PRESENT LAW AND BACKGROUND 

RELATING TO EXECUTIVE COMPENSATION 

Scheduled for a Hearing 

Before the 

SENATE COMMITTEE ON FINANCE 

on September 6, 2006 

Prepared by the Staff 

of the 

JOINT COMMITTEE ON TAXATION 

September 5, 2006 

JCX-39-06 
i

CONTENTS 

Page

INTRODUCTION .......................................................................................................................... 1 

I. EXECUTIVE SUMMARY ................................................................................................ 2 

II. LIMITATION ON DEDUCTION FOR COMPENSATION IN EXCESS OF 

$1 MILLION....................................................................................................................... 3 

A. Present Law................................................................................................................... 3 

B. Discussion of Issues...................................................................................................... 6 

III. NONQUALIFIED DEFERRED COMPENSATION....................................................... 10 

A. General Description .................................................................................................... 10 

1. In general .............................................................................................................. 10 

2. Types of nonqualified deferred compensation arrangements ............................... 11 

3. Specific types of plans .......................................................................................... 12 

4. Comparison with qualified employer plans .......................................................... 14 

B. Tax Treatment of Nonqualified Deferred Compensation ........................................... 19 

1. Timing of income inclusion for the individual ..................................................... 19 

2. Timing of deduction.............................................................................................. 27 

3. Payroll taxes and wage reporting.......................................................................... 27 

C. Discussion of Issues.................................................................................................... 29 

IV. STOCK-BASED COMPENSATION............................................................................... 32 

A. General Description .................................................................................................... 32 

B. Compensatory Stock ................................................................................................... 33 

1. In general .............................................................................................................. 33 

2. Tax treatment ........................................................................................................ 33 

C. Compensatory Stock Options ..................................................................................... 34 

1. In general .............................................................................................................. 34 

2. Nonqualified options............................................................................................. 34 

3. Statutory options ................................................................................................... 35 

4. Accounting for stock options................................................................................ 38 

5. Backdating stock options ...................................................................................... 39 

D. Other Examples of Stock-Based Arrangements ......................................................... 42 

1. In general .............................................................................................................. 42 

2. Stock appreciation rights....................................................................................... 42 

3. Phantom stock unit................................................................................................ 42 

E. Discussion of Issues.................................................................................................... 43 

V. TAXATION OF EXCESS PARACHUTE PAYMENTS ................................................ 44 
1

INTRODUCTION 

The Senate Committee on Finance has scheduled a hearing for September 6, 2006, on 

issues related to the tax treatment of executive compensation, including issues relating to 

backdating of stock options. This document,1

 prepared by the staff of the Joint Committee on 

Taxation, provides a description of present-law tax rules and issues relating to certain types of 

executive compensation arrangements, including the $1 million dollar cap on the deduction for 

executive compensation, nonqualified deferred compensation, stock-based compensation 

(including the tax issues relating to backdating stock options), and golden parachute payments. 

 1

 This document may be cited as follows: Joint Committee on Taxation, Present Law and 

Background Relating to Executive Compensation (JCX-39-06), September 5, 2006. 
2

I. EXECUTIVE SUMMARY 

Executives are covered by a wide range of compensation arrangements. Executive 

compensation arrangements may include several employees or may consist of individual 

agreements between the company and one executive. In addition to typical arrangements such as 

nonqualified deferred compensation and stock option programs, executive compensation 

arrangements often allow executives benefits such as the personal use of the company aircraft or 

an allowance for financial planning. There is no limit to the scope of particular arrangements. 

This document discusses commonly used executive compensation arrangements, including 

nonqualified deferred compensation and stock-based compensation. This document does not 

address the many other forms of executive compensation such as split-dollar life insurance 

arrangements, corporate-owned life insurance in connection with a corporation’s executive 

compensation arrangements, and individualized arrangements. 

In the case of publicly traded companies, the Code imposes a limit on a company’s 

deduction for compensation of certain employees in excess of $1 million. The limitation applies 

to the chief executive officer and the four other most highly compensated employees. 

Performance-based compensation is not subject to the deduction limitation. Studies have 

indicated that the deduction limitation may have led to some substitution away from salary 

compensation toward performance-based compensation, but that growth in overall executive 

compensation has not been reduced. 

Nonqualified deferred compensation is a common form of executive compensation. 

There are several reasons that companies and executives engage in such arrangements. 

Nonqualified deferred compensation arrangements are not subject to the rules and limitations 

applicable to qualified employer retirement plans. Congress recently enacted Code section 

409A, which provides specific rules for the tax treatment of nonqualified deferred compensation. 

Prior to the enactment of section 409A, the tax treatment of nonqualified deferred compensation 

was governed by general tax principles. Several practices had developed that allowed executives 

deferral of income inclusion, but inappropriate degrees of security and control over amounts 

deferred. Section 409A was intended to address these practices. 

Stock-based compensation is prevalent in executive compensation arrangements. Stockbased compensation includes stock, restricted stock, stock options, stock appreciation rights and 

phantom stock. The extent to which the use of stock-based compensation is appropriate has been 

questioned by some. Many believe that executive compensation should be dependent on a 

company’s performance. Others believe that the emphasis on stock-based compensation is 

inappropriate as it is not directly linked to an individual’s performance and may encourage 

artificial inflation of a company’s stock price. 

Stock options, in particular, are commonly used for compensation. Recently enacted 

accounting rules now require stock options to be reflected in financial statements upon the grant 

of the options. Stock option backdating has received much media attention recently. The SEC 

and IRS are investigating this practice with respect to many publicly traded companies. There 

are financial statement, securities and tax law implications of backdating stock options. 
3

II. LIMITATION ON DEDUCTION FOR COMPENSATION 

IN EXCESS OF $1 MILLION 

A. Present Law 

In general

A corporation generally may deduct compensation expenses as an ordinary and necessary 

business expense. However, the otherwise allowable deduction for compensation paid or 

accrued with respect to a covered employee of a publicly held corporation2

 is limited to no more 

than $1 million per year (sec. 162(m)).3 The deduction limitation applies when the deduction 

would otherwise be taken. Thus, for example, in the case of compensation resulting from a 

transfer of property in connection with the performance of services, such compensation is taken 

into account in applying the deduction limitation for the year for which the compensation is 

deductible under section 83. 

Covered employees

Covered employees are defined by reference to the Securities and Exchange Commission 

(“SEC”) rules governing disclosure of executive compensation. Thus, with respect to a taxable 

year, a person is a covered employee if (1) the employee is the chief executive officer of the 

corporation (or an individual acting in such capacity) as of the close of the taxable year or (2) the 

employee's total compensation is required to be reported for the taxable year under the Securities 

Exchange Act of 1934 because the employee is one of the four highest compensated officers for 

the taxable year (other than the chief executive officer). If disclosure is required with respect to 

fewer than four executives (other than the chief executive officer) under the SEC rules, then only 

those for whom disclosure is required are covered employees. Under Treasury regulations, the 

requirement that the individual meets the criteria as of the last day of the taxable year applies to 

both the chief executive officer and the four highest compensated officers.4

 

Compensation subject to the deduction limitation

In general

Unless specifically excluded, the deduction limitation applies to all remuneration for 

services, including cash and the cash value of all remuneration (including benefits) paid in a 

medium other than cash. If an individual is a covered employee for a taxable year, the deduction 

limitation applies to all compensation not explicitly excluded from the deduction limitation, 

regardless of whether the compensation is for services as a covered employee and regardless of 

 2

 A corporation is treated as publicly held if it has a class of common equity securities that is 

required to be registered under section 12 of the Securities Exchange Act of 1934. 

3

 This deduction limitation applies for purposes of the regular income tax and the alternative 

minimum tax. 

4

 Treas. Reg. sec. 1.162-27(c)(2). 
4

when the compensation was earned. The $1 million cap is reduced by excess parachute 

payments (as defined in sec. 280G, discussed below) that are not deductible by the corporation. 

Certain types of compensation are not subject to the deduction limit and are not taken 

into account in determining whether other compensation exceeds $1 million. The following 

types of compensation are not taken into account: (1) remuneration payable on a commission 

basis; (2) remuneration payable solely on account of the attainment of one or more performance 

goals if certain outside director and shareholder approval requirements are met 

(“performance-based compensation”); (3) payments to a tax-qualified retirement plan (including 

salary reduction contributions); (4) amounts that are excludable from the executive's gross 

income (such as employer-provided health benefits and miscellaneous fringe benefits (sec. 132)); 

and (5) any remuneration payable under a written binding contract which was in effect on 

February 17, 1993, and all times thereafter before such remuneration was paid and which was 

not modified thereafter in any material respect before such remuneration was paid. 

Performance-based compensation

In general.–Compensation qualifies for the exception for performance-based 

compensation only if (1) it is paid solely on account of the attainment of one or more 

performance goals, (2) the performance goals are established by a compensation committee 

consisting solely of two or more outside directors,5

 (3) the material terms under which the 

compensation is to be paid, including the performance goals, are disclosed to and approved by 

the shareholders in a separate vote prior to payment, and (4) prior to payment, the compensation 

committee certifies that the performance goals and any other material terms were in fact 

satisfied. 

Definition of performance-based compensation.–Compensation (other than stock options 

or other stock appreciation rights) is not treated as paid solely on account of the attainment of 

one or more performance goals unless the compensation is paid to the particular executive 

pursuant to a preestablished objective performance formula or standard that precludes discretion. 

In general, this means that a third party with knowledge of the relevant performance results could 

calculate the amount to be paid to the executive. What constitutes a performance goal includes, 

for example, any objective performance standard that is applied to the individual executive, a 

business unit (e.g., a division or a line of business), or the corporation as a whole. Performance 

standards could include, for example, increases in stock price, market share, sales, or earnings 

per share. 

Stock options or other stock appreciation rights generally are treated as meeting the 

exception for performance-based compensation, provided that the requirements for outside 

director and shareholder approval are met (without the need for certification that the performance 

standards have been met), because the amount of compensation attributable to the options or 

 5

 A director is considered an outside director if he or she is not a current employee of the 

corporation (or related entities), is not a former employee of the corporation (or related entities) who is 

receiving compensation for prior services (other than benefits under a tax-qualified pension plan), was not 

an officer of the corporation (or related entities) at any time, and is not currently receiving compensation 

for personal services in any capacity (e.g., for services as a consultant) other than as a director. 
5

other rights received by the executive would be based solely on an increase in the corporation's 

stock price. 

Stock-based compensation is not treated as performance-based if it is dependent on 

factors other than corporate performance. For example, if a stock option is granted to an 

executive with an exercise price that is less than the current fair market value of the stock at the 

time of grant, then the executive would have the right to receive compensation on the exercise of 

the option even if the stock price decreases or stays the same. Thus, stock options that are 

granted with an exercise price that is less than the fair market value of the stock at the time of 

grant do not meet the requirements for performance-based compensation. Similarly, if the 

executive is otherwise protected from decreases in the value of the stock (such as through 

automatic repricing), the compensation is not performance-based. 

