Corporate Executive Compensation: Is Your Firm In Compliance?
Executive compensation has evolved dramatically in recent years, in creativity, complexity, and dollar value. Stock options, deferred compensation, fringe benefits, and other “non-cash” alternative forms of compensation are becoming increasingly popular and making up larger and larger parts of executives’ overall compensation packages.
There are multi-faceted tax implications for all forms of executive compensation: income and employment tax issues for the employers who pay the compensation and the executive employees who receive it. In addition to the increasing use of non-cash compensation, the use of partnerships and trusts (both domestic and offshore) in the handling of compensation is increasing. These factors add considerable complexity in determining current and future year tax liabilities for executives and their employers.
Generally, stock options are granted to individuals in blocks of shares with a specified exercise price, for example, $10 per share. The individual has a specified period of time to exercise the stock option. When the individual wishes to exercise the options, they notify the company and complete paperwork to affect the exercise. Assuming a fair market value of the stock at the time of exercise of $50, the individual would report income at exercise of $40 ($50 less the exercise price paid). This $40, often called the “spread”, is income under § 83(a) and is reported on the individual’s Form W-2. The employer is entitled to a corresponding deduction at that time under § 83(h). The income is subject to employment taxes in the year of exercise.
Similar treatment applies to restricted stock, which is stock that is not fully vested. Generally, restricted stock is included in income as the stock vests. Vesting of the stock often occurs on a graduated schedule.
However, for transactions described in Notice 2003-47, the arrangement is established in a manner to avoid the reporting of income at exercise of the options or vesting of the restricted stock. The primary issue is whether an individual can transfer or sell compensatory options to a related entity such as a family limited partnership and receive in exchange, from the partnership, a non-transferable, non-negotiable unsecured obligation calling for the purchase price to be paid in a 15 to 30 year balloon payment and defer compensation income and wages until the payment on the obligation is made.
The transaction involves three parties: an individual who holds non statutory stock options; the corporation that granted the stock options; and a related entity, such as a family limited partnership. The related entity purports to purchase the stock options from the individual by giving the individual an unfunded, unsecured long-term balloon payment obligation equal to the fair market value of the stock options, typically determined through a valuation report supplied by the promoter. The related entity may then exercise the options but does not pay any cash to the individual (except perhaps interest on the obligation) until the balloon payment comes due.
The arrangement attempts to establish that the purpose of the partnership is to aggregate and diversify assets. Often the individual retains the vast majority of the ownership of the partnership (up to a 99% limited partnership interest), and/or may be general partner. The other partners typically include members of the individual’s family and may include a family trust. Generally, the related person is thinly capitalized by the individual’s initial contribution of their personal stock holdings.
This transaction typically involves the transfer or sale of stock options to a related person. However, variations may include the transfer of restricted stock instead of stock options or may include a combination of stock options and restricted stock. Other related persons may include a limited liability corporation or an individual’s foreign or a domestic trust. Usually, the person transferring the stock is an officer/employee. However, individuals have included non-employee directors.
The individual transfers the stock options or restricted stock to the related person in exchange for a deferred payment obligation. The deferred payment obligation may include a promissory note, contractual agreement or annuity. The parties to the deferred payment obligation are the related person and the individual. The deferred payment obligation is typically structured as an unsecured, nonnegotiable 15 to 30 year obligation, with a principal balloon payment due at the end of the term. Usually the obligation calls for the payment of periodic interest over the term of the obligation that is taken into income by the individual and would be reported on their Form 1040 in the year the interest is paid. The most common instruments utilized in this transaction are promissory notes and contractual or sales agreements. Annuities are also utilized, but usually in conjunction with a foreign trust and/or foreign corporation as the related person.
A Black-Scholes valuation or similar methodology is prepared by the promoter to determine the fair market value of the stock options at transfer. Typically, the fair market value of the options determined by the valuation equals the option spread (the difference between the fair market value of the stock option at exercise less the exercise price). The stated principal amount of the obligation is usually the same amount as the fair market value of the stock options determined by the valuation and the option spread. In some arrangements, these amounts may differ.
