 409A (I like to think it is for assholes, with a big “A”). This code section says that unless excepted, all deferred compensation plans fall under 409A. The plan (the little “p” agreement between employer and employee) becomes a Plan (big “P”): very scary, formal, lots of rules.
A Plan must satisfy the following requirements:
- Be a written plan
- Follow election rules
- Follow distribution rules
- Follow acceleration restrictions
If a Plan does not follow the four requirements, the IRS will levy an excise tax of 20% on all amounts not reported correctly as income. Who is this excise tax levied on? Well, think back to the Enron case. Enron’s ship is going down in flames, and the execs are fleeing with the remaining assets. Think the execs will care if Enron the company has to pay an exorbitant tax for the execs’ transgressions? Uncle Sam is hip to this, and he says the excise tax is levied ON THE EMPLOYEE (makes sense when you consider the history). Hard to believe a company would create deferred compensation plans and not include its highest paying execs. Hold the individual executives accountable and you get a well behaved corporation (in theory).
Not only does the individual pay the excise tax, all the plans of the same type are aggregated for the individual and all treated as violating the requirements. That means all current and all prior deferred amounts are suddenly includable in income. This is not minor to these execs. This can be a huge income and excise tax hit.
Short-Term Accruals (2.5 month rule)
Let’s go back real quick and fill some holes. Section 404(a)(5) came before §409A, and with it there were some temporary regs issues that said Uncle Sam will allow a corporation to act as a tax accrual taxpayer with regards to unforfeitable compensation to the extent compensation that was accrued for at year end for book purposes is paid out by the 15th day of the 3rd month after its tax year end (3/15 for calendar end returns). §1.404(b)-1T Q&A A-2(b)(i). Essentially, if you pay it out quick enough then we’ll turn a blind eye and let you deduct it as an accrual payer. Section 409A also took this treatment in as its own set of regs, calling such payments “Short-Term Deferrals”. (However, be wary of writing this language into a written Plan, because then you may, in written language, be taking a short-term deferral and making it into a Plan. Section 409A professionals should always be the ones writing Plans.)
Stock Options
One of the exceptions to §409A is stock options. Certain stock options, that is. ISOs and ESPPs are excepted from §409A. Other options are excepted as well if the exercise price is greater than the grant date FMV of the underlying stock (so not creating an in-the-money asset at grant date for the employee). This sounds pretty simple, until you consider companies that do not have readably ascertainable fair market values. How does a corporation prove their options are excepted from §490A if their stock isn’t actively traded? Enter the §409A evaluation. If you know them, you know they are not cheap. Again, scared executives run well behaved companies.
ISOs and ESOPs are qualified plans, meaning for the most part any compensation expense related to these grants is not deductible to the corporation (because they are not taxable to the employee). If an employee violates the holding provision of an ISO, then the amount becomes taxable to the employee and deductible to the corporation. ESPPs give employees preferential treatment in purchase stock, and generally do not create book to tax differences, so I won’t be covering them.
NSOs, RSUs, RSAs, PSUs, PSA, these are all subject to §83. Section 83 covers property transferred as compensation, but most of what we deal with regarding §83 is “restricted” property.
Compensation derived from property transferred is measured as the difference between any payments by the employee (like exercise price) and the fair market value on the earlier of 1) the date the property was transferred or 2) the date that significant restrictions were removed. It is at this time that compensation is realized. Compensation is ordinary income, and now the employee holds an asset (stock) which when it is sold will yield capital gains/losses.
If I give my employees options, but say if they leave my employ before they are exercisable, then the options are not yet free of significant restrictions (employment). If I allow them to take with them the options that are fully vested but not yet exercisable, there is still a restriction (time, as the FMV of the stock could lose value and the employee may never exercise and thus never have income). It is when they exercise, generally, that they become taxable.
The corporation’s tax deduction is the same amount as the employee’s recognized income (fmv at transfer less price paid by employee).
In the case of an RSA or a PSA, these are straight awards. The employee is given stock, not a financial instrument based on stock, but the stock itself. No exercise price is paid, and thus the entire transfer date fmv of the award is compensation and thus the transfer fmv is also the corporate deduction.
These awards, because they are true property, are eligible for the employee to make a §83(b) election which allows the employee to elect to treat the grant date fmv as ordinary income includable as taxable income on that grant date (and they best be withholding or making an estimated tax payment because come year end when they have forgotten about this election, they may have a bunch of tax to pay). The corporation thus follows, taking its deduction as grant date fmv in the same tax year. In the future, the employee will receive the stock and (hopefully) have significant tax savings for the difference between the transfer and grant date fmv, and has now additionally shifted that difference from ordinary income to capital gain.
Tax Sophomore 