In contrast to options or other stock appreciation rights, grants of restricted stock are not 

inherently performance-based because the executive may receive compensation even if the stock 

price decreases or stays the same. Thus, a grant of restricted stock is treated like cash 

compensation and does not satisfy the definition of performance-based compensation unless the 

grant or vesting of the restricted stock is based upon the attainment of a performance goal and 

otherwise satisfies the standards for performance-based compensation. 

Compensation does not qualify for the performance-based exception if the executive has 

a right to receive the compensation notwithstanding the failure of (1) the compensation 

committee to certify attainment of the performance goal (or goals) or (2) the shareholders to 

approve the compensation. 

Shareholder approval and adequate disclosure.–In order to meet the shareholder approval 

requirement, the material terms under which the compensation is to be paid must be disclosed 

and, after disclosure of such terms, the compensation must be approved by a majority of shares 

voting in a separate vote. 

In the case of performance-based compensation paid pursuant to a plan (other than a 

stock option plan), the shareholder approval requirement generally is satisfied if the shareholders 

approve the specific terms of the plan, including the class of executives to which it applies. In 

the case of a stock option plan, the shareholders generally must approve the specific terms of the 

plan, the class of executives to which it applies, the option price (or formula under which the 

price is determined), and the maximum number of shares subject to option that can be awarded 

under the plan to any executive. Further shareholder approval of payments under a plan or 

grants of options is not required after the plan has been approved. If there are material changes 

to the plan, shareholder approval has to be obtained again in order for the exception to apply to 

payments under the modified plan. 
6

B. Discussion of Issues 

Prior to the enactment of section 162(m) in 1993 (effective for taxable years beginning on 

or after January 1, 1994), there was no specific limit on the amount of deductible compensation. 

Section 162 generally limits the deduction for compensation to a "reasonable allowance." While 

in theory the reasonableness requirement could add as a limit on total compensation paid, this 

requirement has been applied primarily to prevent dividends of closely-held companies (which 

are not deductible) from being characterized as compensation (which is deductible). 

The legislative history states that section 162(m) was motivated by then-current concerns 

regarding the amount of executive compensation in public companies, and that the purpose of the 

provision was to reduce "excessive" compensation.6

 While not specifically mentioned in the 

legislative history, the exception to the limitation for performance-based compensation reflects 

the view that such compensation, by its nature, is not "excessive." A provision similar to section 

162(m) was also proposed by the Clinton Administration. The rationale behind this provision 

was stated a bit differently, and focused on the "unlimited tax benefit" provided to executive 

compensation. This tax benefit was described as particularly inappropriate in cases in which 

executive compensation increased while company performance suffered. The Administration 

proposal also had as a stated objective the intent to provide an incentive to link compensation to 

business performance.7

 Since the enactment of section 162(m) the appropriateness of executive 

compensation has remained a topic in the public eye.8

Companies may decide to structure compensation arrangements to maximize deductible 

compensation under section 162(m) or simply to forgo a full compensation deduction. If they 

decide to maximize the deduction, they may do so in a number of different ways, for example, by 

providing more deferred compensation or by structuring compensation in a way so that it 

qualifies as performance based. Literature suggests that these decisions may be affected by a 

variety of factors including pressure from shareholder groups, the transaction costs involved in 

changing compensation arrangements, the extent to which the company is already paying 

compensation that is viewed as high compared to other similar companies, insider ownership, the 

amount of current tax cost associated with failure to comply (i.e., whether the loss of a deduction 

 6

 H.R. Rep. No. 103-111, at 646 (1993). Concerns regarding the amount of compensation paid in 

non-public companies may also arise, but may present different issues than with respect to public 

companies. 

7

 Department of the Treasury, Summary of the Administration’s Revenue Proposals (February 

1993), at 40. 

8

 See, for example, Laura Smitherman, Earning Power: Maryland’s Highest-Paid Executives, 

Baltimore Sun, June 18, 2006, at 1A; Renee Degross, CEO Beats Peers in Pay, Atlanta Journal and 

Constitution, April 15, 2006, at B1; Shabina S. Khatria, Who’s Winning? (How the battle between 

shareholder activists and corporate boards over pay policy is shaping up), The Wall Street Journal 

Online, April 11, 2005, at R3; Joann S. Lublin, Goodbye to Pay for No Performance, The Wall Street 

Journal Online, April 11, 2005, at R1. 
7

will have an immediate effect on the tax liability of the company), and the risk characteristics of 

the executives involved.9

 

According to a number of studies, section 162(m) has not reduced the growth in 

executive compensation.10 Some studies indicate that the provision may have increased total 

compensation. One reason this may occur is that firms may substitute performance-based 

compensation for fixed salary. Performance-based compensation presents greater risk to the 

employee, so that an increase in such compensation must more than offset any reduction in fixed 

compensation. In addition, some companies with fixed compensation below the $1 million level 

may have increased compensation because the provision altered perceptions as to what is 

considered to be an excessive level of compensation.11 Some firms with compensation near the 

$1 million limit may have forgone salary increases as a result of the cap.12 This does not mean, 

however, that total compensation was reduced. 

Studies have also looked at whether section 162(m) has caused a shift away from salary 

compensation toward performance-based compensation.13 A number of studies have found that 

section 162(m) has caused such a shift, although there are mixed results on the extent of shifting. 

Some have observed that compensation may be more responsive to factors other than the tax 

 9

 Steven Balsam and Jennifer Yin, Explaining Firm Willingness to Forfeit Tax Deductions under 

Internal Revenue Code section 162(m): The Million Dollar Cap, 24(4) Journal of Accounting and Public 

Policy, 300 (2005); Steven Balsam and David H. Ryan, Response to Tax Law Changes Involving the 

Deductibility of Executive Compensation: A Model Explaining Corporate Behavior, 18 Journal of the 

American Taxation Association, 1, 11-12 (Supp. 1996). 

10 Tod Perry and Marc Zenner, Pay for Performance? Government Regulation and the Structure 

of Compensation Contracts, 62(3) Journal of Financial Economics, 453 (Dec. 2001); Robert M. Halperin, 

Young K. Kwon, and Shelley C. Rhoades-Catanach, The Impact of Deductibility Limits on Compensation 

Contracts: A Theoretical Examination, 23 Journal of the American Taxation Association 52 (Supp. 

2001); Brian J. Hall and Jeffrey B. Leibman, “The Taxation of Executive Compensation” Tax Policy and 

The Economy, James M. Poterba, Ed, v. 14, Cambridge: MIT Press for the NBER, 1 (2000). 

11 David G. Harris and Jane R. Livingstone, Federal Tax Legislation as an Implicit Contracting 

Cost Benchmark: The Definition of Excessive Executive Compensation, 77(4) The Accounting Review 

997 (Oct. 2002). 

12 Nancy L. Rose and Catherine Wolfram, Regulating Executive Pay: Using the Tax Code to 

Influence Chief Executive Officer Compensation, 20(2) Journal of Labor Economics S138 (Pt. 2, 2002). 

13 Tod Perry and Marc Zenner, Pay for Performance? Government Regulation and the Structure 

of Compensation Contracts, 62(3) Journal of Financial Economics, 453 (Dec. 2001); Robert M. Halperin, 

Young K. Kwon, and Shelley C. Rhoades-Catanach, The Impact of Deductibility Limits on Compensation 

Contracts: A Theoretical Examination, 23 Journal of the American Taxation Association 52 (Supp. 

2001); Brian J. Hall and Jeffrey B. Leibman, “The Taxation of Executive Compensation” Tax Policy and 

The Economy, James M. Poterba, Ed, v. 14, Cambridge: MIT Press for the NBER, 1 (2000); Steven 

Balsam and David H. Ryan, Response to Tax Law Changes Involving the Deductibility of Executive 

Compensation: A Model Explaining Corporate Behavior, 18 Journal of the American Taxation 

Association, 1, 11-12 (Supp. 1996).
8

laws and that in some cases complying with section 162(m) is merely a formalization of 

preexisting practices. 

Some studies have noted some possible unintended consequences from section 162(m), 

even in situations where firms comply with the provision through the use of performance-based 

compensation. One study found that, to the extent the substitution of fixed compensation by 

performance-based compensation occurs, firm profits are reduced because the resulting 

compensation tends to be higher. Firm profits may also be reduced to the extent that firms 

decide to forgo the tax deduction.14 In such cases, shareholders may be adversely affected due to 

decreased profits. One study has noted that one effect of section 162(m) is that executive pay is 

more adversely affected during periods of very poor corporate performance and less positively 

affected during period of very high performance, with the result that executives may try to 

manipulate earnings to provide a more smooth earnings pattern.15

Issues have been raised as to whether changes to the $1 million limitation should be made 

in an effort to provide more effective limitations on excessive compensation. Broad reaching 

changes are possible. Any changes are likely to raise issues similar to those raised under present 

law regarding the effects of the change, as well as possibly additional issues. 

Some have suggested that the exception for performance-based compensation should be 

eliminated or at least restricted by a dollar amount. Such proposals are typically motivated by 

concerns that section 162(m) has had little effect on total executive compensation and that the 

existing performance-based exception is flawed. For example, the present-law rules have been 

criticized as overly broad and as merely providing a structure for present practices without 

causing any greater link between individual performance and compensation. 

Some have also noted that, to the extent excessive compensation is a concern, it is not 

limited to a few executives in public companies. In some cases, the "reasonable compensation" 

standard may be viewed as not providing sufficient limits on compensation. Thus, some suggest 

that the scope of the deduction limitation be expanded, for example, to apply to a larger group of 

executives, all employees of public companies, to all employees (whether or not the employer is 

publicly traded), or to any individual whose compensation for services provided. 

Others have suggested changes to the definition of performance-based compensation 

within the existing structure of section 162(m) to provide a better link between performance and 

pay. For example, at least one commentator has suggested that options should be granted with 

an exercise price that is greater than fair market value at the time of grant and that repricing of 

 14 Robert M. Halperin, Young K. Kwon, and Shelley C. Rhoades-Catanach, The Impact of 

Deductibility Limits on Compensation Contracts: A Theoretical Examination, 23 Journal of the 

American Taxation Association 52 (Supp. 2001); Steven Balsam and Jennifer Yin, Explaining Firm 

Willingness to Forfeit Tax Deductions under Internal Revenue Code section 162(m): The Million Dollar 

Cap, 24(4) Journal of Accounting and Public Policy 300 (2005). 

15 Austin Reitenga, Steve Buchheit, Qin Jennifer Yin, and Terry Baker, CEO Bonus Pay, Tax 

Policy, and Earnings Management, 24 Journal of the American Tax Association 1 (2002). 
9

underwater options (i.e., options with an exercise price greater than current fair market value) 

should be restricted.16

The present-law rules have also raised some issues in terms of scope. As discussed above, 

under present law, in order to be a covered employee, an individual must have that status on the 

last day of the year. In some situations, this rule has been applied so that a person who has been, 

for example, the chief executive officer for all but the last day of the year, is not subject to the 

provision. Modifications to the definition of covered employee, for example, to apply to anyone 

who is a covered employee at any time during the year, could address such concerns. In 

addition, former employees often receive substantial amounts of compensation with respect to 

services rendered before employment. However, former employees are not subject to section 

162(m). To the extent this is a concern, the definition of covered employee could be modified to 

apply to former employees who had been a covered employee before separation from service. 

