COMPENSATION WITH RESTRICTED PROPERTY

An employee's compensation can be paid in either cash or noncash property. It is common for an executive's compensation to include payment in property, usually employer stock or securities, that is subject to some form of restriction at the time it is paid. The restriction on the property is usually designed to serve an employer goal, such as retaining a valued employee, and the restriction also can be designed to postpone taxability of the compensation to the employee and correspondingly postpone the employer's tax deduction.

Restricted stock or other restricted property is not an attractive benefit to an executive if the executive must pay income tax on the property when it is received, even though it is subject to restrictions. Therefore, most restricted property plans are designed around Code Section 83 that allows deferral of taxation to the employee if the restrictions meet certain requirements. Basically, the rules provide that an employee is not subject to tax on the value of restricted property until the year in which the property becomes substantially vested. Property is not considered substantially vested if it is subject to a substantial risk of forfeiture and not transferable by the employee free of the risk of forfeiture. As with most types of nonqualified compensation plans, the employer does not get a tax deduction until the year in which the property becomes substantially vested and includable in the employee's income.

The question whether there is a substantial risk of forfeiture depends on the facts and circumstances of each case. However, a substantial risk of forfeiture usually exists when the employee must return the property if a specified period of service for the employer is not completed-for example, five years of service. A forfeiture that results only from an unlikely event, such as the commission of a crime by the executive, probably would not constitute a substantial risk of forfeiture. Forfeitures as a result of failing to meet certain sales targets or going to work for a competitor could constitute substantial risks, depending on the facts and circumstances. If the employee is an owner of the company, the IRS is likely to be skeptical of any forfeiture provision in the plan, no matter how rigid it may appear on paper.

The nontransferability provision-the second half of the test-can be complied with in the case of the company stock by inscribing a statement on the share certificate to the effect that the shares are part of a restricted property plan. Thus, any prospective transferee is aware that the employee is not free to sell the shares to an outsider without restriction.

Suppose that executive Rita Bill is permitted to buy 500 shares of company stock at $10 per share in 2000, while the current market value is $100 per share. Rita must resell the shares to the company for $10 per share if she terminates employment with the company at any time during the next five years. The share certificates are also stamped with an appropriate statement to meet the nontransferability requirement. Rita pays no taxes on this arrangement until the restriction expires in 2005. If the unrestricted shares in 2005 have a market value of of $200 per share, Rita will have additional taxable compensation income for 2005 of $100,000, the market value of the shares, less $5,000, the amount Rita paid, or a net additional compensation income of $95,000. The company will get a tax deduction of $95,000 in 2005, but gets no deduction for 2000. Also, the allowance of the tax deduction to the company is, like all tax deductions for compensation paid, subject to the requirement that the total compensation package for the employee constitutes reasonable compensation for services rendered.

Many variations are possible in the design of restricted stock plans. The plan, for example, may provide that dividends on the restricted stock are payable to the executive during the restriction period; if so, these dividends are taxable currently to the executive as compensation income. The plan also might provide graduated vesting over a period of years, rather than full vesting at the end of a specified period like five years; this would mean that the executive would be taxed each year on the value of the property that became substantially vested that year.

In some plans, there are no forfeiture provisions; instead the stock is subject to other restrictions. For example, the employee may have a fully vested interest in the stock but may not be permitted to resell the stock without first offering it back to the company at a specified price. In that case, the value of stock to the executive would not be its market value, but would be a reduced value reflecting the restriction. Under the Internal Revenue Code, a restriction will be taken into account in valuing the property for tax purposes only if it is a nonlapse restriction-a restriction which by its terms will never lapse. The restriction in the example with a requirement of resale to the company at a fixed price would qualify as a nonlapse restriction. Other types of restrictions must be assessed on their own facts and circumstances, and the IRS tends to take a very limited view of what constitutes a nonlapse restriction.

Once an executive has become substantially vested in the restricted property and paid any tax on the compensation element involved, gain on a subsequent sale of the property is usually taxed as capital gain just as in the case of the sale of such property acquired by other means.

