Equity-Based and Nonqualified Deferred Compensation Plans

By Mark P. Altieri, J.D., LL.M., CPA/PFS


  • Under a restricted stock plan, an employee is issued stock subject to a substantial risk of forfeiture. When the stock is no longer subject to a risk of forfeiture, the employee has income in the amount of the fair market value of the stock less any amount paid for it by the employee.
  • Under stock option plans, an employee is issued stock options to purchase stock that may be subject to a substantial risk of forfeiture. The tax treatment of the plan further depends on whether the plan is statutory or nonstatutory.
  • Under a nonqualified deferred compensation arrangement (DCA), the employee does not receive an equity interest in the company; instead, the employer and employee or independent contractor have a contractual arrangement under which the person agrees to be compensated in cash (or much less frequently in property) in the future for services the person is providing currently. There are a number of forms of DCAs.
  • The rules under Sec. 409A potentially affect every nonqualified arrangement that defers the receipt (and taxation) of compensation income.

This article provides an overview of the federal income taxation rules governing equity-based compensation plans as well as nonqualified deferred compensation plans. Publicly traded companies and privately held firms frequently use these plans to enhance the overall compensation packages of higher-end management. The advent of Sec. 409A has added further complexity to the myriad tax laws governing such arrangements.

Actual Stock and Stock Option Plans

Restricted Stock

Under a restricted stock plan, the corporate employer currently issues actual shares of stock to a key management employee. The employee usually pays nothing for the stock. The fair market value (FMV) of the stock in excess of any amount paid by the employee (the bargain element) will be ordinary income to the employee. 1 The inclusion of this income occurs at such time as the stock is transferable or is no longer subject to a substantial risk of forfeiture (the vesting date). 2 A substantial risk of forfeiture normally requires ongoing full-time employment through the vesting date. 3

An exception to this general rule occurs if the employee makes a Sec. 83(b) election. Such an election triggers the taxable event upon issuance of the nonvested stock and does not require a subsequent inclusion in income when the risk of forfeiture lapses in a future tax year. The Sec. 83(b) election is frequently referred to as a “gambler’s choice” because if the stock is subsequently forfeited, the employee will receive no deduction that would offset the earlier inclusion in income on having made the Sec. 83(b) election. This election is usually advisable in situations where the stock has a relatively low FMV on issuance but there is a high expectation that it will substantially rise in value in the future (e.g., a high-tech startup company).

In either situation, the employee’s tax basis in the restricted stock normally is measured by the amount of ordinary income the employee reports on the occurrence of the taxable event (a tax-cost basis under Sec. 1012). The employer would have a corresponding compensation deduction for federal income tax purposes when the employee recognizes income regardless of the employer’s tax accounting method. 4

Example 1: P Inc., a publicly traded corporation, has seen its per share common stock value fall from $40 to $10 as a result of the general economic downturn. P’s board of directors and its management team believe the firm will triple in value in the next two to three years. In an attempt to motivate management to attain that goal, the board authorizes the issuance of a number of shares of restricted stock to management, who will pay nothing for the shares. The stock has a two-year vesting period and is considered to have a substantial risk of forfeiture because the company requires the employees to remain full-time employees of P for two years after the restricted stock is issued. At the time P issues the restricted stock, it is trading at $10 per share.

Employee A decides to take the gambler’s choice and makes a Sec. 83(b) election. A files the requisite form with the IRS and as a result has to include $10 per share in his ordinary W-2 wage income for the current year. That year he also establishes a $10 tax-cost basis per share in the stock. P will take a $10 per share compensation deduction the same year that A picks up the $10 per share of income. A remains a full-time employee of P for the required two-year vesting period, at which time the stock is worth $30 per share. At this time, the $20 of appreciation that occurred from the time A received the stock until its vesting date would not be included in his income until A disposed of the stock. Also, it should be noted that P would not be entitled to any additional compensation deduction.

