Page 100 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

86 The Complete Guide to Executive Compensation

of the fair market value over the amount paid for such property. Notice of such election before
end of the 30-day window must be sent to the IRS, with a copy to the company. When the
executive files the tax return (for the year in which election was made), a copy of the notice filed
with the IRS should be included. The stock must also be subject to the risk of forfeiture and be
nontransferable. If these requirements are met when the restrictions lapse, the fair market value
less the adjusted taxable base will be eligible for long-term capital gains (LTCG) tax if held long
enough. However, if the property is forfeited, no deduction will be permitted in respect to such
forfeiture except for the amount paid (if any) by the executive to purchase the restricted stock.
The risk of forfeiture also comes into play in determining when to subject the monies to
FICA and HI (health insurance or Medicare) taxation. The rule is that individuals covered
by a nonqualified plan will be subject to such taxation when the amount can be reasonably
determined. Namely, it will be taxed when actually or constructively received unless it is not
subject to forfeiture, in which case it is taxed at that time.
Thus, said taxation may occur when received or earlier if the risk of forfeiture require-
ment has not been met. In the latter situation, the individual having been taxed on the
amounts set aside will not be again subject to taxation when received. This is the nonduplica-
tion rule, namely, amounts once taxed (plus any future earnings on such values) will not be
subject to taxation when received.
Proposed IRS regulations indicate that restricted stock, regardless of whether or not
an 83(b) election has been made, is not subject to the 2004 American Jobs Creation Act
Section 409A requirements for deferred compensation.
Salary Reduction Plans

In the early 1970s, the “salary reduction” plan became popular. It effectively allowed the
employee to have a portion of salary deferred by placing it in a money-purchase-type
investment plan.
It worked like this. An executive would be hired at $200,000 but would agree that
$20,000 of this would be invested in a Section 403(b) tax-sheltered annuity program. The
executive would have $180,000 (not $200,000) of reportable income; however, the company
could claim a $200,000 compensation deduction ($180,000 for salary and $20,000 for contri-
bution to the money purchase plan). Effectively, it allowed the company to take a deduction
before the executive had a taxable event!
During the mid-1970s, these plans were allowed to continue by the IRS, but new plans
lost the attractive tax feature. More specifically, such contributions were considered to be
made by the employee; thus, the person had $200,000 salary with a $20,000 contribution
made from after-tax income. The company had a $200,000 deduction for salary.
The Tax Reform Act of 1976 made deferred compensation generally attractive. It
amended the definition of “personal service income” (which it substituted for “earned
income”) to include amounts received as annuities, pensions, or other deferred compensa-
tion. Thus, properly designed, deferred compensation plans are subject to the same maxi-
mum tax in effect when the monies are earned. Prior to this act, it might be subject to a 50
percent tax when earned, but if deferred, it could be subject to a 70 percent tax, if received
later than the year following the year in which it was earned. The one-year grace period then
in effect was helpful only in exempting short-term incentive awards, usually paid in the first
part of the year subsequent to the year in which earned. The 1976 Tax Reform Act allowed
both qualified and nonqualified deferred compensation to be subject to the 50 percent