NONQUALIFIED DEFERRED-COMPENSATION PLANS

For qualified plans, imposes limits on the benefits or contributions that can be provided to any one individual. Annual additions to a qualified defined-contribution plan are limited to the lesser of 25 percent of the employee's compensation or $30,000. Correspondingly, for a defined-benefit plan, the maximum projected annual benefit is the lesser of 100 percent of the employee's compensation or $90,000. For very highly paid executives, it may be desirable to provide additional retirement income in excess of these limits. Also, in some cases, an employer does not have a qualified plan because the employer does not want to provide the kind of broad retirement plan coverage required by the nondiscriminatory coverage requirements. Thus, a common form of executive benefit is the provision of retirement income or deferred compensation outside of a qualified plan. Plans that do this are generally referred to as nonqualified deferred-compensation plans. Many names have been coined by consulting firms and insurance companies to describe specific plans of this type-for example, supplemental retirement plans, top-hat plans, and the like. The design of nonqualified deferred-compensation plans is open-ended and almost any combination of features can be provided in one way or another.

Objectives for the Plan

The design of a nonqualified deferred-compensation plan will reflect the objectives of the person establishing it. A broad distinction can usually be made between plans designed to meet employer objectives and those designed primarily to meet employee objectives. The employer's objectives in instituting the plan are usually to provide an inducement for hiring key employees and then to provide additional inducements to the key employees to continue working for the employer-especially so that employees do not leave and go to work for a competitor. Employee objectives are usually to obtain an additional form of compensation at retirement or termination of employment, with tax on the additional amounts deferred, if possible, until the money is actually received.

Employer-Instituted Plan

Eligibility in an employer-instituted plan is usually confined to key executives or technical employees who are difficult to recruit and keep. The plan does not have to specify a class of employees to be covered; it can simply be adopted for specific individuals as the need arises. However, the need for fairness among a similarly situated group of executives often dictates that the plan cover a specified class of employees rather than individuals.

A plan instituted for employer objectives usually has some kind of forfeiture provision to discourage key employees from leaving. The plan may require that the employee forfeit all rights under the nonqualified deferred-compensation plan in the event of termination of employment prior to normal retirement age without the employer's consent. The employer might wish to soften this forfeiture provision somewhat by including graduated vesting similar to that required under a qualified plan. However, as long as the plan avoids the applicability of the ERISA vesting provisions discussed later, no particular vesting schedule is required and complete forfeiture can be provided for any reason. The plan might include additional forfeiture provisions, such as a forfeiture of any unpaid benefits, if the employee enters into competition with the employer or goes to work for a competitor. The courts have held that such covenants not to compete can be enforced by the employer, so long as the scope of the prohibited competition is reasonable in terms of the geographic area over which it applies and the period of time during which it is in effect.

Nonqualified deferred-compensation plans often require that the employee remain available for consulting services to the employer after retirement, with possible forfeiture of benefits if the employee does not comply. Actually, consulting services provisions can be beneficial to the employee, as they often provide a means for the employee to receive additional amounts from the employer after retirement in return for relatively nominal consulting services.

Employee-Option Nonqualified Deferred Compensation

Different objectives for a nonqualified deferred-compensation plan come from the employee's side. Employees with enough income to have substantial savings programs often seek tax-favored methods of saving. Additional amounts of tax-favored savings can be provided beyond the limits of a qualified plan through a salary-reduction arrangement, with the amount of the salary reduction paid to the employee after retirement instead of currently. This provides tax savings because income tax on the salary reduction is paid in the future instead of currently, a valuable benefit because of the time value of money. It is also possible that the employee may be in a lower marginal tax bracket after retirement.

The initial problem in designing a plan for this objective is to ensure that the employee is not taxed currently on the salary reduction that goes into the plan. The salary-reduction arrangement must avoid the constructive receipt doctrine, under which income is taxable to a taxpayer if it is credited to the taxpayer's account, set apart, or otherwise made available, even though it is not actually received. To avoid this doctrine, the amount set aside must be subject to substantial limitations. This can generally be accomplished if the salary-reduction agreement is made prior to the time the income is earned by the employee and if the employee's receipt of it is deferred for a period of time, such as to termination of employment or retirement, which constitutes a substantial limitation.