When A sells the stock, his gain will be measured by the tax basis established by Sec. 1012 when the Sec. 83(b) election was made and the FMV of the amount realized on the sale, with the resulting gain being taxed at favorable long-term capital gain rates. If A terminates employment prior to the two-year vesting date, he will forfeit the stock back to P and will have no tax deduction despite the fact that he previously reported the $10 per share received as ordinary income.

At the same time, employee B receives the same P stock and does not make the Sec. 83(b) election. She remains a full-time employee of P for the requisite two-year vesting period, at which time the stock is worth $30 per share. In the year of vesting, B has to report $30 per share as ordinary income and has a $30 per share tax-cost basis in the stock. P has a $30 per share compensation deduction in the year of vesting. However, if B terminates employment with P prior to the two-year vesting period, she will forfeit her shares back to P and will have no income inclusion or tax deduction.

Nonqualified Stock Options

A nonqualified stock option (NQSO) arrangement is a highly flexible method of giving an employee (or independent contractor) an opportunity to purchase employer stock. This variety of options is labeled nonqualified to distinguish them from the more employee-favorable incentive stock options, described below, which are often known as qualified options. Most stock options are nonqualified. To the extent that the employer does not have publicly traded options substantially similar to those granted under an NQSO, the grant of an option does not create a taxable event. 5 Because of the Sec. 409A rules discussed below, it will be a rare NQSO that sets the exercise price at a number less than the FMV of the underlying stock as of the option grant date. Upon exercise and purchase of the underlying stock, the difference between the stock’s FMV and the exercise price is ordinary wage income to the employee. 6

Absent a Sec. 83(b) election, to the extent that the stock received on exercise is subject to a substantial risk of forfeiture, the stock is not immediately taxable as noted above under the restricted stock discussion. In that case, the resulting wage income will not be taxable until that forfeiture condition lapses, at which time the stock’s FMV in excess of the exercise price will be included in the employee’s wage income. As also noted above, the employer will have a corresponding compensation deduction for federal income tax purposes equal to the amount of the employee’s income inclusion in the year the employee recognizes income.

Because the optionee has to come up with sufficient after-tax cash to pay the exercise price and cover the taxable event related to the exercise, cashflow becomes a problem. Therefore, as noted below, stock appreciation rights (which allow for a cash payment) are frequently coupled with nonqualified options.

Incentive Stock Options

Incentive stock options (ISOs) are frequently more desirable from the employee’s standpoint (independent contractors cannot participate in an ISO arrangement). 7 As noted above, ISOs frequently are referred to as qualified options to distinguish them from nonqualified options. On grant of the option, the exercise price must be no lower than the underlying stock’s FMV. 8 Upon exercise, the employee must come up with the exercise price in after-tax dollars (as with the NQSO) but suffers no regular income tax liability. 9 The bargain element (the difference between the stock’s FMV and the exercise price) may trigger alternative minimum tax (AMT) liability as it is frequently a substantial positive AMT adjustment. 10

The lack of a regular taxable event better assures the optionee that he or she will be able to retain the stock after exercise because there will be no regular tax liability to contend with at that time. Upon selling the stock at a profit at a later point in time (no earlier than two years from the date of grant or within one year after the exercise of the option), the employee will obtain long-term capital gain treatment. 11 Otherwise the sale will be a disqualified disposition that will generate ordinary income. 12

Even though the tax results are much better for the option holder, the employer will have no compensation deduction under an ISO. Another negative aspect is that an employer may grant no more than $100,000 worth of ISOs to an employee in any year, thus limiting it as a compensatory tool for very highly compensated employees (HCEs). 13

Example 2: Employer R Inc. grants an NQSO to employee C, entitling him to purchase R shares at $10 per share, the current price of the stock, over the next two years. R simultaneously grants an ISO to employee D, entitling her to buy R shares at $10 per share over a two-year period. A year later the stock has risen to $20 per share, and C and D both exercise their options in full, receiving stock not subject to a risk of forfeiture. C recognizes $10 per share of ordinary wage income at that time, and R is entitled to a $10 per share compensation deduction. In contrast, D does not recognize any regular income at the time of exercise, and R will have no deduction.