The SEC has announced new disclosure rules relating to executive compensation, which 

are scheduled to be effective for fiscal years ending on or after December 15, 2006. Among 

other things, these new rules change the group of employees whose compensation is required to 

be disclosed. Section 162(m) should be reviewed in light of these new rules. 

 16 Susan J. Stabile, Does Performance-Based Compensation Positively Affect Managerial 

Performance?, 2 University of Penn. Journal of Labor and Employment Law 227 (1999). 
10

III. NONQUALIFIED DEFERRED COMPENSATION 

A. General Description 

1. In general 

Deferred compensation occurs when the payment of compensation is deferred for more 

than a short period after the compensation is earned (i.e., the time when the services giving rise 

to the compensation are performed). Payment is generally deferred until some specified event, 

such as the individual’s retirement, death, disability, or other termination of services, or until a 

specified time in the future, such as five or ten years. 

The Internal Revenue Code (the “Code”) provides tax-favored treatment for certain types 

of employer-sponsored deferred compensation arrangements that are designed primarily to 

provide employees with retirement income. These arrangements include qualified defined 

contribution and defined benefit pension plans (sec. 401(a)), qualified annuities (sec. 403(a)), 

tax-sheltered annuities (sec. 403(b)), savings incentive match plans for employees or “SIMPLE” 

plans (sec. 408(p)), simplified employee pensions or “SEPs” (sec. 408(k)), and eligible deferred 

compensation plans of State or local government employers (sec. 457(b)).17 For simplicity, these 

plans are referred to collectively here as “qualified employer plans.” A nonqualified deferred 

compensation arrangement is generally any deferred compensation arrangement that is not one of 

these qualified employer plans. 

The America Jobs Creation Act of 200418 added section 409A to the Code which 

provides specific rules governing the tax treatment of nonqualified deferred compensation.19 

Prior to section 409A, there were not rules that specifically governed the tax treatment of 

nonqualified deferred compensation. In determining the tax treatment of nonqualified deferred 

compensation, a variety of tax principles and Code provisions were relevant (as discussed in 

more detail below). Under section 409A, unless certain requirements are satisfied, amounts 

deferred under a nonqualified deferred compensation plan are currently includible in income to 

the extent not subject to a substantial risk of forfeiture. The requirements imposed under section 

409A affect that the way that nonqualified deferred compensation arrangements are now 

commonly structured. These requirements are discussed in more detail below. 

 17 An eligible deferred compensation plan (sec. 457(b)) is a nonqualified deferred compensation 

arrangement that is maintained by a tax-exempt or a State or local government employer and that meets 

certain requirements. An eligible deferred compensation plan of a State or local governmental employer 

generally receives tax-favored treatment under the Code similar to qualified employer plans. Eligible 

deferred compensation plans of tax-exempt employers are discussed more fully in Part A.3, below. 

18 Pub. L. No. 108-357 (2004). 

19 Section 409A generally applies to amounts deferred after December 31, 2004. 
11

2. Types of nonqualified deferred compensation arrangements 

(a) In general 

Nonqualified deferred compensation arrangements are contractual arrangements between 

the employer and the employee, or employees, covered by the arrangement. Such arrangements 

are structured in whatever form achieves the goals of the parties; as a result, they vary greatly in 

design. Considerations that may affect the structure of the arrangement are the current and future 

income needs of the employee, the desired tax treatment of deferred amounts, and the desire for 

assurance that deferred amounts will in fact be paid.20

In the simplest form, a nonqualified deferred compensation arrangement is merely an 

unsecured, unfunded promise to pay a stated dollar amount at some point in the future. 

However, in many cases, such a simple arrangement might not meet the needs of the parties to 

the arrangement; thus, the typical nonqualified defined compensation arrangement is more 

complicated and may involve a funding vehicle or other mechanism to provide security to the 

employee. 

(b) Possible structures 

Some nonqualified deferred compensation arrangements are structured as formal plans 

with formal governing documents. In such cases, the plan generally specifies the employees 

covered by the plan. In other cases, nonqualified deferred compensation may be provided for 

under the terms of an individual’s employment contract and apply only to that particular 

individual (although the same type of arrangement may be included in the employment contracts 

of multiple individuals). 

A nonqualified arrangement may provide for the deferral of base compensation (i.e., 

salary), incentive compensation (e.g., commissions or bonuses), or supplemental compensation. 

The arrangement may permit the employee to elect, such as on an annual basis, whether to defer 

compensation or to receive it currently, similar to a salary reduction or cash-or-deferred 

arrangement under a qualified employer plan. Alternatively, the arrangement may provide for 

compensation that is payable only on the occurrence of future events, not currently. In addition, 

some stock-based compensation arrangements are forms of nonqualified deferred compensation. 

For example, see the discussion of phantom stock plans below. 

A nonqualified deferred compensation arrangement may be structured as an account for 

the employee (similar to a defined contribution or individual account plan) or may provide for 

specified benefits to be paid to the employee (similar to a defined benefit pension plan). Under 

an account structure, depending on whether the arrangement is unfunded or funded, a 

hypothetical or actual account is maintained for the employee, to which specified contributions 

and earnings are credited. The employee may be permitted to direct the investments under the 

 20 Before 2005, the tax treatment of nonqualified deferred compensation was generally governed 

by general tax principles. As discussed more fully below, since 2005, section 409A provides specific 

rules for nonqualified deferred compensation arrangements, which limits how such arrangements may be 

structured without current income inclusion. 
12

hypothetical or actual account. The benefits to which the employee is entitled are based on the 

amount in the account. Under a defined benefit structure, the terms of the nonqualified 

arrangement specify the amount of benefits (or formula for determining benefits) to be paid to 

the employee. 

3. Specific types of plans 

(a) In general 

Certain types of nonqualified deferred compensation arrangements are referred to by 

specific terms, often based on a particular feature or purpose of the arrangement. Generally, 

these terms do not prescribe the structure of the arrangement other than with respect to the 

particular feature or purpose. In addition, because these terms often are not legally defined, they 

are not always used consistently. 

(b) Top-hat plan 

A “top-hat plan” is the term generally used for certain nonqualified deferred 

compensation plans that are exempt from most ERISA requirements. The ERISA exemption 

applies to a plan that is unfunded and is maintained by an employer primarily for the purpose of 

providing deferred compensation for a select group of management or highly compensated 

employees. ERISA does not provide statutory definitions of “select group,” “management,” or 

“highly compensated employees,” and the Department of Labor has not issued regulations 

defining these terms.21 Employees sometimes claim ERISA protection (such as vesting or 

funding) for benefits under a nonqualified deferred compensation plan. However, most 

nonqualified deferred compensation arrangements are intended to fall under the top-hat 

exemption. 

A top-hat plan is exempt from the ERISA requirements relating to participation and 

vesting, funding, and fiduciary responsibility. A top-hat plan is not exempt from the reporting 

and disclosure requirements or the administration and enforcement provisions under ERISA. 

However, under Department of Labor regulations, the reporting and disclosure requirements are 

satisfied by (1) a one-time filing with the Secretary of Labor of a statement that includes the 

name and address of the employer, the employer’s tax identification number, a declaration that 

the employer maintains a plan or plans primarily for the purpose of providing deferred 

compensation for a select group of management or highly compensated employees, and a 

statement of the number of such plans and the number of employees in each, and (2) providing 

plan documents, if any, to the Secretary of Labor upon request.22

Another term commonly used for an unfunded plan that covers only a select group of 

management or highly compensated employees is a supplemental executive retirement plan or 

“SERP.” 

 21 The Code definition of “highly compensated employee” (sec. 414(q)) has not been applied for 

this purpose. 

22 29 CFR 2520.104-23. 
13

(c) Excess benefit plan 

ERISA does not apply to an “excess benefit plan” that is unfunded. As a result, an 

unfunded excess benefit plan is exempt from all ERISA requirements. ERISA defines an excess 

benefit plan as a plan maintained by an employer solely for the purpose of providing benefits for 

certain employees in excess of the limits on contributions and benefits under section 415 of the 

Code, without regard to whether the plan is funded.23 To the extent that a separable part of a 

plan (as determined by the Secretary of Labor) maintained by an employer is maintained to 

provide benefits in excess of the Code section 415 limits, that part is treated as a separate plan 

that is an excess benefit plan. 

Coverage under an excess benefit plan need not be limited to a select group of 

management or highly compensated employees. Depending on the design of the plan that is 

subject to Code section 415, nonmangement or nonhighly compensated employees may be 

covered by an excess benefit plan. For example, a subsidized early retirement benefit provided 

to long-service employees (regardless of age) under a qualified defined benefit plan could exceed 

the section 415 limit applicable to a nonhighly compensated employee, making the employee 

eligible for benefits under an excess benefit plan. As a practical matter, however, the limits on 

contributions and benefits are more likely to affect highly paid employees. In addition, the terms 

of the excess benefit plan may limit coverage to certain management and highly compensation 

employees. 

(d) “Make-up” or “mirror” plan 

Nonqualified deferred compensation arrangements are sometimes designed to provide 

benefits in excess of Code limits that apply to qualified retirement plans other than the limits 

under section 415. For example, the Code limits the amount of annual compensation that may be 

taken into account under a qualified retirement plan ($220,000 for 2006) and the amount of an 

employee’s annual elective deferrals ($15,000 for 2006). In addition, the amount of elective 

deferrals or matching contributions for a highly compensated employee may be limited in order 

to satisfy special nondiscrimination requirements that apply to such contributions. A plan that 

provides the additional benefits that cannot be provided under a qualified retirement plan 

because of these limits is sometimes referred to as a “make-up” plan (or “mirror” or “tandem” 

plan or SERP), based on its connection to the qualified plan. 

A make-up plan does not meet the definition of an excess benefit plan under ERISA, 

which requires that the plan be maintained solely for the purpose of providing benefits in excess 

of the Code section 415 limits. However, a make-up plan may be a top-hat plan. 

(e) Phantom stock plan 

A “phantom stock” plan is a nonqualified deferred compensation arrangement under 

which deferred amounts are determined by reference to hypothetical (or “phantom”) shares of 

employer stock. Phantom stock plans are often used to provide incentive compensation. For 

 23 The limits under sec. 415 apply to qualified defined contribution and defined benefit plans, 

which generally must be funded. 
14

example, an employee may be awarded 1,000 units of phantom stock and have the right to “cash 

out” 200 shares a year over five years if certain performance goals are met. Depending on the 

terms of the arrangement, the employee may be entitled to receive only the growth in the value 

of the stock between the time the phantom shares are awarded and the time they are cashed out, 

or the employee may be entitled to receive the entire value of the stock at cash-out as well as any 

dividends paid since the time the phantom shares were granted. Actual shares of stock are not 

held for the employee under a phantom stock plan, but, depending on the terms of the plan, the 

employee may be entitled to be paid in actual shares or in cash at the time of the cash-out. 