In the typical transaction, the transfer of the stock option, the exercise of the option occur within a very short period of time. Usually, this time frame is within 1 week or may all occur on the same day. Often, the option exercise and the sale of the acquired stock occur within a couple months of the original transfer of the stock option. When non-vested stock options or restricted stock is utilized, the sale of the stock by the related person can be delayed an extended period of time until the options or restricted stock vests.
Capital gain or loss may apply to the related person for the subsequent sale of stock, after exercise of options or vesting of restricted stock by the related person.
In some transactions, the corporation has claimed a deduction in the year of transfer of the stock options or restricted stock, and in other transactions no deduction was claimed. As part of the arrangement, many corporations agree to forgo the deduction until the payments are made on the obligation as compensation under the terms of the transaction.
At the time of transfer or sale of the stock options, a Form W-2 is not issued to the individual and income is not reported on the individual’s Form 1040. In addition, employment taxes a re not withheld by the employer. For non-employee directors, Form 1099 is not issued to report the income to the individual at transfer or exercise.
With respect to information reporting for the related person, Form 1099 has infrequently been issued by the corporation to the related person to report the transfer or sale.
Fees are paid to the promoters of the transaction and have been deducted by the party who has paid the fees or included in the basis of the related person for the sale of stock. In some instances, all parties to the transaction have paid and deducted or included in basis promoter fees including the corporation, related persons and individuals.
A nonqualified deferred compensation (NQDC) plan is any elective or nonelective plan, agreement, method, or arrangement between an employer and an employee (or service recipient and service provider) to pay the employee compensation some time in the future. NQDC plans do not afford employers and employees with the tax benefits associated with qualified plans because, unlike qualified plans, NQDC plans do not satisfy all of the requirements of § 401(a).
Despite their many names, NQDC plans typically fall into four categories. Salary Reduction Arrangements simply defer the receipt of otherwise currently includible compensation by allowing the participant to defer receipt of a portion of his or her salary. Bonus Deferral Plans resemble salary reduction arrangements, except they enable participants to defer receipt of bonuses. Top-Hat Plans (aka Supplemental Executive Retirement Plans or SERPs) are NQDC plans maintained primarily for a select group of management or highly compensated employees. Finally, Excess Benefit Plans are NQDC plans that provide benefits solely to employees whose benefits under the employer’s qualified plan are limited by § 415. Despite their name, phantom stock plans are NQDC arrangements, not stock arrangements.
NQDC plans are either funded or unfunded, though most are intended to be unfunded because of the tax advantages unfunded plans afford participants. An unfunded arrangement is one where the employee has only the employer’s”mere promise to pay” the deferred compensation benefits in the future, and the promise is not secured in any way. The employer may simply keep track of the benefit in a bookkeeping account, or it may voluntarily choose to invest in annuities, securities, or insurance arrangements to help fulfill its promise to pay the employee. Similarly, the employer may transfer amounts to a trust that remains a part of the employer’s general assets, subject to the claims of the employer’s creditors if the employer becomes insolvent, in order to help it keep its promise to the employee. To obtain the benefit of income tax deferral, it is important that the amounts are not set aside from the employer’s creditors for the exclusive benefit of the employee. If amounts are set aside from the employer’s creditors for the exclusive benefit of the employee, the employee may have currently includible compensation.
A funded arrangement generally exists if assets are set aside from the claims of he employer’s creditors, for example in a trust or escrow account. A qualified retirement plan is the classic funded plan. A plan will generally be considered funded if assets are segregated or set aside so that they are identified as a source to which participants can look for the payment of their benefits. For NQDC purposes, it is not relevant whether the assets have been identified as belonging to the employee. What is relevant is whether the employee has a beneficial interest in the assets. If the arrangement is funded, the benefit is likely taxable under §§ 83 and 402(b).
NQDC plans may be formal or informal, and they need not be in writing. While many plans are set forth in extensive detail, some are referenced by nothing more than a few provisions contained in an employment contract. In either event, the form of a NQDC arrangement is just as important as the way the plan is operated. That is, while the parties may have a valid NQDC arrangement on paper, they may not operate the plan according to the plan’s provisions. In such a circumstance, the efficacy of the arrangement is not dependant upon its form.