Subsequent appreciation in R stock will be treated as a capital gain to either C or D on disposition of the stock, assuming they hold the stock at least a full additional year. C’s tax basis will be $20 per share (the $10 per share paid on exercise and the $10 per share recognized as ordinary income when the option was exercised), and D’s tax basis will be $10 per share (the $10 per share paid on exercise).

Nonqualified Deferred Compensation Arrangements

General Features

A nonqualified deferred compensation arrangement (DCA) does not involve equity ownership in the employer; instead, it is a contractual arrangement under which an employee or independent contractor agrees to be compensated (usually in cash) in a future year for services currently being rendered. The structure of a DCA can be very flexible. Apart from the Sec. 409A restrictions discussed below, the only major restrictions are that the arrangement not be formally funded (to avoid tax problems under Sec. 83(a)) and that the DCA participants be limited to management or HCEs in order to avoid Employee Retirement Income Security Act (ERISA) problems. 14 A so-called rabbi trust (discussed below) does not violate the no formal funding requirement and does provide participants with some enhanced assurance that their benefits will be paid except in cases of the employer’s legal insolvency or bankruptcy.

Payments under a DCA usually start when the employment ends (e.g., upon retirement) or upon pre-retirement death or disability. There are two broad structural categories of DCAs: elective and nonelective. Under an elective DCA, the employee agrees to receive less salary and bonus compensation than he or she would otherwise currently receive and to defer receipt of the reduced amount to a future tax year. The point here is that the employee initiates the deferral. The election to defer income must be made prior to the time in which the income is earned (e.g., a salary reduction agreement to defer 10% of compensation that would otherwise be earned and payable in the 2012 calendar year must be entered into on or before December 31, 2011). 15

Because under an elective DCA the employee initiates deferral of compensation that he or she would otherwise shortly earn and receive, imposing a substantial risk of forfeiture on the DCA benefits would be inappropriate. As noted above, a substantial risk of forfeiture is a vesting mechanism requiring substantial future services before benefits become nonforfeitable. Therefore, an elective deferral will typically be fully vested and payable in the event of termination of employment for virtually any reason.

Nonelective deferred compensation is a different type of contractual arrangement. It is not unusual for larger employers to provide a deferred compensation benefit as a pure add-on fringe benefit to key employees. It does not result in a reduction in their current salary or bonus compensation otherwise payable. This is the so-called velvet handcuff mechanism for retaining key employees, and it usually incorporates a substantial risk of forfeiture requiring a number of years of service before the benefits become nonforfeitable.

In both elective and nonelective DCAs, the employee’s taxable event typically is deferred until the employee receives the DCA benefits in the future, 16 and the employer’s deduction is deferred until the tax year in which the employee recognizes the deferred compensation. 17 All the arrangements described below are of the nonelective variety.

The Sec. 409A rules are discussed following the description of these forms of nonqualified DCAs.

Stock Appreciation Rights

A stock appreciation right (SAR) is a form of nonqualified deferred compensation (NQDC) that frequently is coupled with an NQSO plan and sometimes with an ISO plan. The SAR will pay a benefit linked to the appreciation in value of the employer’s stock after issuance of the SAR. The purpose of the SAR often is to provide a contemporaneous cash payment to the optionee when he or she exercises a stock option. The SAR thus provides cash to the NQSO holder to cover both exercise price and tax liability while providing the ISO holder with cash to accommodate the exercise price (and perhaps AMT liability). As long as the SAR is issued only to key management and HCEs, there will be minimal ERISA issues (the other arrangements discussed herein can also be provided on a completely discriminatory basis for the sole benefit of HCEs and, indeed, must be in order to avoid ERISA entanglements). The SAR cash benefits are ordinary wage income taxable to the employee on receipt of the cash on exercise and generate a compensation deduction to the employer in the same tax year as the employee recognizes the income.

