Deducting equity-based and deferred compensation after a reorg. or employee transfer.

With the increasing incidence of spin-offs, split-ups, dropdowns and other reorganizations, corporations frequently face the issue of which entity is entitled to a deduction for equity-based or deferred compensation granted before the transaction but paid or vested after the transaction. Similar issues arise when an employee is transferred from one member of a controlled group to another.

Governing Principles

Sec. 83(h) determines the deductibility of stock options, restricted stock and other forms of equity-based compensation; Sec. 404(a)(5) determines the deductibility of nonqualified deferred compensation. Although these provisions differ in some respects, the fundamental principles underlying each are similar. First, compensation is deductible to the extent it is an ordinary and necessary business expense under Sec. 162. Second, the deduction is delayed until the compensation is included in the gross income of the employee or other service provider (the employee).

Section 162. The weight of relevant authority provides that reasonable compensation paid for services is generally deductible under Sec. 162 only by the employer for whom the services are performed. Because parents, subsidiaries and other members of a controlled group are separate corporate entities, absent unique and compelling circumstances, one member of a controlled group may not deduct expenses properly attributable to another; see, e.g., Columbian Rope Company, 42 TC 800 (1964); Young & Rubicam, 410 F2d 1233 (Ct. Cl. 1969); GCM 39208; and Letter Ruling 8012005. Thus, compensation is generally deductible under Secs. 83(h) and 404(a)(5) only by the particular employer for whom the related services are performed.

Deduction timing. Both Secs. 83(h) and 404(a)(5) provide that the deduction for reasonable compensation expenses is delayed until the compensation is included in the employee's gross income. Regs. Sec. 1.83-6(a)(3) provides that for property vested at the time of transfer (including vested stock transferred pursuant to the exercise or a nonqualified stock option, even if the option was subject to a vesting schedule), the deduction is generally allowed in accordance with the employer's method of accounting. For an accrual-basis taxpayer, this means that the deduction is generally allowed in the tax year in which the obligation to make the transfer accrues, provided the transfer is made within 2 1/2 months after the corporation's year-end; otherwise, the deduction is allowed in the year of transfer. Property not substantially vested at the time of transfer is deductible in the employer's tax year in which, or with which, ends the employee's tax year in which the compensation is included in gross income (the throw-forward rule).

Sec. 404(a)(5) and the regulations are less clear-cut. Regs. Sec. 1.404(a)12(b)(2) permits a deduction for "unfunded pensions ... paid directly to former employees" in the tax year in which paid to the employees. The term "unfunded pension" would appear to include compensation deferred until employment termination or beyond, consistent with the use of the term in Section 3(2) of the Employee Retirement Income Security Act of 1974; see, e.g., Letter Rulings 9807004 and 9127040. For a funded (or secured) pension or an unfunded deferred compensation program that is not a pension (e.g., a phantom stock plan), the throw-forward rule applies.

Compensation paid within 2 1/2 months after the end of the employer's tax year in which the related employee services are performed is not deferred compensation subject to Sec. 404(a)(5), and is deductible in accordance with the employer's accounting method. Thus, for an accrual-basis taxpayer, the deduction is generally permitted in the year such compensation is accrued (Sec. 404(b) and Temp. Regs. Sec. 1.404(b)-1T).

Deduction Following a Reorganization or Employee Transfer

The application of these deduction rules can be difficult following a reorganization or intra-group employee transfer, because the employer's identity may have changed between the time property was transferred or compensation was deferred and the time the property or compensation was paid. Thus, it is often difficult to identify the "employer" entitled to a compensation deduction.

Intra-group employee transfer. Consider an employee who is awarded a nonqualified stock option and subsequently transferred to a subsidiary. On exercise of the option, the employee must recognize income equal to the spread between the exercise price and the fair market value of the stock received. But which company is entitled to the corresponding deduction? In other words, which company received the services compensated with the stock option?

Assuming that (1) the exercise price of the option was the value of the parent stock at the time of grant, (2) the option was exercisable only if the employee remained employed with a corporation in the controlled group for at least three years, (3) the employee was transferred from the parent to the subsidiary two years after grant, and (4) the option was exercised four years after grant, did the option compensate services performed for the parent, the subsidiary or both?

There is no controlling authority determining the "correct" answer. However, applying the general principles outlined above and taking cues from IRS guidance in analogous situation (e.g., allocation of compensation income between foreign and U.S. sources), the deduction arguably could be allocated under any of the following methods:

1. The parent is entitled to the full deduction, because the stock option was granted on account of services performed for the parent in the year before the grant.

2. The subsidiary is entitled to the full deduction, because the services critical to vesting were performed in the third year, while the employee was employed by the subsidiary.

3. The deduction should be allocated between the parent and subsidiary using one of the following methodologies:

(i) Two-thirds to the parent and onethird to the subsidiary, because two years of vesting service were performed with the parent and one year with the subsidiary;

(ii) One-half to each, consistent with the period of service performed for each entity between the time of grant and exercise;

(iii) The parent's deduction equals any appreciation in the underlying stock as of the date of transfer; the subsidiary is entitled to the remainder.

