Sec. 1032 in structuring deferred compensation plans.

• Author: O'Connell, Frank J., Jr.

In an effort to foster employee participation in corporate performance, many corporations offer a variety of compensation packages to encourage investment in company stock. In addition to stock options, stock grants and phantom stock plans, many employers offer company stock as an investment option under their deferred compensation plans. In fact, some employers require that deferred compensation be invested in company stock, because it can result in favorable financial accounting treatment. When setting up deferred compensation plans, employers must consider the potential impact of the Sec. 1032(a) nonrecognition rules to achieve the maximum tax benefit for such arrangements.

Background

Under Sec. 1032(a), generally, a corporation recognizes no gain or loss when it transfers its stock for property, regardless of whether such stock is newly issued or sold out of treasury stock. For this purpose, a transfer includes any transaction that would otherwise give rise to the recognition of gain or loss on the transfer of property (e.g., a transfer of property as compensation for the performance of services under Sec. 83).

Sec. 1032(a) applies only to a corporation's transfer of its own stock. Thus, a transfer of the parent's stock by a subsidiary does not fall within the scope of the nonrecognition rules. If a subsidiary actually purchases stock of its parent (i.e., directly from the parent or on the open market), the stock would have a basis equal to the purchase price and gain or loss would be recognized on its disposal.

In Rev. Rul. 74-503, the IRS held that a corporation has no basis in its own stock. Thus, if a corporation transfers its stock to a subsidiary as a contribution to capital, the subsidiary will have a zero carryover basis in the parent stock. This "zero basis" issue has caused considerable controversy, particularly in the area of taxable corporate acquisitions. Before the Service issued regulations specifically addressing this issue, a literal application of the zero-basis rules would cause a taxable gain equal to the value of the parent stock when a subsidiary transferred stock of its parent in a taxable transaction. This gain would not result if the stock were transferred directly by the parent, because the gain would be covered by Sec. 1032(a).

The zero-basis issue has also caused concern for transfers of parent stock by a subsidiary under a nonqualified deferred compensation plan. If a subsidiary maintains a plan for its employees' benefit, a zero-basis issue could arise if the deferred compensation liability were settled in parent stock and the parent contributed (or was deemed to contribute) its stock to the subsidiary. Absent regulations to the contrary, this situation would arguably generate a taxable gain at the subsidiary level on the transfer of parent...