(f) Eligible deferred compensation plan of a tax-exempt employer 

The Code limits the amount of nonqualified deferred compensation that can be provided 

by a tax-exempt employer on a tax-deferred basis (sec. 457). Generally, amounts deferred under 

a nonqualified deferred compensation arrangement of a tax-exempt employer (other than a 

church) are currently included in the employee’s income unless the arrangement is an eligible 

deferred compensation plan (a “section 457 plan”). The maximum annual deferral under such a 

plan generally is $15,000 (for 2006), or the employee’s total includible compensation, if less. In 

general, amounts deferred under a section 457 plan may not be made available to a plan 

participant before the earlier of (1) the calendar year in which the participant attains age 70-1/2, 

(2) when the participant has a severance from employment with the employer, or (3) when the 

participant is faced with an unforeseeable emergency. 

Amounts deferred under an eligible deferred compensation plan of a tax-exempt 

employer are includible in the employee’s income when paid or otherwise made available to the 

employee. Amounts deferred under a section 457 plan of a tax-exempt entity must remain the 

property of the employer, subject only to the claims of the employer’s general creditors. 

If compensation is deferred under a plan that is not an eligible deferred compensation 

plan (an “ineligible plan”), deferred amounts are includible in income when the deferred 

compensation is not subject to a substantial risk of forfeiture, even if the deferred compensation 

is not funded.24

4. Comparison with qualified employer plans 

(a) Tax treatment and general qualification requirements 

Qualified employer plans receive the following tax-favored treatment: 

• Contributions to the plan (and earnings thereon) are not includible in the gross 

income of employees until the benefits are distributed, even though the plan is funded 

and the benefits are nonforfeitable; 

• The employer is entitled to a current deduction (within limits) for contributions to the 

plan even though the contributions are not currently included in an employee's 

income; and 

 24 Ineligible plans are also subject to section 409A. 
15

• The trust that holds the plan assets is tax-exempt. 

Qualified employer plans are subject to various Code requirements that must be satisfied 

in order for favored tax treatment to apply. The particular requirements a qualified employer 

plan must satisfy in order to receive tax-favored treatment depend on the type of arrangement. In 

general, however, among the applicable rules are limits on the amount of contributions or 

benefits that can be provided, minimum participation rules that restrict the age and number of 

years of employment an employer can require as a condition of plan participation, 

nondiscrimination rules that seek to ensure that qualified employer plans benefit a broad group of 

employees, and, in the case of certain plans, minimum funding rules designed to ensure that 

employer contributions are sufficient to provide for plan benefits.25 For example, the maximum 

annual contribution that can be made to a qualified defined contribution plan is the lesser of 

(1) 100 percent of compensation and (2) $44,000 (for 2006). The maximum annual benefit 

payable at age 62 under a qualified defined benefit plan is the lesser of (1) 100 percent of 

compensation and (2) $175,000 (for 2006). 

Nonqualified deferred compensation does not receive such favorable tax treatment. For 

example, the employer is generally not entitled to a deduction for nonqualified deferred 

compensation until the compensation is includible in the gross income of the employee.26 Such 

compensation is also not subject to the limits applicable to qualified employer plans. Thus, for 

example, there is no dollar limit on the annual aggregate nonqualified deferred compensation that 

may be provided. Also, nonqualified deferred compensation arrangements typically are limited 

to a named class of employees; in some cases, a particular arrangement may cover a single 

employee. 

(b) Eligible individuals 

Qualified employer plans generally may cover only employees.27 Nonqualified deferred 

compensation arrangements are not subject to this restriction, and thus may cover employees and 

individuals who are not employees. For example, a nonqualified deferred compensation 

arrangement may cover the “outside” directors of a corporation (i.e., directors who are not 

employees of the corporation) or independent contractors who provide services.28

 25 Government plans and church plans are generally exempt from some of these requirements. 

26 The tax treatment of nonqualified deferred compensation is discussed in detail in Part B, 

below. 

27 Self-employed individuals are generally considered employees for purposes of the rules 

relating to qualified employer plans. 

28 In general, arrangements discussed in this document may apply to individuals who are not 

employees as well as to employees. 
16

(c) Funding and security 

In general

Qualified employer plans provide a high degree of security. Such plans are required to be 

funded, i.e., assets must be set aside exclusively to provide benefits to employees. Qualified 

employer plan assets may not be used by employers for purposes other than providing benefits 

and are not subject to the claims of creditors of the employer. 

A nonqualified deferred compensation arrangement may be funded or unfunded, 

depending on the terms of the arrangement. As discussed below, whether such an arrangement is 

funded affects the tax treatment. 

Qualified defined benefit pension plan benefits are guaranteed (within limits) by the 

Pension Benefit Guaranty Corporation (“PBGC”). The PBGC does not guarantee benefits under 

other types of qualified employer plans or under nonqualified deferred compensation 

arrangements. 

Attempts to provide security for nonqualified deferred compensation 

In general

As discussed below, to avoid current income inclusion, individuals covered under 

nonqualified deferred compensation arrangements typically prefer for such arrangements not to 

be funded for tax purposes. Nevertheless, such individuals are often interested in providing 

some security with respect to payment of the deferred compensation. Unfunded status presents 

the risk that the employee will not receive his or her deferred compensation payments when 

due.29 Thus, the question that arises in many cases is what sort of security can be provided for 

the individual without incurring current income tax consequences, i.e., without having the 

arrangement being considered funded for tax purposes. Various arrangements have been 

developed in an effort to provide employees with security for nonqualified deferred 

compensation. 

Rabbi trusts

A “rabbi trust” is a trust or other fund established by the employer to hold assets from 

which nonqualified deferred compensation payments will be made. The trust or fund is 

generally irrevocable and does not permit the employer to use the assets for purposes other than 

to provide nonqualified deferred compensation. However, the terms of the trust or fund provide 

that the assets are subject to the claims of the employer’s creditors in the case of bankruptcy.30

 29 This risk is not a substantial risk of forfeiture as defined under sec. 83. 

30 A rabbi trust is generally a grantor trust of the employer for tax purposes, so trust earnings are 

treated as income to the employer. 
17

For purposes of section 83, property includes a beneficial interest in assets set aside from 

the claims of creditors, such as in a trust or fund, but does not include an unfunded and 

unsecured promise to pay money in the future. In the case of a rabbi trust, terms providing that 

the assets are subject to the claims of creditors of the employer in the case of bankruptcy have 

been the basis for the conclusion that the creation of a rabbi trust does not cause the related 

nonqualified deferred compensation arrangement to be funded for income tax purposes.31 As a 

result, no amount is included in income by reason of the rabbi trust; generally income inclusion 

occurs as payments are made from the trust.32

Since the concept of a rabbi trust was developed, techniques have developed that attempt 

to protect the assets from creditors despite the terms of the trust. For example, the trust or fund 

may be located in a foreign jurisdiction, making it difficult or impossible for creditors to reach 

the assets.33 In such a case, the existence of the assets may be unknown or the assets may be 

protected from creditors under the laws of the jurisdiction where the trust is located. 

Secular trusts

In contrast to a rabbi trust, a “secular” trust is a trust established by an employer 

exclusively for the purpose of providing nonqualified deferred compensation; assets are not 

subject to claims of creditors. A secular trust constitutes a funding of a nonqualified deferred 

compensation arrangement, so that vested amounts are includible in income by the employees 

(i.e., such amounts are not tax-deferred).34 A secular trust provides security for the employees, 

but also causes current taxation. In some cases, under the terms of the nonqualified deferred 

compensation arrangement, the employer pays the taxes attributable to the deferred 

compensation by grossing up the employees’ current compensation by a corresponding amount. 

Other forms of security

Other methods are sometimes used in an attempt to provide employees with security that 

deferred compensation payments will be made when due, such as third party guarantees, letters 

of credit, and surety bonds. As discussed below, section 409A includes rules requiring current 

income inclusion upon the use of an offshore arrangement or other arrangement contingent on 

the employer’s financial health. Other funding arrangements are not covered by section 409A 

and there is little specific guidance as to how these arrangements should be treated for tax 

purposes. The tax treatment depends on the facts of the particular arrangement. 

 31 This conclusion was first provided in a 1983 private ruling issued by the IRS with respect to an 

arrangement covering a rabbi; hence the popular name “rabbi trust.” 

32 The same analysis has been applied to conclude that the rules of sec. 402(b), relating to 

nonexempt employee trusts, do not apply to a rabbi trust. 

33 An offshore rabbi trust has been referred to as a “Rastafarian” rabbi trust. Under section 

409A, such arrangement would result in current income inclusion. 

34 A secular trust is generally structured as a separate entity for tax purposes, and earnings are 

includible in the income of the trust. 
18

(d) Application of ERISA 

Most types of qualified employer plans are subject to requirements under Title I of the 

Employee Retirement Income Security Act of 1974 (“ERISA”), as well as under the Code.35 

ERISA requirements deal with reporting and disclosure (part 1 of ERISA), participation and 

vesting (part 2), funding (part 3), fiduciary responsibility (part 4), and administration and 

enforcement (part 5).36

As discussed more fully in Part A.3, above, ERISA contains exemptions for nonqualified 

deferred compensation arrangements that are top-hat plans or excess benefit plans. Most 

nonqualified deferred compensation arrangements are designed to fall within these ERISA 

exemptions. ERISA does not apply to nonqualified deferred compensation arrangements 

covering only nonemployees, such as outside directors. 

 35 Governmental plans and church plans are generally exempt from ERISA. 

36 Some requirements under ERISA correspond to parallel requirements under the Code. 
19

B. Tax Treatment of Nonqualified Deferred Compensation 

1. Timing of income inclusion for the individual 

(a) In general 

The determination of when amounts deferred under a nonqualified deferred compensation 

arrangement are includible in the gross income of the individual earning the compensation 

depends on the facts and circumstances of the arrangement. The America Jobs Creation Act of 

200437 added section 409A to the Code which provides specific rules governing the tax treatment 

of nonqualified deferred compensation.38

Prior to section 409A, there were not rules that specifically governed the tax treatment of 

nonqualified deferred compensation. A variety of tax principles and Code provisions were 

relevant, including the doctrine of constructive receipt, the economic benefit doctrine, the 

provisions of section 83 relating generally to transfers of property in connection with the 

performance of services, and provisions relating specifically to nonexempt employee trusts 

(sec. 402(b)) and nonqualified annuities (sec. 403(c)). Section 409A does not override these tax 

principles and Code provisions. Thus, they are relevant in determining the tax treatment of 

nonqualified deferred compensation and are discussed below. Section 409A does not prevent the 

inclusion of amounts in gross income under any provision or rule of law earlier than the time 

provided under its rules. 

