“Deferred Compensation”		«BACK
	by John E. Berg
	from Krass Monroe, P.A.

A restricted stock plan is commonly used in closely held corporations. With a restricted stock plan, a corporation issues stock to an executive either without cost or for a nominal price. The executive's right to ownership in the stock is subject to certain restrictions such as continuing employment. Vesting may occur ratably or upon the expiration of a stated term. The plan usually requires forfeiture of the non-vested shares if the executive terminates the employment relationship during the restriction period. The executive generally includes in income an amount equal to the excess of the fair market value of the stock over the amount paid for the stock in the first tax period in which the shares are either transferable or not subject to a substantial risk of forfeiture period. The executive may, however, elect under Section 83(b) to recognize income in the year in which he receives the stock. In such case, the sale of such stock at a later date generates capital gain (as opposed to ordinary income). The employer receives a deduction for the amount the employee includes in income during the tax year the employee recognizes the income.

There are two types of stock option plans: nonstatutory stock option plans and incentive stock option plans. Typically, a nonstatutory stock option plan grants an executive the right to purchase stock at a price below the market value. In many cases, the executive cannot exercise the option before the expiration of a specific holding period. Upon the expiration of the holding period, all of the options become exercisable. Usually, the options expire upon the termination of employment. Stock option plans are generally combined with buy-sell agreements that restrict sales of such stock and address other corporate governance issues.

The tax treatment of nonstatutory stock options depends upon whether the value of the option is readily ascertainable. If the option value is readily ascertainable, it is taxed as compensation at the time of its issuance. If the option has no readily ascertainable fair market value, the option is taxable income for the employee at the time the option is exercised. The employer gets a deduction during the year that the employee recognizes the income.

An incentive stock option is similar to a nonstatutory stock option except for its tax treatment. The principal attraction of an incentive stock option plan is the additional tax deferral opportunity generally available to an executive. Although the exercise of a nonstatutory stock option is typically a taxable event, the internal revenue code generally provides for the deferral of gain in connection with an incentive stock option plan until disposition of the acquired shares. If the employee does not dispose of the stock within (i) two years after the option is granted, or (ii) one year after receipt of the stock, the employee will recognize capital gain upon such disposition.

If the employee does not satisfy this holding period, the employee will recognize ordinary income upon the disposition, and the employer will receive a corresponding deduction. An employee who acquires stock pursuant to an incentive stock option, is taxed for alternative minimum tax purposes in the year that the stock is freely transferable or not subject to a substantial risk of forfeiture. The Code imposes a trade-off for the beneficial tax treatment. They are very specific and technical requirements for ISO's. These rules often make ISO's impractical for non-publicly traded corporations.

A stock appreciation right ("SAR") permits an executive to receive cash equal to the appreciation in the value of the corporate stock occurring between the date of grant and the date of exercise. Usually a holder of an SAR can exercise the SAR at specific times during employment and at the termination of employment. At the time of exercise, the SAR is payable in cash. With stock appreciation rights, the employee includes the income in the year of receipt and the employer gets the deduction in the same year. One of the principal attractions of an SAR is the employee does not receive any equity interest in the employer (i.e., voting privileges) yet receives the economic benefits of their services through compensation tied to the increased value of the employer.

Certain companies prefer deferred compensation agreements to stock or equity based plans. Such agreements provide that if the employee is employed with the employer for a certain number of years, the employee will become entitled to receive cash payments over a period of time. In such instances, the employee includes in income and the employer receives a deduction for the amount of deferred compensation paid or received during that year. Deferred compensation can either be isolated into a trust (i.e., rabbi trust) or can be an unsecured promise of the corporation to pay the employee certain rights in the future.

In summary, deferred compensation arrangements create an attractive benefit for employees and employers. Consequently, many corporations are implementing deferred compensation plans. The flexibility and variety of deferred compensation plans allows employers a competitive advantage in attracting and retaining key employers. If you are interested in learning more about deferred compensation plans and how they could benefit your business, please contact us at Krass Monroe and we will be happy to evaluate how a deferred compensation plan will add value to your business.