Editor: Lori Anne Johnston, CPA, J.D.
Because of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, some U.S. companies have converted their controlled foreign corporations (CFCs) to make them subject to U.S. tax rules (a "domestication," for purposes of this discussion). One driver of CFC domestication is the TCJA's tax on global intangible low-taxed income (GILTI). Even if the employees of the domesticated entity are not U.S. taxpayers, the compensation paid to the employees is subject to U.S. tax deduction rules. Regular wages are generally deductible as paid to the employees, but equity compensation and nonqualified deferred compensation are subject to special U.S. deduction timing rules and limitations.
This item briefly discusses some risk areas for newly domesticated CFCs to help advisers spot issues for clients. For simplicity, this discussion uses the term "employee" but may include other service providers.
Who gets a compensation tax deduction?
In general, only the employer receiving the services, not a parent company, can deduct compensation for those services, even if the parent actually paid the employees (see Rev. Rul. 84-68 and Regs. Sec. 1.83-6(a)). If a U.S. parent corporation pays compensation to subsidiary employees, the parent corporation is generally treated as making a capital contribution to the employer-subsidiary, and the subsidiary takes the deduction for the taxable compensation, though there are a few exceptions to this rule (see Young & Rubicam, Inc., 410 F.2d 1233 (Ct. Cl. 1969)).
Restricted stock/capital units deduction timing rule
When an employer transfers stock to an employee subject to a substantial risk of forfeiture (vesting) condition, the shares are not generally treated as "transferred" for most U.S. federal income tax purposes until the actual vesting date. On vesting, the employee has compensation equal to the vesting date fair market value (FMV) of the shares (less any amount paid for the shares) (see Regs. Sec. 1.83-1(a)). The employer cannot take the restricted stock tax deduction until the employee includes the equity compensation as taxable income.
If both the employee and the employer have the same tax year end (such as Dec. 31), the employer can take the deduction in the employer's year in which the employee includes the amount as taxable compensation. The deduction timing rules for restricted stock vesting need to be examined if the company and the employee have different tax years. Under Regs. Sec. 1.83-6(a)(1), the employer takes the deduction in the employer's tax year in which ends the employee's tax year in which the employee includes the stock compensation in taxable income.
Example 1: Employee A's tax year ends Dec. 31, 2019. Employer B's tax year ends Nov. 30, 2019. A vests in restricted shares on June 30, 2019, and has restricted share compensation in A's 2019 tax year. Because B's tax year ends before A's tax year end, B cannot take a tax deduction for the restricted shares in its Nov. 30, 2019, year and instead deducts the amount in B's year ending Nov. 30, 2020 (the year including A's Dec. 31, 2019, tax year end).
An employee can make a Sec. 83(b) election to include restricted stock as taxable compensation on the grant date (using the FMV of the stock on the grant date). Under this election, the employer reports the compensation, pays appropriate payroll tax withholding (if payroll tax is required for the CFC employee), and takes the tax deduction in the year of the grant rather than the later vesting date.
Similar rules apply in the case of a partnership, but if the service provider is a partner, further rules may apply (see Secs. 267(a)(2) and (e)). Under Sec. 83, if equity is transferred to a nonresident alien who is exempt from U.S. taxation, the employer takes the deduction when an employee would have taken the amount into taxable compensation income had the employee been subject to U.S. taxation (see Regs. Sec. 1.83-6(a)(1)).
Stock option deduction timing rule
Under U.S. tax rules, if an employer grants Sec. 409A-exempt stock rights (including being granted with an exercise price equal to the FMV of the underlying stock), the employer can generally take a stock option deduction in the year in which the employee exercises the stock option (see Regs. Sec. 1.83-6(a)(3)). Employees generally cannot make Sec. 83(b) elections on stock options. Discounted stock options may be subject to further deduction timing rules and different employee inclusion rules.
Nonqualified deferred compensation
U.S. tax rules provide significantly different rules and treatment for "qualified" and "nonqualified" deferred compensation plans (NQDC plans). Qualified deferred compensation plans generally include Sec. 401(k) retirement plans (and other defined contribution plans) or certain pension plans (also called defined benefit plans) and are subject to very specific qualification requirements under Sec. 401(a). This discussion focuses on the NQDC plan deduction timing rules.