Plans designed to meet employee objectives generally will have generous provisions and, in particular, there will be few forfeiture provisions-usually 100 percent immediate vesting-unless the plan is formally funded.

Funded and Unfunded Plans

A nonqualified deferred-compensation plan can be either funded by the employer or unfunded. With a funded plan, the employer sets aside money or property to the employee's account in an irrevocable trust or through some other means that restricts access by the employer and the employer's creditors to the fund. With an unfunded plan, either there is no fund at all or the fund that is set up is accessible to the employer and its creditors at all times, so that it provides no particular security to the employee other than the knowledge that the fund exists.

It might appear desirable from the employee's point of view to have a funded plan. However, there are significant disadvantages: The amounts put into a funded plan generally are taxable to the employee at the time the employee's rights to the fund become nonforfeitable, or substantially vested, a concept to be discussed under "Compensation with Restricted Property." This may occur well in advance of the time these funds are actually received by the employee, thus producing a tax disadvantage. Also, funded plans are subject to the ERISA vesting and fiduciary requirements, as discussed later, and this is usually undesirable from the employer's point of view.

As a result of these disadvantages, nonqualified deferred-compensation plans generally are unfunded. The employee relies only on the employer's unsecured contractual obligation to pay the deferred compensation. Because such plans provide no real security to the employee, their value as an inducement may be minimal if the company is risky; employees will then probably opt for greater benefits in current cash or property rather than deferred compensation.

Informal Funding

To provide some assurance, the employer can informally fund the plan by setting money aside in some kind of separate account, with this arrangement known to the employee but with no formal legal rights on the part of the employee and with the amount in the fund therefore available to the employer's creditors. Life insurance policies on the employee's life (owned by and payable to the employer) are often used to provide this kind of informal funding. Life insurance is particularly useful for this purpose if the deferred-compensation plan provides a death benefit to the employee's designated beneficiary, because if the employee dies after only a few years of employment, the life insurance will make sufficient funds available immediately to pay the death benefit. Sometimes a trust is set up by the employer to finance the plan. If the trust assets are available to the employer's creditors, the arrangement is deemed unfunded by the IRS. This type of arrangement is sometimes referred to as a rabbi trust because an early IRS ruling on this issue involved a rabbi.

Form of Benefits

Most nonqualified deferred-compensation plans provide for benefit payments in installments beginning at retirement or termination of employment. The five-year averaging provision available for qualified plan lump-sum benefits does not apply to nonqualified plans; benefits are taxable as ordinary income when received at the taxpayer's regular tax rates, assuming that the taxpayer has not already paid taxes on the amounts in prior years.

Nonqualified deferred-compensation plans often provide a death benefit, usually in the form of a benefit to a designated beneficiary in the amount the employee would have received if he or she had lived. If the plan uses life insurance as an informal funding medium, it usually also provides a flat-amount death benefit-usually related to the face amount of the life insurance policies-that is payable regardless of how much deferred compensation has accrued to the date of death. Death benefits are taxable as ordinary income to the beneficiary.

Employer's Tax Treatment

In a nonqualified deferred-compensation plan, the employer does not receive a tax deduction for deferred compensation until the year in which the employee must include the compensation in taxable income. This is the case even if the employer has put money aside through formal or informal funding of the plan in an earlier year. For an unfunded plan, the year of inclusion for the employee is the year in which the compensation is actually or constructively received. If the plan is formally funded, the employee includes the compensation in income in the year in which it becomes substantially vested.

Impact of ERISA and Other Regulatory Provisions

To retain design flexibility and keep administrative costs down, most deferred compensation plans are designed to avoid the fiduciary, vesting, and reporting and disclosure requirements of ERISA to the maximum extent possible. Generally, if the plan is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees, the plan will be exempt from all provisions of ERISA. However, if the plan does not come within this exemption, most of the provisions of ERISA become applicable, and the plan must comply with almost all of the ERISA provisions that apply to a qualified plan. The nonqualified plan could discriminate in participation, benefits or contributions, but for all other purposes-vesting, fiduciary, and reporting and disclosure-the plan would have to be designed like a qualified plan without the tax benefits for qualified plans. Consequently, most nonqualified deferred-compensation plans are designed to be unfunded and are limited to management or highly compensated employees.