(b) Section 409A 

Section 409A in general

Under section 409A, all amounts deferred under a nonqualified deferred compensation 

plan39 for all taxable years are currently includible in gross income to the extent not subject to a 

substantial risk of forfeiture40 and not previously included in gross income, unless certain 

requirements are satisfied. If the requirements of section 409A are not satisfied, in addition to 

current income inclusion, interest at the rate applicable to underpayments of tax plus one 

percentage point is imposed on the underpayments that would have occurred had the 

compensation been includible in income when first deferred, or if later, when not subject to a 

substantial risk of forfeiture. The amount required to be included in income is also subject to a 

20-percent additional tax. 

 37 Pub. L. No. 108-357 (2004). 

38 Section 409A generally applies to amounts deferred after December 31, 2004. 

39 A plan includes an agreement or arrangement, including an agreement or arrangement that 

includes one person. Amounts deferred also include actual or notional earnings. 

40 As under section 83, the rights of a person to compensation are subject to a substantial risk of 

forfeiture if the person’s rights to such compensation are conditioned upon the performance of substantial 

services by any individual. 
20

Definition of nonqualified deferred compensation plan

For purposes of section 409A, a nonqualified deferred compensation plan is any plan that 

provides for the deferral of compensation other than a qualified employer plan or any bona fide 

vacation leave, sick leave, compensatory time, disability pay, or death benefit plan. A qualified 

employer plan means a qualified retirement plan, tax-deferred annuity, simplified employee 

pension, and SIMPLE. A qualified governmental excess benefit arrangement (sec. 415(m)) is a 

qualified employer plan. An eligible deferred compensation plan (sec. 457(b)) is also a qualified 

employer plan. A tax-exempt or governmental deferred compensation plan that is not an eligible 

deferred compensation plan is not a qualified employer plan. 

Section 409A does not apply to an arrangement taxable under section 83 providing for 

the grant of an option on employer stock with an exercise price that is not less than the fair 

market value of the underlying stock on the date of grant if such arrangement does not include a 

deferral feature other than the feature that the option holder has the right to exercise the option in 

the future or to incentive stock options meeting the requirements of 422 or options granted under 

an employee stock purchase plan meeting the requirements of section 423. Certain other stockbased arrangements may be treated as nonqualified deferred compensation under section 409A. 

Permissible distributions

In general

Under section 409A, distributions from a nonqualified deferred compensation plan may 

be allowed only upon separation from service (as determined by the Secretary), death, a specified 

time (or pursuant to a fixed schedule), change in control of a corporation (to the extent provided 

by the Secretary), occurrence of an unforeseeable emergency, or if the participant becomes 

disabled. A nonqualified deferred compensation plan may not allow distributions other than 

upon the permissible distribution events and, except as provided in regulations by the Secretary, 

may not permit acceleration of a distribution. 

Separation from service

In the case of a specified employee who separates from service, distributions may not be 

made earlier than six months after the date of the separation from service or upon death. 

Specified employees are key employees41 of publicly-traded corporations. 

Specified time

Amounts payable at a specified time or pursuant to a fixed schedule must be specified 

under the plan at the time of deferral. Amounts payable upon the occurrence of an event are not 

treated as amounts payable at a specified time. 

 41 Key employees are defined in section 416(i) and generally include officers having annual 

compensation greater than $130,000 (adjusted for inflation and limited to 50 employees), five percent 

owners, and one percent owners having annual compensation from the employer greater than $150,000. 
21

Change in control

Distributions upon a change in the ownership or effective control of a corporation, or in 

the ownership of a substantial portion of the assets of a corporation, may only be made to the 

extent provided by the Secretary. 

Unforeseeable emergency

An unforeseeable emergency is defined as a severe financial hardship to the participant: 

(1) resulting from an illness or accident of the participant, the participant’s spouse, or a 

dependent (as defined in sec. 152(a)); (2) loss of the participant’s property due to casualty; or (3) 

other similar extraordinary and unforeseeable circumstances arising as a result of events beyond 

the control of the participant.42 The amount of the distribution must be limited to the amount 

needed to satisfy the emergency plus taxes reasonably anticipated as a result of the distribution. 

Distributions may not be allowed to the extent that the hardship may be relieved through 

reimbursement or compensation by insurance or otherwise, or by liquidation of the participant’s 

assets (to the extent such liquidation would not itself cause a severe financial hardship). 

Disability

A participant is considered disabled if he or she (1) is unable to engage in any substantial 

gainful activity by reason of any medically determinable physical or mental impairment which 

can be expected to result in death or can be expected to last for a continuous period of not less 

than 12 months; or (2) is, by reason of any medically determinable physical or mental 

impairment which can be expected to result in death or can be expected to last for a continuous 

period of not less than 12 months, receiving income replacement benefits for a period of not less 

than three months under an accident and health plan covering employees of the participant’s 

employer. 

Prohibition on acceleration of distributions

Except as provided in regulations by the Secretary, no accelerations of distributions may 

be allowed. 

Requirements with respect to elections

Section 409A requires that a plan must provide that compensation for services performed 

during a taxable year may be deferred at the participant’s election only if the election to defer is 

made no later than the close of the preceding taxable year, or at such other time as provided in 

 42 Section 826 of the Pension Protection Act of 2006 (Pub. L. No. 109-280) provides that within 

180 days after enactment (the date of enactment was August 17, 2006), the Secretary of Treasury must 

modify the rules for determining whether a participant has an unforeseeable emergency for purposes of 

section 409A to provide that if an event would qualify as an unforeseeable emergency if it occurred with 

respect to the participant’s spouse or dependent, such event shall, to the extent permitted under the plan, 

constitute an unforeseeable emergency if it occurs with respect to a person who is a beneficiary with 

respect to a participant. 
22

Treasury regulations.43 In the case of any performance-based compensation based on services 

performed over a period of at least 12 months, such election may be made no later than six 

months before the end of the service period. 

The time and form of distributions must be specified at the time of initial deferral. 

A plan may allow changes in the time and form of distributions subject to certain 

requirements. A nonqualified deferred compensation plan may allow a subsequent election to 

delay the timing or form of distributions only if: (1) the plan requires that such election cannot be 

effective for at least 12 months after the date on which the election is made; (2) except in the 

case of elections relating to distributions on account of death, disability or unforeseeable 

emergency, the plan requires that the payment with respect to which the election is made is 

deferred for a period of not less than five years from the date such payment would otherwise 

have been made; and (3) the plan requires that an election related to a distribution to be made 

upon a specified time may not be made less than 12 months prior to the date of the first 

scheduled payment. 

Foreign trusts

In the case of assets set aside (directly or indirectly) in a trust (or other arrangement 

determined by the Secretary) for purposes of paying nonqualified deferred compensation, such 

assets are treated as property transferred in connection with the performance of services under 

section 83 (whether or not such assets are available to satisfy the claims of general creditors) at 

the time set aside if such assets (or trust or other arrangement) are located outside of the United 

States or at the time transferred if such assets (or trust or other arrangement) are subsequently 

transferred outside of the United States. Any subsequent increases in the value of, or any 

earnings with respect to, such assets are treated as additional transfers of property. Interest at the 

underpayment rate plus one percentage point is imposed on the underpayments that would have 

occurred had the amounts set aside been includible in income for the taxable year in which first 

deferred or, if later, the first taxable year not subject to a substantial risk of forfeiture. The 

amount required to be included in income is also subject to an additional 20-percent tax. 

Triggers upon financial health

A transfer of property in connection with the performance of services under section 83 

also occurs with respect to compensation deferred under a nonqualified deferred compensation 

plan if the plan provides that upon a change in the employer’s financial health, assets will be 

restricted to the payment of nonqualified deferred compensation. An amount is treated as 

restricted even if the assets are available to satisfy the claims of general creditors. 

The transfer of property occurs as of the earlier of when the assets are so restricted or 

when the plan provides that assets will be restricted. Any subsequent increases in the value of, 

or any earnings with respect to, restricted assets are treated as additional transfers of property. 

 43 In the first year that an employee becomes eligible for participation in a nonqualified deferred 

compensation plan, the election may be made within 30 days after the date that the employee is initially 

eligible. 
23

Interest at the rate applicable to underpayments of tax plus one percentage point is imposed on 

the underpayments that would have occurred had the amounts been includible in income for the 

taxable year in which first deferred or, if later, the first taxable year not subject to a substantial 

risk of forfeiture. The amount required to be included in income is also subject to an additional 

20-percent tax. 

Rules applicable in the case of underfunded defined benefit pension plans

The Pension Protection Act of 200644 amended section 409A by providing that if, during 

any restricted period with respect to a single-employer defined benefit pension plan of a plan 

sponsor, assets are set aside (directly or indirectly) in a trust (or other arrangement as determined 

by the Secretary of the Treasury), or transferred to such a trust or other arrangement, for 

purposes of paying deferred compensation of an applicable covered employee, such transferred 

assets are treated as property transferred in connection with the performance of services (whether 

or not such assets are available to satisfy the claims of general creditors) under section 83. The 

provision also applies if a nonqualified deferred compensation plan of a plan sponsor provides 

that assets will be restricted to the provision of benefits under the plan in connection with a 

restricted period of any defined benefit pension plan of the employer, or assets are so restricted. 

A restricted period is (1) any period in which a single-employer defined benefit pension 

plan of the plan sponsor is in at risk-status,45 (2) any period in which the plan sponsor is in 

bankruptcy, and (3) the period that begins six months before and ends six months after the date 

any defined benefit pension plan of the plan sponsor is terminated in an involuntary or distress 

termination. 

Covered employees include the chief executive officer (or individual acting in such 

capacity), the four highest compensated officers for the taxable year (other than the chief 

executive officer), and individuals subject to section 16(a) of the Securities Exchange Act of 

1934. An applicable covered employee includes any (1) covered employee of a plan sponsor; 

(2) covered employee of a member of a controlled group which includes the plan sponsor; and 

(3) former employee who was a covered employee at the time of termination of employment 

with the plan sponsor or a member of a controlled group which includes the plan sponsor. 

If an employer provides directly or indirectly for the payment of any Federal, State or 

local income taxes with respect to any compensation required to being included in income under 

the rule, interest is imposed on the amount of such payment in the same manner as if the 

payment were part of the deferred compensation to which it related. In addition to be included in 

 44 Pub. L. No. 109-280 (2006). 

45 At-risk status is determined under the general funding rules for single-employer defined 

benefit pension plans. In general, a plan is in at-risk status for a year if, for the preceding year: (1) the 

plan’s funding target attainment percentage, determined without regard to the at-risk assumptions, was 

less than 80 percent and (2) the plan’s funding target attainment percentage, determined using the at-risk 

assumptions (without regard to whether the plan was in at-risk status for the preceding year), was less 

than 70 percent. 
24

income, the payment is subject to a 20 percent additional tax. The payment is also nondeductible 

by the employer. 