The most appropriate allocation method in a given situation depends on the facts and circumstances. The parties' intent would seem to be the most important factor (i.e., which services the stock options were intended to compensate). If the parties have not otherwise expressed their intent, the period over which the options vest may reflect best the services intended to be compensated by the grant. Thus, one reasonable approach may be to allocate two-thirds of the deduction to the parent and one-third to the subsidiary; see, e.g., Letter Rulings 9037008, 8711107 and 6701305110A. On the other hand, it may be more consistent with the principles underlying Sec. 83 to allocate the deduction attributable to the options based on all services performed between grant and exercise, since this is the period over which the amount of compensation includible in the employee's gross income is determined; see, e.g., Letter Ruling 6208215200A (allocating deduction over the period between grant and exercise). This means that the deduction would be allocated equally between the parent and the subsidiary. Alternatively, the parent may be entitled to the portion of the deduction attributable to the appreciation in the option stock as of the date the employee is transferred, with the subsidiary entitled to the remainder.

Similar deduction allocation principles should apply to restricted stock and other forms of equity-based compensation. In theory, these principles should also apply to nonqualified deferred compensation. As a practical matter, however, in the case of compensation deferred for many years, the employer from which an employee retires often claims the entire deduction rather than allocating the deduction among two or more related employers. The Service seems unlikely to challenge this approach in most circumstances.

In many situations involving intragroup employee transfers, the proper allocation of the deduction may be largely irrelevant for Federal income tax purposes because the controlled group files a consolidated return. The same may be true of split-ups in which the new company remains within the controlled group (e.g., a drop-down of a subsidiary).

Split-up. When a corporation splits into two or more separate entities after an option grant, property transfer or deferral of compensation, the deduction generally must be allocated among the new entities. This is similar to an employee transfer situation, but with an additional twist; the "employer" for whom services were performed before the split no longer is identifiable as a single corporation. Thus, not only must the deduction be allocated based on services performed before and after the split, but the deduction for services performed before the split should be allocated among the new entities in proportion to their relative values immediately following the split.

Example: An option to purchase stock in Company X is granted to Employee A. X subsequently is split into two companies, Y and Z; X optionholders receive two options to purchase Y stock and one option to purchase Z stock for each option held prior to the split to purchase X stock. If a share of Y stock is equal in value to a share of Z stock, the initial value of Y relative to Z is 2:1. Thus, Y should be entitled to two-thirds of the compensation deduction attributable to services performed before the split; Z is entitled to the remaining one-third. A's post-split employer should be entitled to the deduction attributable to services performed after the split. (See, e.g., R.J. Nicoll Co., 59TC 37 (1972), acq. 1973-2 CB 3, cited favorably in Letter Ruling 9738009.)

Because of the administrative complexity involved in allocating the deduction in the manner described, many corporations adopt a "rough justice" approach (e.g., allocating the entire deduction generated on exercise of the Y options to Y and the entire deduction generated on exercise of the Z options to Z). Taxpayers may explain adoption of this approach by arguing that the options were granted on account of services performed for X before the date of grant (consistent with the first allocation method described), which means the deduction should be split in proportion to the initial value of the post-split companies. (The IRS has approved this approach in Letter Rulings 9738009 and 9317033.)

Spin-off The proper allocation of compensation deductions following a spin-off of an existing subsidiary would appear to be relatively straightforward. Nonetheless, the deduction allocation rules often are misapplied in this situation.

A typical fact pattern involves a nonqualified option to purchase parent stock granted to an employee of a subsidiary. Following the grant, the subsidiary is spun off, and the option is subsequently exercised. Another common fact pattern involves restricted stock granted to the subsidiary employee before the spin-off, with the stock becoming vested after the spin. Which corporation is entitled to the deduction available under Sec. 83(h) at the time of option exercise or restricted stock vesting?

Applying the deduction principles outlined above, there would appear to be only one answer--the spun-off subsidiary. Under Sec. 162, the taxpayer entitled to the deduction is the company that received the services performed by the employee that was compensated with the option or restricted stock. The only company that satisfies this condition is the subsidiary, the employer both before and after the spin. Not surprisingly, this is the ruling position generally espoused by the Service; see, e.g., Letter Rulings 9743048 and 9351029.

The IRS has apparently been persuaded in some circumstances that an entity other than the direct employer should be entitled to the deduction, perhaps in the interest of administrative simplicity. As a result, taxpayers that would prefer to take a more aggressive position (e.g., that the deduction attributable to post-spin vesting or option exercise should be allocated to the former parent) should study Letter Rulings 9738009 and 9317033. These rulings address reorganizations that appear to involve spin-offs of existing subsidiaries as well as split-ups. Rather than requiring the reorganizing entities strictly to apply Sec. 162 deduction principles, the Service approved the rough justice allocation approach described (in the split-up discussion) to the entire transaction (i.e., effectively allocating the deduction in proportion to the initial values of the post-spin and post-split companies). Taxpayers with similar fact patterns may be able to secure a comparable result.