Current developments.

• Author: Elinsky, Peter I.
• Position: Employee benefits - Part 2

This two-part article provides an overview of recent developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation. Part II focuses on general developments in executive compensation, health and welfare plans and fringe benefits.

This two-part article provides an overview of recent developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation. Part I, in the last issue, addressed general developments in retirement plan qualification requirements and employee stock ownership plans. Part II, below, focuses on general developments in executive compensation, health and welfare plans and fringe benefits.

Executive Compensation

Sec. 1032 Final Regs.

The IRS issued final regulations(32) on the purchase and sale of stock and other property between a corporation and its corporate shareholder (e.g., a parent). Although they have broader corporate tax implications, the regulations affect the treatment of stock and options when the company issuing them is not the one using them for compensatory purposes (e.g., a parent's issuance of stock or options to subsidiary employees). The tax treatment remains unchanged for a company issuing stock or options to its own employees.

Regs. Sec. 1.83-6(b) provides that, except as provided in Sec. 1032, when property is transferred for the performance of services, the transferor recognizes gain to the extent he received an amount in excess of his basis in the property. Regs. Sec. 1.83-6(d) provides that if a shareholder transferred stock to employees, the transfer is treated as a corporate contribution of capital by the shareholder. Any amount paid to the shareholder for the stock is deemed paid to the company and transferred from it to the shareholder as a distribution. The owner's basis in the shares is transferred with the stock to the company.

Regulations: Regs. Sec. 1.1032-3 is substantially similar to the proposed regulations, but modifications were made in response to comments. The regulations provide a special rule if (1) a subsidiary is obtaining parent stock, (2) it intends to transfer the stock immediately to acquire money or property and (3) no one receiving the stock from the subsidiary will take a substituted basis.

If these conditions are met, the parent is treated as having made a capital contribution to the subsidiary of cash equal to the shares' fair market value (FMV); the subsidiary is treated as having purchased the shares at FMV immediately before they are transferred to the employee. The subsidiary then has a basis equal to the FMV of the shares transferred and is unlikely to have gain or loss on the transfer.

For Sec. 1032 purposes, "money or other property" is defined to include services rendered. Thus, if the company transfers shares to an employee as part of a compensation plan, Regs. Sec. 1.1032-3 considers this a disposition of shares for money or property.

Example: X Corp., a parent, transfers 100 shares of stock to Y Corp., its subsidiary; Y immediately gives 10 of its employees 10 shares each. The FMV of each share is $5. X is deemed to have made a $500 capital contribution to Y; Y is treated as buying the shares from X for $500. Thus, Y recognizes no gain or loss on the transfer of shares to its employees.

Stock received by an acquiring corporation must be immediately transferred to acquire money or other property. The regulations apply to rabbi trust arrangements only if the immediacy requirement is met, not if the issuing corporation's stock is treated as owned for a period by a subsidiary.

Previous rulings have stated that a rabbi trust must be subject to the subsidiary's general creditors.(33) Questions arose as to whether the subsidiary would be the trust grantor, failing the immediacy requirement. The IRS and Treasury determined that subjecting the trust assets to the subsidiary's creditors' claims does not make the subsidiary the trust grantor; thus, the immediacy requirement may still be met. Further, the IRS will not challenge a taxpayer's position that no gain is recognized by an acquiring corporation on the disposition by a rabbi mast, established before June 16, 2000, of issuing corporation stock, if such stock was contributed by the issuing corporation to the trust before May 17, 2001. The IRS is planning to release further guidance on rabbi trust issues.

The final regulations do not apply when options without a readily ascertainable FMV are granted to employees. If the regulations are met when the options are exercised, they apply at that time to determine the issuing and acquiring corporations' treatment.

In an area especially important to corporations with foreign subsidiaries, the regulations address instances in which an acquiring corporation makes an actual payment to the issuing corporation for stock. The final regulations provide that the cash deemed contributed by the issuing corporation to the acquiring corporation equals the difference between the issuing corporation stock's FMV and the cash received by the issuing corporation as payment from the employee.