(c) Other relevant tax principles 

In general

As previously discussed, in addition to section 409A, a variety of tax principles and Code 

provisions may be relevant in determining the tax treatment of nonqualified deferred 

compensation, including the doctrine of constructive receipt, the economic benefit doctrine, the 

provisions of section 83 relating generally to transfers of property in connection with the 

performance of services, and provisions relating specifically to nonexempt employee trusts 

(sec. 402(b)) and nonqualified annuities (sec. 403(c)). Before the enactment of section 409A, in 

general, the time for inclusion of nonqualified deferred compensation depended on whether the 

arrangement was unfunded or funded. If the arrangement was unfunded, then the compensation 

was generally includible in income when it was actually or constructively received (i.e., when it 

was paid or otherwise made available). If the arrangement was funded, then it was generally 

treated as a transfer of property under section 83, and income was includible for the year in 

which the individual’s right to the property was transferable or not subject to a substantial risk of 

forfeiture. These general rules continue to apply in addition to those under section 409A. 

Income inclusion under an unfunded arrangement

As discussed above, if the arrangement is unfunded, then the compensation is generally 

includible in income when it is actually or constructively received under section 451 (unless 

earlier income inclusion applies under section 409A).46 Income is constructively received when 

it is credited to an individual’s account, set apart, or otherwise made available so that it may be 

drawn on at any time.47 Income is not constructively received if the taxpayer’s control of its 

receipt is subject to substantial limitations or restrictions. A requirement to relinquish a valuable 

right in order to make withdrawals is generally treated as a substantial limitation or restriction. 

Income inclusion under a funded arrangement

Section 83

In general, an arrangement is considered funded if there has been a transfer of property 

under section 83. Section 83 provides rules for the tax treatment of property transferred in 

connection with the performance of services. Under section 83, the excess of the fair market 

value of property received in connection with the performance of services over the amount, if 

any, paid for the property is includible in the income of the person performing the services 

(“service provider”). Income is generally includible for the year in which the service provider’s 

 46 Treas. Reg. secs. 1.451-1 and 1.451-2. 

47 Compensation that is constructively received is includible in income regardless of whether the 

requirements of section 409A are met. 
25

right to the property is either transferable or is not subject to a substantial risk of forfeiture. The 

amount includible in income is based on the fair market value of the property at that time. 

A transfer of property occurs when a person acquires a beneficial ownership interest in 

such property. The term “property” is defined very broadly for purposes of section 83.48 

Property includes real and personal property other than money or an unfunded and unsecured 

promise to pay money in the future. Property also includes a beneficial interest in assets 

(including money) that are transferred or set aside from claims of the creditors of the transferor, 

for example, in a trust or escrow account. Accordingly, if, in connection with the performance of 

services, vested contributions are made to a trust on an individual’s behalf and the trust assets 

may be used solely to provide future payments to the individual, the payment of the contributions 

to the trust constitutes a transfer of property to the individual that is taxable under section 83, 

regardless of whether the arrangement otherwise meets the requirements of section 409A. On 

the other hand, amounts deferred under an arrangement that meets the requirements of section 

409A are generally not includible in income if deferred amounts are payable from general 

corporate funds that are subject to the claims of general creditors, as such amounts are treated as 

unfunded and unsecured promises to pay money or property in the future. 

Property is subject to a substantial risk of forfeiture if the individual’s right to the 

property is conditioned on the future performance of substantial services (such as full-time 

services for two years or more) or on the nonperformance of services (such as a noncompete 

requirement). In addition, a substantial risk of forfeiture exists if the right to the property is 

subject to a condition other than the performance of services and there is a substantial possibility 

that the property will be forfeited if the condition does not occur. Risks that do not fall within 

this legal definition, such as the risk that the property will decline in value, do not result in a 

substantial risk of forfeiture. Whether a substantial risk of forfeiture exists depends on the facts 

and circumstances, including whether the service requirement or other condition will in fact be 

enforced. Property that is subject to a substantial risk of forfeiture is referred to as nonvested 

property; property that is not (or is no longer) subject to a substantial risk of forfeiture is referred 

to as vested property. 

Property is considered transferable if a person can transfer his or her interest in the 

property to anyone other than the transferor from whom the property was received. However, 

property is not considered transferable if the transferee’s rights in the property are subject to a 

substantial risk of forfeiture. A temporary restriction on the transferability of property (called a 

“lapse” restriction) is disregarded in determining the value of the property for purposes of section 

83. A permanent restriction on the transferability of property (a “nonlapse” restriction) is taken 

into account in determining the value of the property. 

Depending on the design of a particular nonqualified deferred compensation arrangement 

(e.g., if it covers only employees), either the economic benefit doctrine or Code provisions 

dealing with nonexempt employee trusts and nonqualified annuities may be relevant as legal 

authority for this tax treatment in addition to section 83. 

 48 Treas. Reg. sec. 1.83-3(e). This definition in part reflects previous IRS rulings on nonqualified 

deferred compensation. 
26

Economic benefit

The economic benefit doctrine is based on the broad definition of gross income in the 

Code (sec. 61), which includes income in whatever form paid. Under the economic benefit 

doctrine, if an individual receives any economic or financial benefit or property as compensation 

for services, the value of the benefit or property is includible in the individual’s gross income. 

For example, courts have applied the economic benefit doctrine to the receipt of stock options or 

the receipt of an interest in a trust.49

A concept related to economic benefit is the cash equivalency doctrine.50 Under this 

doctrine, if the right to receive a payment in the future is reduced to writing and is transferable, 

such as in the case of a note or a bond, the right is considered to be the equivalent of cash and the 

value of the right is includible in gross income.51

Nonexempt trusts and nonqualified annuities

The Code contains provisions that deal specifically with nonexempt employee trusts and 

nonqualified employee annuities (i.e., trusts and annuities not meeting the requirements 

applicable to qualified retirement plans and annuities).52 These provisions apply rules similar to 

those under section 83.53 Under these provisions, if vested contributions are made to a 

nonexempt trust or a nonqualified annuity on an employee’s behalf, the contributions are 

includible in the employee’s income when made, regardless whether the arrangement otherwise 

meets the requirements of section 409A. If the employee’s interest is not vested when 

contributions are made, the value of the employee’s interest in the trust or annuity (including 

earnings since the time of contribution) is includible in the employee’s income when it vests. 

The amount included in the employee’s income constitutes cost or basis to the employee in the 

trust or annuity. Payments from the trust or annuity are taxed under the general rules that apply 

to annuities (sec. 72) (unless earlier income inclusion applies under section 409A). That is, a 

portion of each payment is treated as a nontaxable return of basis and the remainder of each 

payment is includible in income. Section 83 applies to any service provider; however, these 

provisions apply only to trusts and annuities for employees. 

 49 Commissioner v. Smith, 324 U.S. 177 (1945); E.T. Sproull v. Commissioner, 16 T.C. 244 

(1951), aff’d per curiam, 194 F.2d 541 (1952). 

50 In the case of nonqualified deferred compensation arrangements, these doctrines have largely 

been codified in the Code provisions discussed herein. However, because many of the legal precedents 

related to nonqualified deferred compensation predate these Code provisions, the economic benefit and 

cash equivalency doctrines are sometimes considered in analyzing the tax treatment of nonqualified 

deferred compensation. 

51 See, e.g., Cowden v. Commissioner, 289 F.2d 20 (5th Cir. 1961). 

52 Secs. 402(b) and 403(c). 

53 Although these Code provisions predate the enactment of section 83 in 1969, they were 

amended at that time to reflect the enactment of section 83. 
27

2. Timing of deduction 

Special statutory provisions govern the timing of the deduction for nonqualified deferred 

compensation, regardless of whether the arrangement covers employees or nonemployees and 

regardless of whether the arrangement is funded or unfunded.54 Under these provisions, the 

amount of nonqualified deferred compensation that is includible in the income of the individual 

performing services is deductible by the service recipient for the taxable year in which the 

amount is includible in the individual’s income. 

3. Payroll taxes and wage reporting 

(a) In general 

In the case of an employee, nonqualified deferred compensation is generally considered 

wages both for purposes of income tax withholding and for purposes of taxes under the Federal 

Insurance Contributions Act (“FICA”), consisting of social security tax and Medicare tax. 

However, the income tax withholding rules and social security and Medicare tax rules that apply 

to nonqualified deferred compensation are not the same. 

(b) Income tax withholding and reporting 

In the case of an employee, nonqualified deferred compensation is generally subject to 

income tax withholding at the time it is includible in the employee’s income as discussed above. 

In addition, amounts includible in income are required to be reported on the employee’s Form 

W-2 for the year includible in income. 

Income tax withholding and Form W-2 reporting are required even if the employee has 

already terminated employment. For example, if nonqualified deferred compensation is 

includible in income only as payments are made after retirement, income taxes must be withheld 

from the payments and the payments must be reported on a Form W-2. 

Income tax withholding and Form W-2 reporting are required when amounts are 

includible in income even if no actual payments are made to the employee. For example, if 

nonqualified deferred compensation is included in income under section 409A before 

distribution of such amount, the amount is includible in the employee’s income and is subject to 

income tax withholding55 and Form W-2 reporting. 

In the case of an individual who is not an employee, nonqualified deferred compensation 

amounts includible in income are required to be reported in a Form 1099 for the year includible 

in income. Income tax withholding generally does not apply to such amounts. 

 54 Secs. 404(a)(5), (b) and (d) and sec. 83(h). 

55 The required income tax withholding is accomplished by withholding income taxes from other 

wages paid to the employee in the same year. 
28

In connection with the enactment of section 409A, annual reporting to the Internal 

Revenue Service of amounts deferred is also required. Such amounts are generally required to 

be reported on an individual’s Form W-2 (or Form 1099) for the year deferred even if the 

amount is not currently includible in income for that taxable year. 

(c) Social security and Medicare taxes 

The Code provides special rules for applying social security and Medicare taxes to 

nonqualified deferred compensation of employees.56 In general, nonqualified deferred 

compensation is subject to social security and Medicare tax when it is earned (i.e., when services 

are performed), unless the nonqualified deferred compensation is subject to a substantial risk of 

forfeiture. If nonqualified deferred compensation is subject to a substantial risk of forfeiture, it is 

subject to social security and Medicare tax when the risk of forfeiture is removed (i.e., when the 

right to the nonqualified deferred compensation vests). This treatment is not affected by the 

timing of income inclusion. 

The amount of nonqualified deferred compensation that is treated as wages for social 

security and Medicare tax purposes depends on whether it is an account-type arrangement. In 

the case of an account-type arrangement, the amount treated as wages is generally the vested 

amount credited to the employee’s account or the value of the account at vesting. In the case of 

other arrangements, such as a defined benefit-type arrangement, the amount treated as wages is 

the present value of the amount (or amounts) to be paid to the employee in the future. The 

present value of the future payments is determined actuarially. Under a special rule, amounts 

deferred under a nonaccount balance plan that are not reasonably ascertainable are not required 

to be taken into account as wages subject to social security and Medicare taxes until the first date 

that such amounts are reasonably ascertainable. 

In the case of a self-employed individual, nonqualified deferred compensation amounts 

that are includible in income are also taken into account in determining net earnings from selfemployment for social security and Medicare tax purposes unless an exception applies. 

 56 Because nonqualified deferred compensation arrangements generally cover only highly paid 

employees, the other compensation paid to the employee during the year generally exceeds the social 

security wage base. In that case, nonqualified deferred compensation amounts are subject only to 

Medicare tax. 
29

C. Discussion of Issues 

Reasons for nonqualified deferred compensation arrangements

Nonqualified deferred compensation is a common form of executive compensation. 

