Equity-based and nonqualified deferred compensation plans.

• Author: Altieri, Mark P.

This article provides an overview of the federal income taxation rules governing equity-based compensation plans as well as nonqualified deferred compensation plans. Publicly traded companies and privately held firms frequently use these plans to enhance the overall compensation packages of higher-end management. The advent of Sec. 409A has added further complexity to the myriad tax laws governing such arrangements.

Actual Stock and Stock Option Plans

Restricted Stock

Under a restricted stock plan, the corporate employer currently issues actual shares of stock to a key management employee. The employee usually pays nothing for the stock. The fair market value (FMV) of the stock in excess of any amount paid by the employee (the bargain element) will be ordinary income to the employee. (1) The inclusion of this income occurs at such time as the stock is transferable or is no longer subject to a substantial risk of forfeiture (the vesting date). (2) A substantial risk of forfeiture normally requires ongoing full-time employment through the vesting date. (3)

An exception to this general rule occurs if the employee makes a Sec. 83(b) election. Such an election triggers the taxable event upon issuance of the nonvested stock and does not require a subsequent inclusion in income when the risk of forfeiture lapses in a future tax year. The Sec. 83(b) election is frequently referred to as a "gambler's choice" because if the stock is subsequently forfeited, the employee will receive no deduction that would offset the earlier inclusion in income on having made the Sec. 83(b) election. This election is usually advisable in situations where the stock has a relatively low FMV on issuance but there is a high expectation that it will substantially rise in value in the future (e.g., a high-tech startup company).

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In either situation, the employee's tax basis in the restricted stock normally is measured by the amount of ordinary income the employee reports on the occurrence of the taxable event (a tax-cost basis under Sec. 1012). The employer would have a corresponding compensation deduction for federal income tax purposes when the employee recognizes income regardless of the employer's tax accounting method. (4)

Example 1: P Inc., a publicly traded corporation, has seen its per share common stock value fall from $40 to $10 as a result of the general economic downturn. P's board of directors and its management team believe the firm will triple in value in the next two to three years. In an attempt to motivate management to attain that goal, the board authorizes the issuance of a number of shares of restricted stock to management, who will pay nothing for the shares. The stock has a two-year vesting period and is considered to have a substantial risk of forfeiture because the company requires the employees to remain full-time employees of P for two years after the restricted stock is issued. At the time P issues the restricted stock, it is trading at $10 per share. Employee A decides to take the gambler's choice and makes a Sec. 83(b) election. A files the requisite form with the IRS and as a result has to include $10 per share in his ordinary W-2 wage income for the current year. That year he also establishes a $10 tax-cost basis per share in the stock. P will take a $10 per share compensation deduction the same year that A picks up the $10 per share of income. A remains a full-time employee of P for the required two-year vesting period, at which time the stock is worth $30 per share. At this time, the $20 of appreciation that occurred from the time A received the stock until its vesting date would not be included in his income until A disposed of the stock. Also, it should be noted that P would not be entitled to any additional compensation deduction

When A sells the stock, his gain will be measured by the tax basis established by Sec. 1012 when the Sec. 83(b) election was made and the FMV of the amount realized on the sale, with the resulting gain being taxed at favorable long-term capital gain rates. If A terminates employment prior to the two-year vesting date, he will forfeit the stock back to P and will have no tax deduction despite the fact that he previously reported the $10 per share received as ordinary income.

At the same time, employee B receives the same P stock and does not make the Sec. 83(b) election. She remains a full-time employee of P for the requisite two-year vesting period, at which time the stock is worth $30 per share. In the year of vesting, B has to report $30 per share as ordinary income and has a $30 per share tax-cost basis in the stock. P has a $30 per share compensation deduction in the year of vesting. However, if B terminates employment with P prior to the two-year vesting period, she will forfeit her shares back to P and will have no income inclusion or tax deduction.

Nonqualified Stock Options

A nonqualified stock option (NQSO) arrangement is a highly flexible method of giving an employee (or independent contractor) an opportunity to purchase employer stock. This variety of options is labeled nonqualified to distinguish them from the more employee-favorable incentive stock options, described below, which are often known as qualified options. Most stock options are nonqualified. To the extent that the employer does not have publicly traded options substantially similar to those granted under an NQSO, the grant of an option does not create a taxable event. (5) Because of the Sec. 409A rules discussed below, it will be a rare NQSO that sets the exercise price at a number less than the FMV of the underlying stock as of the option grant date. Upon exercise and purchase of the underlying stock, the difference between the stock's FMV and the exercise price is ordinary wage income to the employee. (6)

Absent a Sec. 83(b) election, to the extent that the stock received on exercise is subject to a substantial risk of forfeiture, the stock is not immediately taxable as noted above under the restricted stock discussion. In that case, the resulting wage income will not be taxable until that forfeiture condition lapses, at which time the stock's FMV in excess of the exercise price will be included in the employee's wage...