NQDC plans in the United States are usually just for top employees and are "unfunded" (not held in a trust or held in a grantor trust that is an employer asset available to the employer's creditors). U.S. tax rules for a funded NQDC plan are generally unfriendly to the U.S. employees. However, employers established outside of the United States may have funded NQDC plans (deferred bonus plans or retirement plans). NQDC plan contributions are generally governed under Sec. 404(a)(5) or under the limited "short-term deferral" exception to Sec. 404(a)(5). Additional rules apply depending on whether the NQDC plan is funded or unfunded. As with Sec. 83, to the extent the employees covered under the NQDC plan are nonresident aliens (and are exempt from U.S. taxation), the employer can take the deduction when the employees would take the amounts into taxable compensation if the employees were subject to U.S. taxation (see Regs. Sec. 1.404(a)-12(b)(1)).
For many unfunded NQDC plans, Sec. 404(a)(5) allows the deduction for an NQDC plan only once the employee takes a plan distribution as taxable income. Under this Sec. 404(a)(5) timing rule, which closely resembles the Sec. 83 restricted stock deduction timing rule, the employer can only take the deduction in the year in which ends the employee's tax year in which the employee includes the deferred compensation as taxable income.
Example 2: An NQDC amount is granted on Dec. 30, 2019, vests 25% per year over four years, and is distributed on Jan. 2, 2024. Employee C has compensation income in the 2024 tax year (ending Dec. 31, 2024). Employer D has a calendar tax year. D can take the tax deduction for the payment in D's tax year ending Dec. 31, 2024, D's tax year in which C takes the distribution into taxable income.
Example 3: Assume the same facts as Example 2, but D has a tax year ending June 30. D can take the distribution tax deduction in D's tax year ending June 30, 2025. Sec. 404(a)(5) only allows a deduction in D's tax year that covers Dec. 31, 2024 (the end of C's tax year in which C includes the distribution as taxable compensation).
Under the short-term deferral plan exception, the employer may claim the tax deduction for NQDC payments slightly sooner (see Temp. Regs. Sec. 1.404(b)-1T). If the NQDC amount is totally unvested, vests, and is distributed within 2½ months after the year of vesting, the employer can take the tax deduction under the employer's method of accounting. In many instances, an accrual-basis employer may have a method of accounting that permits the employer to take a deduction in the year in which a deferred compensation plan is "fixed and determinable," even if the payment is not included in the employee's taxable compensation until payment early in the following tax year.
Example 4: Assume the same facts as Example 2, except that the entire arrangement is unvested until the end of 2023. Under the short-term deferral exception, although the amount is included in employee C's taxable compensation in 2024, employer D can take a tax deduction in 2023 (when the benefit becomes fixed and determinable) because the payment will vest in 2023 and will be paid no more than 2½ months after the year of vesting.
The deduction timing rules for funded NQDC plans (such as foreign long-term bonus or retirement plans) are beyond the scope of this discussion. However, the deduction further depends upon whether the plan is a defined contribution or a defined benefit plan, and Sec. 404(a)(5) can limit or eliminate the deduction for a funded defined benefit plan unless the plan is subject to a Sec. 404A election.
Certain transaction issues
When a Sec. 280G change in control occurs, Sec. 280G can limit the corporation's deductions for certain types of change-in-control payments, based on the "excess parachute payment" received by Sec. 280G disqualified individuals. Private companies may be able to avoid a Sec. 280G deduction loss by taking certain steps and securing shareholder approval of the excess parachute payments. A Sec. 280G analysis is usually needed to support the necessary disclosures for a proper shareholder vote.
Public company executive compensation deductions
U.S. public companies are subject to a $1 million deduction limit on compensation paid to certain executives ("covered employees"). After the TCJA, this rule now includes certain foreign companies that have U.S. public debt or American depositary receipts traded in the United States. In addition, if a foreign company is related to a U.S. public company, the $1 million limitation on compensation may be applied based on the aggregate compensation paid to executives who provide services to both a U.S. company and a non-U.S. company. An entity domesticating in the United States needs to determine, working with an SEC attorney, whether the company or a related company may be subject to SEC reporting requirements.
Matter of timing
The U.S. compensation deduction rules can be complicated and can provide for unexpected deduction limits and timing rules. Advisers need to gather additional information about the types of plans and payments, types of equity, vesting provisions, the types of companies involved, the employer's and employee's tax years, and other critical information before determining the timing and amounts of tax deductions for compensation under U.S. tax rules.
Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.
For additional information about these items, contact Karen Field (Karen.Field@rsmus.com) and T. Christopher D'Avico (Chris.D'Avico@rsmus.com).
Unless otherwise noted, contributors are members of or associated with RSM US LLP.