Deducting compensation paid in property.

Compensation can be paid in cash or in property. An employee includes the value of the property in his or her income at the time of receipt (or, if the property is restricted, when it vests). Recently, an employer questioned at what point it was entitled to a deduction for compensation paid.

Venture Funding issued stock to 12 of its employees as compensation for services as part of a bankruptcy reorganization. Although Venture neither withheld taxes nor issued forms W-2 or 1099 on the compensation paid--as the rules require--it deducted the value of the stock as compensation. The IRS denied the deduction because the company failed to meet the requirement that a business either withhold tax or issue an information return before claiming a deduction. The taxpayer appealed.

IRC section 83(h) permits a deduction for compensation paid in property in the year the recipient includes the property in income. Before 1995, employers could claim a deduction if they withheld income taxes. The current rules require the employer to issue an information return. For property that is vested at the time of transfer, a special exception allows the employer to take a deduction under its normal accounting method.

Result: For the IRS. Although the taxpayer argued it was entitled to a deduction because either the regulations were invalid or the company qualified under the special exception, the Tax Court found the regulations were valid and denied the deduction. The court also found that the special exception addressed only the timing issue. If the property is vested and included in income (or deemed to be included because it meets the requirements of the regulation), then an employer can take a deduction in the year specified under its normal accounting method rather than in the year the recipient includes it in income. This special rule does not eliminate the requirement that the property first be included in the recipient's income.

This case clarifies that property is deductible as compensation only in the year it is included on a return or amended return or included as the result of an IRS audit or in the year the taxpayer meets the regulatory safe harbor by issuing an information return.

* Venture Funding, Ltd., 110 TC no. 19 (1998).

Prepared by Edward Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.