Timing of incentive compensation deductions.

• Author: Alden, Judith E.

Before implementing an incentive compensation plan, most employers consider first human resource, shareholder dilution and financial accounting issues, then turn to the tax consequences. If an employer decides to grant stock options, it analyzes whether to forego a potential deduction by granting incentive stock options. If an employer considers granting restricted stock or other property, it usually takes into account the potential for a reduced (but accelerated) deduction should the employee make a Sec. 83(b) election.

Another issue is whether to provide the incentive compensation currently in the form of stock (subject to return if certain goals are not met) or simply to promise the stock will be paid when those goals are met. By receiving the stock currently, an employee generally receives some sort of certification that he owns the stock, a dividend stream and voting rights, even though he generally cannot sell, alienate or otherwise dispose of the stock until it vests. By receiving the stock only after goals have been met, the employee has nothing more than the employer's promise that the incentive compensation will be paid once it is earned.

Delay in Deduction

Employers should be aware that designing a plan as an immediate transfer of unvested property might delay a deduction, without providing any additional significant benefit. In such events, the plan wastes the time value of tax money.

Under Sec. 83(a), property transferred subject to substantial risk of forfeiture is not taxable until the year in which the risk lapses (e.g., when the employee actually receives a vested interest in the property). Sec. 83(h) provides that the employer will not receive its deduction until the employer's year in which (or with which ends the year in which) the employee takes amounts into income.

Similarly, for nonqualified deferred compensation, when the employer promises to pay money or property in the future, the employee recognizes income under Sec. 451 when he actually or constructively receives the benefit. Under Sec. 404(a)(5), the employer's deduction generally is delayed until the employer's year in which (or with which ends the year in which) the employee takes amounts into income.

The 2 1/2-Month Rule

Temp. Regs. Sec. 1.404(b)-1T, Q&A-2, defines deferred compensation as a plan, method or arrangement deferring the receipt of compensation to the extent that an employee receives compensation "more than a brief period of time after the end of...