Deducting equity-based and deferred compensation after a reorg. or employee transfer.

• Author: Sollee, Will
• Position: Reorganization

With the increasing incidence of spin-offs, split-ups, dropdowns and other reorganizations, corporations frequently face the issue of which entity is entitled to a deduction for equity-based or deferred compensation granted before the transaction but paid or vested after the transaction. Similar issues arise when an employee is transferred from one member of a controlled group to another.

Governing Principles

Sec. 83(h) determines the deductibility of stock options, restricted stock and other forms of equity-based compensation; Sec. 404(a)(5) determines the deductibility of nonqualified deferred compensation. Although these provisions differ in some respects, the fundamental principles underlying each are similar. First, compensation is deductible to the extent it is an ordinary and necessary business expense under Sec. 162. Second, the deduction is delayed until the compensation is included in the gross income of the employee or other service provider (the employee).

Section 162. The weight of relevant authority provides that reasonable compensation paid for services is generally deductible under Sec. 162 only by the employer for whom the services are performed. Because parents, subsidiaries and other members of a controlled group are separate corporate entities, absent unique and compelling circumstances, one member of a controlled group may not deduct expenses properly attributable to another; see, e.g., Columbian Rope Company, 42 TC 800 (1964); Young & Rubicam, 410 F2d 1233 (Ct. Cl. 1969); GCM 39208; and Letter Ruling 8012005. Thus, compensation is generally deductible under Secs. 83(h) and 404(a)(5) only by the particular employer for whom the related services are performed.

Deduction timing. Both Secs. 83(h) and 404(a)(5) provide that the deduction for reasonable compensation expenses is delayed until the compensation is included in the employee's gross income. Regs. Sec. 1.83-6(a)(3) provides that for property vested at the time of transfer (including vested stock transferred pursuant to the exercise or a nonqualified stock option, even if the option was subject to a vesting schedule), the deduction is generally allowed in accordance with the employer's method of accounting. For an accrual-basis taxpayer, this means that the deduction is generally allowed in the tax year in which the obligation to make the transfer accrues, provided the transfer is made within 2 1/2 months after the corporation's year-end; otherwise, the deduction is allowed in the year of transfer. Property not substantially vested at the time of transfer is deductible in the employer's tax year in which, or with which, ends the employee's tax year in which the compensation is included in gross income (the throw-forward rule).

Sec. 404(a)(5) and the...