Phantom Stock Plans

A phantom stock plan is another form of DCA in which there is a deferred cash benefit but no actual stock ownership. Conceptually similar to the SAR but not linked to a stock option plan, the amount of the benefit is generally measured by appreciation in the value of the employer’s stock from the inception of the arrangement. As with any DCA, ordinary income is taxable to the employee on receipt, and the employer gets a compensation deduction in that same tax year.

In terms of participation, the board of directors commonly provides new phantom stock grants each year or two based on past performance. Thus, the level of participation will be based on past performance and merit, yet the future benefit value will still be a function of future appreciation, thereby providing the desired incentive to management.

Performance Unit Plan

Like the phantom stock plan, this DCA pays a deferred cash benefit based on company performance. Here, however, the benefit is not linked to the value of employer stock but to some other measurement such as increase in earnings per share or stockholder equity. As we have seen with the other variations of deferred compensation, income is taxable to the employee on receipt of the cash benefit, and a corresponding compensation deduction is then available to the employer.


A supplemental employee retirement plan (SERP) is another form of nonelective deferred compensation. It makes up for benefits lost by HCEs under the employer’s qualified retirement plans. Due to Sec. 415(c)(3), which imposes benefit accrual restrictions for highly compensated participants, only a limited amount of the employee’s annual compensation can be considered for purposes of accruing qualified plan benefits ($245,000 for 2011). 18 This is a very common form of NQDC.

Other DCAs

Within the constraints mentioned above relative to elective and nonelective DCAs, there are a number of additional possibilities for structuring plans. One key point mentioned earlier is the HCE requirement. All the above DCA arrangements must be HCE plans in order to avoid troublesome ERISA requirements. Therefore, all plan participants must objectively be highly compensated and management class employees relative to nonparticipants.

Example 3: E is a highly compensated executive of S, Inc. S has a qualified profit-sharing plan (a qualified plan) in place for all its employees who work 1,000 hours or more a year (including E). Under that plan, S generally makes an annual contribution of 10% of each participating employee’s compensation for the year. E’s compensation for the year is $500,000. Because Sec. 401(a)(17) limits the amount of compensation that can be considered for annual benefit accrual purposes to $245,000 in 2011, S is precluded from making a profit-sharing contribution for the majority of E’s compensation. However, S does maintain a SERP for E and similar executives whose profit-sharing contributions are affected by Sec. 415.

In 2011, S credits E’s SERP account by $25,500 ($255,000 not considered compensation under the profit-sharing plan × the 10% factor). S does not actually contribute any wealth to an account in which E has a legal interest. As a SERP participant, E has only S’s contractual promise to pay the benefit in the future as called for under the contract. As discussed above, to the extent that E has a legal interest in any formal funding vehicle such as a trust or escrow account (as opposed to an informal funding vehicle such as the rabbi trust discussed below), Sec. 83 will accelerate the taxable event.

E’s benefit under the SERP will commence only on his separation from service because of retirement, death, or disability, which are permissible triggering events under Sec. 409A. There is also a substantial risk of forfeiture associated with the benefit that requires E to continue in the full-time employment of S for at least 10 years from the commencement of his participation in the SERP. At that point in time, he will have a vested benefit in his deferred compensation, and the income taxation of the benefits will be deferred until E actually receives them on separation from service.

Because all participants under the SERP are highly compensated management of S (all HCEs), the SERP need not comply with the eligibility, participation, funding, and reporting and disclosure requirements normally required of an ERISA pension plan.

Sec. 409A Deferred Compensation Rules


Sec. 409A is generally applicable to compensation deferred under a DCA (which definition would apply to all the DCAs noted above) after December 31, 2004. 19 The rules under Sec. 409A potentially affect every nonqualified arrangement that defers the receipt (and taxation) of compensation income. For purposes of the rules, a Sec. 409A deferral includes any individualized arrangement such as an employment agreement or a more formal plan covering multiple HCEs that provides for deferral of compensation from the year in which the employee earns it into a future tax year. 20

The Sec. 409A DCA definition does not include qualified retirement plans (e.g., a tax-qualified pension, a profit-sharing plan, a Sec. 401(k) plan, a Sec. 403(b) tax-deferred annuity, and a Sec. 457(b) eligible plan for state, government, or tax-exempt employees) 21 or bona fide vacation, sick leave, disability pay, or death benefit plans. 22 Also excluded from the definition of a Sec. 409A deferral are so-called short-term deferrals, welfare benefit plans, and certain involuntary severance pay arrangements. 23 Certain equity incentive plans, such as the NQSO and SAR arrangements discussed above, could be DCAs if the exercise or measuring price is less than the FMV of the underlying stock on the date of grant 24 (see the Sec. 409A discussion of stock options below).

