Industry Insights

As this poor economy lingers, employers may not have cash to adequately compensate a key employee. A possible solution to this problem is for the corporation to issue the employee noncash compensation, such as stock, stock options, property or notes in the form of a promise to pay the employee a salary in the future.

In other instances, the corporation may want to reward or motivate an employee for staying through the lean times by offering a lower salary but equity in the corporation equivalent to what the employee has lost in salary. This is especially appealing if the employee believes the value of that equity will appreciate after the transfer date.

No matter the motivation, if an employer transfers property to an employee as compensation, the employee must include the fair market value of the property in his/her gross income. “Property” includes real and personal property but cannot be either money or an unfunded or unsecured promise to pay money or property in the future. An employer can, but is not required to have the employee pay some amount toward the property transferred. Any such payment reduces the amount the employer counts as income.

The employer includes the property’s fair market value in the employee’s gross income the first taxable year the employee’s rights in the property are transferable or do not have a substantial risk of being forfeited, whichever happens first. Property rights are transferable only if the transferee’s rights do not carry a substantial risk of forfeiture. For example, an employee’s stock rights would not be transferable if the corporation has a right of first refusal to purchase the stock if the employee wished to transfer the shares to any person or entity other than the corporation.

A person’s property rights have a substantial risk of forfeiture if those property rights are conditional on any individual’s future performance of substantial services. For example, if an employer transfers property to an employee as compensation for services rendered, but the employer requires the employee to return the property without consideration if, within two years, the employee stops working for the corporation or the corporation’s earnings do not increase to a specified level, then the property is subject to a substantial risk of forfeiture. Therefore, the employee would not include the fair market value of the property in his or her gross income at the time of the transfer, unless he or she makes an election under Internal Revenue Code Sec. 83(b).

Code Sec. 83(b) states an employee can include in gross income the fair market value of the property transferred at the time of the transfer, even if the property is subject to a substantial risk of forfeiture. If the employee makes this election on time, he or she cannot include the property as compensation in gross income when it becomes substantially vested. An employee might want to make this election if he or she anticipates that property subject to a substantial risk of forfeiture will appreciate between the date of the transfer of the property and the lapse of the restrictions.

Issuing noncash compensation can have many positives if the right property is matched to the right employee. Explore these with your BKD advisor, but keep the tax ramifications in mind. Contact your BKD advisor for more information.