Deferring compensation may be attractive for a variety of reasons. Individuals may want to 

defer compensation to a future date because they believe that their tax burden will be lower in 

the future than it is currently, thus resulting in payment of lower taxes than if the compensation 

had been received currently. This may occur, for example, if an individual believes that income 

tax rates will be lower in the future or if the individual anticipates having lower income in the 

future than currently. Some individuals may wish to retire early, and thus defer payment of 

current income until after their expected retirement date. Some may defer compensation in order 

to provide a future income stream in retirement. Others may want to defer compensation to 

provide for future expected expenses, such as college expenses for their children. 

Employers often use nonqualified deferred compensation agreements to induce or reward 

certain behavior. For example, an employer may provide that certain compensation will be paid 

only if an executive continues employment for a certain number of years in order to provide an 

incentive for the executive to remain with the employer for a minimum period of time. In many 

cases, the desire to accommodate the compensation wishes of an individual that a company 

wants to attract or retain as an employee may be a sufficient motivating factor to provide a 

deferred compensation arrangement. In some cases, a company may require the deferral of 

certain amounts of compensation, e.g., salary in excess of $1 million, in order to comply with the 

limitation on the deductibility of compensation in excess of $1 million.57 

Qualified retirement plans and similar arrangements are one means of providing deferred 

compensation. In the case of executives and similar personnel, however, in many cases the 

amount of compensation provided through nonqualified arrangements far exceeds the amount of 

benefits provided through the qualified plan. There may be several reasons for this. Some argue 

that the reduction in the amount of benefits that could be provided through a qualified plan that 

took place during the 1980’s caused some employers to abandon qualified plans (or to not adopt 

a qualified plan) because there was not enough incentive for the owner to establish a plan. 

Concerns of this sort were one of the reasons the limits on qualified plan benefits were increased 

in the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”). For example, 

EGTRRA increased the maximum amount of contributions that can be made to a qualified plan 

and increased the maximum amount of compensation that may be taken into account under a 

qualified plan, thus enabling higher income individuals to receive greater benefits under a 

qualified plan. The amount of benefits that may be provided under a qualified plan for the 

owners is more likely to influence the decision of whether to establish a plan in the case of 

smaller or medium-sized employers. 

In some cases, the amount of deferred compensation that may be provided under a 

qualified retirement plan may have little bearing on the amount of nonqualified deferred 

compensation provided. Other factors may have more weight, including the desire for flexibility 

 57 Sec. 162(m). This limitation is previously discussed in detail in Part II. 
30

with respect to such matters as which employees are eligible under the deferred compensation 

arrangement, vesting, funding, and other plan terms. The fact that there is no limit on the 

amount that may be deferred is also a factor. In theory, there is a tension between the amount of 

deferred compensation an employer is willing to provide and the amount executives may seek, 

because the employer is not entitled to a deduction until there is an income inclusion. However, 

in practice, in many cases this supposed tension does not appear to have much effect; in some 

cases millions of dollars may be deferred annually by a single individual. 

Security and access with respect to nonqualified deferred compensation 

As discussed above, before the enactment of section 409A, in order for an individual to 

avoid current income inclusion with respect to amounts deferred under a nonqualified 

arrangement: (1) in the case of an unfunded arrangement, there must have been substantial 

limitations on the right to withdraw funds, or (2) in the case of a funded arrangement, the 

deferred compensation must have been subject to a substantial risk of forfeiture.58 As a result of 

these limitations, individuals covered under nonqualified deferred compensation arrangements 

faced two main risks: (1) they would not have access to deferred amounts when they want them; 

and (2) the employer would be unable or unwilling to make the payments.59

Prior to the enactment of section 409A, attempts to provide executives with increased 

access and security with respect to nonqualified deferred compensation led to the development of 

a variety of techniques (some of which are mentioned above) some of which were based on 

aggressive positions with respect to the question of whether current income taxation results. For 

example, ways to increase access included allowing distributions in the event of financial 

hardship. There is was no clear definition of financial hardship, which allowed considerable 

flexibility in designing arrangements. Some plans employed a so-called “haircut” approach, 

which allowed the individual access to funds at any time, with the proviso that a portion of the 

distribution was forfeited to the employer. Some plans used a 10-percent haircut, but others used 

varying amounts.60 Questions arose as to what is the lowest amount of the “haircut” that would 

not result in current taxation. Loans based on nonqualified deferred compensation arrangements 

were also used to increase access to deferred amounts. Other efforts to provide security without 

causing current taxation included letters of credit, insurance arrangements that insure against 

future nonpayment by the company, and alternatives to “rabbi trusts,” such as locating the trust 

offshore where, as a practical matter, it is outside the reach of creditors. Another approach to 

providing security was to have a trigger mechanism that results in distributions before the event 

 58 As discussed, these tax principles apply in addition to section 409A. 

59 Access issues could arise, for example, if the individual had unanticipated financial needs 

before the payments are scheduled to begin. Issues regarding the employer’s ability or willingness to 

make payments could arise, for example, if the employer entered bankruptcy, if the employee fell out of 

favor with management, or in the case of a change in control of the employer. In these circumstances, the 

employee has a contractual right to receive the nonqualified deferred compensation, but the contractual 

right may be difficult to enforce. 

60 This uses the qualified retirement plan rules as a guide--there is a 10-percent early withdrawal 

tax on amounts withdrawn before age 59-1/2, unless an exception applies. 
31

giving rise to the risk of nonpayment occurs. For example, payment could be triggered upon the 

occurrence of certain financial events that indicated a possible financial downturn for the 

employer. The means that could be developed to try to increase access and security under 

nonqualified deferred compensation arrangements, without causing current income inclusion, 

were probably endless. While some arrangements may have provided the desired tax 

consequences, in other cases the proper tax treatment was unclear. 

Congress was concerned with the practices that had developed which, in some cases, 

allowed improper deferral of income.61 As previously discussed, while the general tax principles 

governing deferred compensation were well established, the determination whether a particular 

arrangement effectively allowed deferral of income was generally made on a facts and 

circumstances basis and there was limited specific guidance with respect to common deferral 

arrangements. The Congress believed that it was appropriate to provide specific rules regarding 

whether deferral of income inclusion should be permitted. The Congress believed that certain 

arrangements that allow participants inappropriate levels of control or access to amounts deferred 

should not result in deferral of income inclusion and that certain arrangements, such as offshore 

trusts, which effectively protect assets from creditors, should be treated as funded and not result 

in deferral of income inclusion. Section 409A was enacted to address these concerns. As 

previously discussed, the requirements imposed under section 409A affect that the way that 

nonqualified deferred compensation arrangements are now commonly structured. 

Other issues

Other issues are sometimes raised with respect to nonqualified deferred compensation 

arrangements. For example, some are concerned with the amount of compensation that is 

deferred and believe limits should be placed on such compensation, whether through the tax 

Code or otherwise. Some also raise questions of fairness with respect to nonqualified deferred 

compensation compared to the compensation and benefits provided to rank and file employees. 

On the other hand, some argue that it is appropriate to allow businesses to compensate executives 

as they deem necessary in order to be competitive and attract key personnel. 

 61 The Joint Committee staff made recommendations in the nonqualified deferred compensation 

area following its investigation of Enron Corporation. See Joint Committee on Taxation, Report of 

Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation 

Issues, and Policy Recommendations (JCS-3-03), February 2003. 
32

IV. STOCK-BASED COMPENSATION 

A. General Description 

Stock in the employer is a commonly used form of compensation for employees and may 

also be provided as compensation for service providers who are not employees, such as outside 

directors. 

Similar to nonqualified deferred compensation arrangements, an employer may have a 

formal plan that provides stock-based compensation to employees on a regular basis. For 

example, the employer may have a plan under which stock or stock options are granted to 

employees annually. Alternatively, or in addition, an individual’s employment contract may 

provide for stock-based compensation for that individual. 

Stock-based compensation is often used in connection with incentive compensation. For 

example, bonuses may be paid in the form of stock; grants of stock or stock options may depend 

on corporate performance; or the rate at which restrictions on stock lapse or the rate at which 

stock options become exercisable may be accelerated by higher than expected corporate 

earnings. 

In some cases, stock-based plans are a means of providing nonqualified deferred 

compensation and may be subject to the rules under section 409A. For example, discounted 

stock options (i.e., options granted at a price lower than the fair market value of the stock on the 

date of grant) are nonqualified deferred compensation and subject to the rules under section 

409A previously discussed. 
33

B. Compensatory Stock62

1. In general 

Stock may be granted to an employee (or other service provider) without restrictions in 

the sense that the stock is fully vested and transferable. In some cases, the employee is granted 

“restricted” stock in the sense that the stock must be forfeited or sold back to the company in 

certain circumstances. For example, an employee may receive stock that is subject to a 

substantial risk of forfeiture because of a requirement that the stock be forfeited if the employee 

terminates employment within five years.63

2. Tax treatment 

Stock that is granted to an employee (or other service provider) is subject to the rules that 

apply under section 83 to transfers of property in connection with the performance of services. 

Accordingly, if vested stock is transferred to an employee, the excess of the fair market value of 

the stock, over the amount, if any, the employee pays for the stock is includible in the 

employee’s income for the year in which the transfer occurs. 

If nonvested stock is transferred to an employee, no amount is includible in income as a 

result of the transfer unless the employee elects to apply section 83 at that time. Otherwise, the 

excess of the fair market value of the stock at the time of vesting, over the amount, if any, the 

employee pays for the stock is includible in the employee’s income for the year in which vesting 

occurs. 

In the case of an employee, the amount includible in income under section 83 is also 

subject to income tax withholding and to social security tax (subject to the social security wage 

base) and Medicare tax and must be reported on a Form W-2. In the case of an individual who is 

not an employee, the amount includible in income under section 83 must be reported on a Form 

1099. 

The amount includible in the income of the employee (or other service provider) is 

generally deductible by the employer for the taxable year of the employer in which the 

recipient’s taxable year of inclusion ends. 

 62 Employer stock may be used also in connection with a qualified defined contribution or 

defined benefit plan. For a discussion of that topic, see Joint Committee on Taxation, Background 

Information Relating to the Investment of Retirement Plan Assets in Employer Stock (JCX-1-02), 

February 11, 2002. 

63 Stock that is subject to a substantial risk of forfeiture is referred to as nonvested stock; stock 

that is not (or is no longer) subject to a substantial risk of forfeiture is referred to as vested stock. 
34

C. Compensatory Stock Options 

1. In general 

A stock option is the right to purchase stock at a specified price (or at a price determined 

under a specified formula) at a specified time or during a specified period. Stock options granted 

to employees or other service providers are considered to be compensation for services. There 

are two general types of compensation-related stock options under the Code: nonqualified 

options (sec. 83) and statutory options (sec. 421). 

Statutory options include incentive stock options (sec. 422) and options provided under 

an employee stock purchase plan (sec. 423). Nonqualified options are any other options granted 

in connection with the performance of services. 