Sec. 409A imposes a tax acceleration and significant penalty to the extent that the DCA experiences a “plan failure” (described below), and the plan benefits to be paid in the future are not then subject to a substantial risk of forfeiture. As already noted, a contractual requirement to render substantial future services before vesting the benefit is a substantial risk of forfeiture. Upon a plan failure, absent an ongoing substantial risk of forfeiture, not only will all deferred compensation (plus any earnings attributable to it) be accelerated into income, but a 20% penalty tax and interest will be imposed that year. 25

Early Distribution

Plan failures under the rules can take a variety of forms. The first would result from an improper early distribution under the DCA. An improper early distribution would occur if the plan could pay benefits prior to:

  • The date of the participating employee’s separation from service or before that participant became disabled or died; 26
  • The time initially specified in the plan for payout;
  • The time of a change in the ownership or effective control of the employer; or
  • The occurrence of an unforeseen emergency. 27

Subsequent Deferral

A plan failure also includes an ability to again defer payments scheduled to be made under the original terms of the DCA. The plan may permit subsequent elections to delay or change the form of payments if the new election cannot take effect until at least 12 months after it is made. In addition, a more typical election to further defer a distribution due to be made after the participant’s separation from service, upon a predetermined date or schedule or upon a change in ownership of the employer, must defer the delayed payment for at least an additional five years. 28 Therefore, benefits originally scheduled to commence on separation from service can again be deferred if they will not commence for five years after the separation.

Initial Deferral Election

Another major category of plan failure relates to the initial deferral election for elective DCAs (in which the employee initiates the deferral decision). Sec. 409A codifies the IRS’s prior position in Rev. Proc. 71-19 29 by requiring that a participant’s election for deferral is effective only if the participant makes it before the tax year in which he or she will earn the deferred compensation. If the deferred compensation is based on performance criteria or services performed over a period of at least 12 months (e.g., bonus compensation), the election must be made no later than 6 months before the end of the measurement period. With regard to a new participant (for example, a new officer hired during the plan year), the new participant must make the election within 30 days after the date he or she becomes eligible to participate in the DCA. 30

Funding Arrangements

Long before the advent of Sec. 409A, formally funding an NQDC obligation accelerated the taxable event to the participating employee. 31 To the extent that the participant had a vested, nonforfeitable interest in any trusteed money (a secular trust) to be used to satisfy DCA payments, taxation on the deferred compensation was, and still is, accelerated.

An important and frequently used device to somewhat increase the likelihood that deferred compensation will be paid without accelerating the taxable event is through “informal” funding of the obligation in a rabbi trust. In a rabbi trust, the employer irrevocably contributes money to a trust to satisfy the deferred compensation obligations, yet that money remains subject to the employer’s general and secured creditors in the event of legal insolvency or bankruptcy. Because of this contingency, the IRS has long acknowledged that employee taxation is not accelerated by funding deferred compensation obligations in a rabbi trust. 32

Sec. 409A does not change this result, except in the rarest situations. Under the Sec. 409A rules, employee taxation through the use of a rabbi trust is accelerated only if the trust is an offshore trust (thus providing a practical impediment to employer creditors reaching the trust assets) or if it is a “springing” arrangement under which the rabbi trust would be substantially funded (or a preexisting rabbi trust would contractually flip to secular trust 33 status) upon a negative change in the employer’s financial health short of legal insolvency or bankruptcy. 34

