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Recent Tax Developments That Affect Stock Compensation

Tax returns have been our focus (and probably yours too) over much of the past two months. However, now that tax-return season is over, it's time to catch up with some major recent tax-related developments that have an impact on stock compensation. The tax content at myStockOptions.com has been fully updated for the developments presented below. (Relevant updates have also been made at our separate website myNQDC.com, which covers all topics in nonqualified deferred compensation.)

"Substantial Risk Of Forfeiture" And Restricted Stock

The concept of "substantial risk of forfeiture" (SRF) under Internal Revenue Code Section 83 directly affects the timing of:

  • the taxation of restricted stock grants
  • the FICA taxation of RSUs
  • the taxation of nonqualified stock options (in limited situations)

In short, for as long as any type of compensation is subject to the possibility of forfeiture, it is not taxed. With restricted stock, income is therefore not recognized while the stock is subject to this risk during the vesting period. Once this risk lapses upon vesting, and thus you could quit the company without forfeiting the shares, the value of the stock is taxed.

The IRS issued final regulations, somewhat similar to the proposed regulations, that confirm and clarify previous IRS revenue rulings, court decisions, and the widely accepted understanding of what constitutes a substantial risk of forfeiture. For example, the proposed and final regulations confirm that transfer restrictions such as a lockup agreement, a noncompete, or a potential insider-trading liability are not SRFs, even though they present the possible forfeiture or disgorgement of some or all of the stock, or another penalty. For more details, see a related FAQ at myStockOptions.com, along with memos from Towers Watson and a blog analysis from the law firm Winston & Strawn.

Tax Reform?

Dave Camp, the Chairman of the House Ways and Means Committee, has distributed a draft of a broad tax-reform law that carries a few proposals aimed at executive and equity compensation. For example, the bill known as the Tax Reform Act of 2014 would eliminate the exception for performance-based compensation (e.g. stock options) from the $1 million deduction limit under Section 162(m) and would include the CFO among the covered employees whom it applies to. The proposed legislation would repeal Section 409A, and a new Section 409B would tax compensation when it is no longer subject to a risk of forfeiture (i.e. at vesting) under Section 83 of the tax code—a shift that would cause a major change in the taxation of nonqualified deferred compensation. Other proposed tax changes would indirectly affect stock compensation. These proposals include the elimination of the alternative minimum tax and a provision to tax capital gains at 60% of a person's marginal tax rate.

Numerous law, consulting, and accounting firms published memos about the proposed legislation and its potential impact on equity compensation and other employee benefit plans. These include commentaries from Proskauer Rose and Groom Law Group. An analysis from Buck Consultants reassuringly echoes many other commentaries by saying that the draft has "little chance of becoming law." However, the firm notes, many of the revenue-raising provisions in the draft that include modifications to employee benefits could be "picked up in the future to offset federal spending and reduce deficits."

Tax Treatment For Disgorgements And Clawbacks

Uncertainty surrounds the tax treatment that applies when an executive must return compensation through a clawback provision. In a blog commentary about this topic at his firm's website, attorney Michael Melbinger of Winston & Strawn discusses a recent case decided by the US Court of Claims, Nacchio v. United States. This case concerned a disgorgement (as a penalty for insider trading) of stock-sale gains on which taxes had been paid. The court allowed a claim-of-right tax credit under IRC Section 1341. By analogy, notes Mr. Melbinger, this precedent can apply to most (if not all) Dodd-Frank clawback situations. For more on this topic, see a related FAQ at myStockOptions.com.

Comments

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From what I have read and heard in the last year signs point to a strong possibility that meaningful reforms to rein in excessive executive compensation could be a prospect, as many political leaders in Europe and the United States seem to be finally catching up to the public uproar. It has to be said though that compensation is a complex issue. Different circumstances and industries dictate different packages and even severance pay may be justified if a change of control is the end goal. One would hope though that politicians would reject laws about pay, which are too widespread to be useful. Strict legislation might well compel leaders away from listed companies and create compensation packages even more complex—and so much more difficult to monitor.

Thanks,
Rupert Lewis
Bike Accident UK

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