Example:(34) X Corp. owns all of the outstanding stock of Y Corp. B, an individual, is a Y employee. To compensate B for services provided, Y offers him the chance to purchase 10 shares of X stock (with a $100 FMV) for $80. B transfers $80; Y transfers $10 to X as partial payment for the X stock.

No gain or loss is recognized on the deemed disposition of the X stock by Y. Immediately before Y's deemed disposition of the X stock, Y is treated as having purchased the X stock from X for $100 ($80 of which Y is deemed to have received from B, $10 of which originated with Y and $10 of which is deemed to have been contributed to Y by X). Under Sec. 358, X's basis in its Y stock is increased by $10.

The final regulations have been expanded to apply to partnership transactions. Regs. Sec. 1.1032-3(a) treats an acquiring partnership's disposition of an issuing corporation's stock in the same manner as an acquiring corporation's disposition of stock. Further, Regs. Sec. 1.1032-3(b) applies when an issuing corporation's stock is obtained indirectly by the acquiring entity (through either a Sec. 721 or 351 exchange).

The regulations also apply to a corporate Shareholder's transfer of its own stock to any person in consideration of services performed for another entity, if the conditions are met. Regs. Sec. 1.1032-3 applies instead of Regs. Sec. 1.83-6(d) in such cases.

The preamble provides that Rev. Rul. 80-76(35) is obsoleted by the final regulations. In that ruling, a majority shareholder transferred parent stock to a subsidiary's employee as compensation. This type of stock transfer is now addressed in the regulations, which do not require that the transferring corporation be a majority shareholder.

The final regulations apply prospectively, but the IRS will not challenge a position taken in a prior period if consistent with the final rules.

Foreign Corp's U.S. Subsidiary Not Subject to $1 Million Deduction Cap

In Letter Ruling 200021050,(36) the IRS ruled that compensation paid to top executives of a foreign corporation's U.S. subsidiary was not subject to the Sec. 162(m) $1 million deduction limit, because the parent is not required to file a summary compensation table with the Securities and Exchange Commission (SEC).

In the ruling, A is a U.S. corporation and an indirect subsidiary of B. A is the U.S. parent of numerous U.S. businesses and is the highest employer in B's U.S. corporate chain. Each of B's U.S. subsidiaries is a member of B's affiliated group (under Sec. 1504, without regard to Sec. 1504(b)). A and its U.S. subsidiaries pay U.S. taxes and deduct compensation paid to their highest-paid employees. B's common stock is publicly traded. Under the Securities and Exchange Act of 1934 (Exchange Act), B is considered to be a "foreign private issuer" and, thus, is not required by the SEC to file any documentation listing a summary executive compensation table (as described in Item 402(b) of SEC Regularion S-K).

Law: Sec. 162(a)(1) allows a deduction for all ordinary and necessary expenses paid or incurred in the tax year in carrying on a trade or business, including a reasonable allowance for salaries and other compensation for personal services actually rendered. Sec. 162(m) (1) provides that publicly held companies cannot deduct more than $1 million for applicable employee remuneration for a covered employee. Sec. 162(m)(2) defines "publicly held corporation" as any corporation issuing any class of common equity securities required to be registered under Exchange Act Section 12.

"Covered employee" is defined by Sec. 162(m)(3) as any employee of the corporation if, as of the close of the tax year, such employee is the company's chief executive officer (CEO) or is acting in that capacity, or the employee's total compensation for the year is required to be reported to shareholders, because the employee is among the four highest-paid officers (other than the CEO).

The definition of CEO under Regs. Sec. 1.162-27(c)(2)(ii) is determined by the Exchange Act's executive compensation disclosure rules. The preamble to the Sec. 162(m) proposed regulations states that the legislative history provides that covered employees are defined by reference to the SEC rules. The regulations generally consider an individual to be a covered employee if he is reported on the SEC summary compensation table.

Analysis: The IRS determined that, assuming neither A nor B is required to file an SEC summary compensation table, employees of A's or B's affiliated service group are not covered employees under Sec. 162(m)(3); their compensation is not required to be reported to shareholders under the Exchange Act. Thus, A and its U.S. subsidiaries are not subject to the Sec. 162(m)(1) disallowance rule and can fully deduct CEO compensation in excess of $1...