A NQDC plan examination should focus on when the deferred amounts are includible in the employee’s gross income and when those amounts are deductible by the employer. It also should address when deferred amounts must be taken into account for employment tax purposes. The timing rules for income tax and for FICA/FUTA taxes are different. Each of these concerns is discussed below.
It is important to note that § 885 of the American Jobs Creation Act of 2004 changed the rules governing NQDC arrangements significantly. Contact one of our tax experts today to learn more and get your compliance questions answered.
Corporate executives often receive extraordinary fringe benefits that are not provided to other corporate employees. Any property or service that an executive receives in lieu of or in addition to regular taxable wages is a fringe benefit that may be subject to taxation. In 1984, the Internal Revenue Code (“Code”) was amended to include the term “fringe benefits” in the definition of gross income found in §61. A fringe benefit provided in connection with the performance of services, regardless of its form, must be treated as compensation includible in income under §61.
Whether a particular fringe benefit is taxable depends on whether there is a specific statutory exclusion that applies to the benefit. For example, when §61 was amended to include the term “fringe benefits”, §132 was added to provide exclusions for certain commonly provided fringe benefits that had previously not been addressed in the Code. Section 132 provides exclusions for working condition fringes, deminimis fringes, no additional cost services, qualified employee discounts, qualified moving expenses, qualified transportation fringes, and qualified retirement planning services.
Although it is clear that fringe benefits are taxable, employers may not treat them as wages for income and employment tax purposes. Employers may classify a taxable fringe benefit under expense accounts other than compensation, resulting in a failure to subject the fringe benefit to income and employment taxes.
Because the tax treatment of fringe benefits can vary depending on the facts and circumstances under which they are provided, it may be helpful to follow a 3-Step analysis when examining a particular item an employer gives or makes available to an executive.
• First, identify the particular fringe benefit and start with the assumption that its value will be taxable as compensation to the employee.
• Second, check to see if there are any statutory provisions that exclude the fringe benefit from the executive’s gross income.
• Third, value any portion of the benefit that is not excludable for inclusion in the executive’s gross income. Fringe benefits are generally valued at the amount the employee would have to pay for the benefit in an arm’s length transaction.
There are several potential issues regarding fringe benefits; however, this paper is designed to outline those more commonly provided to executives. There are both income and employment tax issues related to fringe benefits.
• Is the expense deductible by the corporation?
• Is the amount excludible from gross income of the executive?
• Is the executive receiving personal benefit from the corporation?
• Does the benefit exceed the §162(m) limitation?
SEC Items such as Form 10-K (Items 10, 11, and 12) and Form 4 can be used to identify executive compensation issues. The Form 4, Statement of Changes in Beneficial Ownership, may indicate whether stock was used for loan repayments. (Sarbanes-Oxley Act restricts the use of loans after July 30, 2002).
The following line items on the income tax return frequently contain taxable fringe benefits; the list is not all inclusive :
• Other Deductions
• Cost of Goods Sold
• Employee Benefits
• Schedule M-1
• Travel and Entertainment
Request a listing of the executives and officers from the taxpayer to identify the highly compensated executives. A representative group of executives may be selected for an in-depth examination. At a minimum the selection should include the SEC §16b executives (CEO and the other four highest compensated officers) for publicly traded companies.
The following steps should aide in the examination of Executive Fringe Benefits:
• Determine the department responsible for approving and processing payments to executives and officers.
• Review the Executive Compensation Committee Minutes, reports, etc.
• Review loan agreements between the corporation and executives/officers.
• Identify all payments to, or on behalf of, the executives/officers.
• Inspect the employment contracts and/or severance agreements to identify salaries and benefits paid to the executives.
• Sample monthly expense reports submitted by executives. Determine if there is an Accountable Plan and if the plan meets the requirements of IRC 62(c).
• Search for the executive’s name, SSN, or title in Accounts Payable. This search may identify payments to executives that were not included on a Form W-2 or Form 1099.
• Request a listing of the specific Payroll Codes or other accounting codes that relate to expenses/expenditures for executives. These codes can be used to identify payments to the executives/officers that may be taxable as compensation.
We hope that these suggestions are helpful. Still have questions? Call us. That’s what we’re here for.