Stock Options

An option to purchase stock that is a nonstatutory stock option may be deemed to be a DCA subject to Sec. 409A. More specifically, a nonstatutory stock option is one other than an incentive (qualified) stock option described in Sec. 422 (the ISO discussed above) or an option granted under a qualified employee stock purchase plan as provided in Sec. 423. Therefore, the NQSOs described earlier will constitute nonstatutory stock options as defined under the new law. 35 Such a nonstatutory stock option will further constitute a Sec. 409A DCA if the amount required to purchase stock under the option is less than the FMV of the underlying stock on the date the option is granted (a fairly rare event even before Sec. 409A). 36


It is incumbent on the business and the tax adviser to scrutinize any arrangement (regardless of how labeled) for deferrals of income beyond the year in which they are earned by the benefited employee. To the extent that such deferrals are not specifically excepted from the Sec. 409A rules (qualified pensions, short-term deferrals, welfare benefit plans, involuntary severance pay arrangements), it is likely that such arrangements are subject to Sec. 409A. The tax adviser must also look for such Sec. 409A deferrals in other contractual arrangements to purchase or receive equity in the employer. The adviser must then ensure that such equity compensation plans are accounted for under older tax law (discussed in the section above on actual stock and stock option plans) as well as Sec. 409A.


1 Sec. 83(a).

2 Id.

3 Sec. 83(c)(1).

4 Sec. 83(h).

5 An option has an FMV that is readily ascertainable if it is actively traded on an established market (Regs. Sec. 1.83-7(b)(1)).

6 Sec. 83(a).

7 Sec. 422(a)(2).

8 Sec. 422(b)(4).

9 Sec. 421(a).

10 Sec. 56(b)(3).

11 Sec. 422(a)(6).

12 Sec. 421(b).

13 Sec. 422(d).

14 Employee Retirement Income Security Act, P.L. 93-406, §§201(2) (participation and vesting), 301(a)(3) (funding), and 401(a)(1) (fiduciary responsibility).

15 Sec. 409A(a)(4)(B).

16 Rev. Rul. 60-31, 1960-1 C.B. 174.

17 Sec. 404(a)(5).

18 Notice 2010-78, 2010-49 I.R.B. 808.

19 Regs. Secs. 1.409A-1–6.

20 Regs. Sec. 1.409A-1(a)(1).

21 Regs. Sec. 1.409A-1(a)(2).

22 Regs. Sec. 1.409A-1(a)(5).

23 Analysis of these items is beyond the scope of this article.

24 Regs. Sec. 1.409A-1(b)(5).

25 Secs. 409A(a)(1)(A) and (B).

26 A disability is defined as a mental or physical impairment that is expected to last for more than a year and (1) prevents the employee from engaging in substantial gainful activity or (2) is one for which the employee is receiving disability income benefits for a period of not less than three months under an employer disability plan (Sec. 409A(a)(2)(c)).

27 An unforeseen emergency is a severe financial hardship to the participating employee resulting from an illness or accident to the participant, the participant’s spouse, or a dependent of the participant not compensated or reimbursed through insurance or otherwise. Such an emergency also includes a loss of the participant’s property due to casualty or a similar extraordinary and unforeseeable circumstance (Sec. 409A(a)(2)(B)(ii)).

28 Sec. 409A(a)(4)(c).

29 Rev. Proc. 71-19, 1971-1 C.B. 698.

30 Sec. 409A(a)(4)(B)(ii).

31 Rev. Rul. 60-31, note 16.

32 Rev. Proc. 92-64, 1992-2 C.B. 422, containing model rabbi trust provisions.

33 A secular trust differs from a rabbi trust in that the employer’s creditors cannot reach the trust’s assets, and the employee’s right to the trust’s assets is vested from the trust’s inception.

34 Sec. 409A(b).

35 Regs. Sec. 1.409A-1(b)(5).

36 Id.


Mark Altieri is an associate professor at Kent State University in Kent, OH, and special tax counsel to Wickens, Herzer, Panza, Cook, and Batista Co. in Avon, OH. For more information about this article, contact Prof. Altieri at maltieri@kent.edu.

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