2. Nonqualified options 

The income taxation of a nonqualified option is determined under section 83 and depends 

on whether the option has a readily ascertainable fair market value when granted. A 

nonqualified option has a readily ascertainable fair market value if (1) the option is actively 

traded on an established market, or (2) the option is transferable, it is immediately exercisable in 

full, the stock subject to the option is not subject to any restriction or condition that has a 

significant effect on the value of the option, and the fair market value of the option privilege is 

readily ascertainable. The option privilege is the opportunity to benefit from increases in the 

value of the stock during the option period without risking capital. 

If an individual receives a nonqualified option that has a readily ascertainable fair market 

value at the time the option is granted (which is generally not the case), the excess of the fair 

market value of the option over the amount, if any, paid for the option is includible in the 

recipient’s gross income as ordinary income in the first taxable year in which the option is either 

transferable or is not subject to a substantial risk of forfeiture (or, if the taxpayer elects, in the 

taxable year in which the option is granted). No amount is includible in the gross income of the 

option recipient due to the exercise of the option. 

If the nonqualified option does not have a readily ascertainable fair market value at the 

time of grant (which is generally the case), no amount is includible in the gross income of the 

recipient with respect to the option until the recipient exercises the option. The transfer of stock 

on exercise of the option is subject to the general rules of section 83. That is, if vested stock is 

received on exercise of the option, the excess of the fair market value of the stock over the option 

price is includible in the recipient’s gross income as ordinary income in the taxable year in which 

the option is exercised. If the stock received on exercise of the option is not vested, the excess of 

the fair market value of the stock at the time of vesting over the option price is includible in the 

recipient’s income for the year in which vesting occurs unless the recipient elects to apply 

section 83 at the time of exercise. 

In the case of an employee, the amount includible in income under section 83 with 

respect to nonqualified stock options is also subject to income tax withholding and to social 

security tax (subject to the social security wage base) and Medicare tax and must be reported on 
35

a Form W-2. In the case of an individual who is not an employee, the amount includible in 

income under section 83 must be reported on a Form 1099. 

A compensation expense deduction equal to the amount of ordinary income included in 

the gross income of the option recipient is generally allowable to the employer for the taxable 

year of the employer in which the recipient’s taxable year of inclusion ends. 

3. Statutory options 

(a) In general 

Although nonqualified stock options may be provided to any service provider, statutory 

options may be granted only to employees. Specifically, a stock option granted to an employee 

does not qualify as a statutory option unless the employee is an employee of the employer at all 

times during the period that begins on the date of grant and ends on the day three months before 

the date the option is exercised. For this purpose, the employer may be the corporation granting 

the option or a parent or subsidiary thereof. The stock subject to a statutory option may be stock 

of the employer corporation, or of its parent or subsidiary. 

(b) Incentive stock options 

An incentive stock option (or “ISO”) is an option that provides an employee with the 

right to purchase stock of an employer corporation and that meets the following requirements: 

• The option is granted pursuant to a plan that describes the aggregate number of shares 

that may be issued under options and the employees or class of employees eligible to 

receive options. 

• The option is granted pursuant to a plan that is approved by the shareholders of the 

employer within 12 months before or after the date the plan is adopted. 

• The option is granted within 10 years from the earlier of the date the plan is adopted 

or the date the plan is approved by the employer’s shareholders. 

• The option by its terms is not exercisable after the expiration of 10 years from the 

date of grant (5 years in the case of an option granted to an individual who, at the 

time the option is granted, owns stock possessing more than 10 percent of the total 

combined voting power of all classes of stock of the employer). 

• The option price is not less than the fair market value of the stock at the time of grant 

(110 percent of the fair market value in the case of an option granted to an individual 

who, at the time the option is granted, owns stock possessing more than 10 percent of 

the total combined voting power of all classes of stock of the employer). 

• The option by its terms is not transferable by the recipient and is exercisable during 

the recipient’s lifetime only by the recipient. 

• The terms of the option must not provide that the option will not be treated an 

incentive stock option. 
36

To the extent that the aggregate fair market value of stock with respect to which incentive 

stock options are exercisable for the first time by any individual during any calendar year (under 

all plans of the individual’s employer) exceeds $100,000, such options are treated as 

nonqualified options. 

(c) Employee stock purchase plans 

An employee stock purchase plan is a plan that provides for the granting of options to 

purchase stock in an employer corporation and that meets the following requirements: 

• The plan must provide for grants of options only to employees of the employer. 

• The plan must be approved by the shareholders of the employer within 12 months 

before or after the date the plan is adopted. 

• Under the terms of the plan, no employee may receive an option grant if the 

employee, immediately after such grant, owns stock possessing 5 percent or more of 

the total combined voting power or value of all classes of stock of the employer. 

• With limited exceptions, the terms of the plan must provide for option grants to all 

employees of the employer (or all employees who are not highly compensated 

employees).64

• The terms of the plan must provide to all option recipients the same rights and 

privileges, except that the amount of stock that an employee may purchase under an 

option may bear a uniform relationship to the total compensation of all employees, 

and the plan may provide that no employee may purchase more than a maximum 

amount of stock specified by the plan. 

• The terms of the plan must provide that the option price is not less than the lesser of 

85 percent of the fair market value of the stock at the time of grant or 85 percent of 

the fair market value of the stock at the time of exercise. 

• The terms of the plan must provide than an option may not be exercised after the 

expiration of 27 months from the date of grant or, if the option price is not less than 

85 percent of the fair market value of the stock at the time of exercise, 5 years from 

the date of grant. 

• The terms of the plan must prohibit an option grant that would permit an employee’s 

rights to purchase stock under all employee stock purchase plans maintained by the 

employer to accrue at a rate that exceeds $25,000 of fair market value of stock, 

determined at the time of grant, for each calendar year in which the option is 

outstanding. 

• The terms of the plan must provide that an option is not transferable by the recipient 

and is exercisable during the recipient’s lifetime only by the recipient. 

 64 Because an employee stock purchase plan generally must cover all the employees of the 

employer, it cannot apply only to corporate executives. 
37

Although it is not required by law, it is common for an employee stock purchase plan to 

provide for an employee’s payment of the option price by means of accumulated payroll 

deductions. 

(d) Tax treatment of statutory stock options 

Income tax treatment

No amount is includable in the gross income of the option recipient on the grant or 

exercise of a statutory option.65 No compensation expense deduction is allowable to the 

employer with respect to the grant or exercise of a statutory option. 

If an employee disposes of stock acquired upon exercise of a statutory option, the 

employee generally is taxed at capital gains rates with respect to the excess of the fair market 

value of the stock on the date of disposition over the option price, and no compensation expense 

deduction is allowable to the employer, unless the employee fails to meet a holding period 

requirement.66 The employee fails to meet this holding period requirement if the disposition 

occurs within two years after the date the option is granted or one year after the date the option is 

exercised. A disposition that occurs prior to the expiration of the applicable holding period(s) (a 

“disqualifying disposition”) does not qualify for capital gains treatment. Instead, the income 

realized on the disqualifying disposition, up to the spread on the acquisition of the stock, is 

treated by the employee as compensation received in the taxable year in which the disposition 

occurs, and a corresponding deduction is allowable to the employer for the taxable year in which 

the disposition occurs. 

Payroll taxes

No income tax withholding is required with respect to the exercise of an ISO or the 

acquisition of employee purchase plan stock because no amount is includible in income as a 

result of the receipt of the stock. In addition, no income tax withholding is required with respect 

to a disposition of ISO or employee stock purchase plan stock.67 No income tax withholding is 

required when compensation is recognized in connection with an employee stock purchase plan 

discount.68

 65 For purposes of the individual alternative minimum tax, the transfer of stock on the exercise of 

an incentive stock option is treated as the transfer of stock pursuant to a nonqualified option. 

66 If the option price under an employee stock purchase plan includes a discount, in the event of a 

disposition of the stock that is not a disqualifying disposition, or in the event of the employee’s death 

while owning such stock, capital gains treatment does not apply to the entire amount of the proceeds of 

the disposition. An amount equal to the lesser of (i) the excess of the fair market value of the stock at the 

time of the disposition or death over the option price, or (ii) the excess of the fair market value of the 

share at the time of grant over the option price, is treated as ordinary income for the taxable year in which 

the disposition or death occurs. The employer is not entitled to a deduction for this amount. 

67 Sec. 421(b). 

68 Sec. 423(c). 
38

Specific exclusions from FICA and FUTA wages apply for remuneration on account of 

the transfer of stock pursuant to the exercise of an incentive stock option or under an employee 

stock purchase plan, or any disposition of such stock.69 Thus, social security and Medicare taxes 

do not apply upon the exercise or disposition of a statutory stock option. 

4. Accounting for stock options 

The accounting rules for the treatment of stock-based compensation, including stock 

options, are governed by Statement of Financial Accounting Standards No. 123(R), Share-Based 

Payment (“FAS 123(R)”).70 FAS 123(R) is a revision of Statement of Financial Accounting 

Standards No. 123, Accounting for Stock-Based Compensation, (“FAS 123”) and superseded 

Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees, 

(“APB 25”).71 FAS 123(R) was issued in response to concerns that the methods under APB 25 

did not result in an accurate representation of the economic transaction of granting stock options. 

There was also concern that stock-based compensation should be accounted for using one 

method (rather than allowing companies to use either APB 25 or FAS 123 as previously 

allowed). The rules under FAS 123(R) are also more consistent with those under International 

Financial Reporting Standards. In most cases, accounting for stock options under FAS 123(R) 

results in a greater compensation expense that would be required under APB 25. 

FAS 123(R) generally requires companies to measure compensation costs based on the 

grant-date fair value of the award.72 The objective is to measure the fair value at the grant date 

that the entity is required to issue when the employees have rendered the requisite service and 

satisfied any other conditions necessary to earn the right to exercise the options. The grant-date 

value of employee stock options must be estimated using option-pricing models that take into 

account the exercise price of the option, the expected option term, the current price of the 

 69 Secs. 3121(a)(22) and 3306(b)(19). 

70 FAS 123(R) is effective for all companies for reporting periods that begin after December 31, 

2005. An earlier effective date applied to certain public companies. 

71 Prior to the effectiveness of FAS 123(R), the accounting rules for treatment of stock-based 

compensation generally were governed by APB 25 and FAS 123. FAS 123 was the preferred accounting 

method, but was not mandatory. If a company accounted for options using APB 25, disclosure of the 

impact of FAS 123 on the income statement was required. APB 25 required compensation costs for 

stock-based employee compensation plans to be recognized based on the difference, if any, between the 

quoted market price of the stock and the amount an employee must pay to acquire the stock. No increase 

in value was ascribed to the right to purchase the stock at a fixed price for a period of years. 

Correspondingly, no decrease in value was ascribed to restrictions on the option. The approach was 

effectively a snapshot of the difference between the market price and exercise price on the grant date 

(except in the case of certain variable option plans). Under APB 25, generally no compensation cost was 

recorded in financial statements for stock options issued to employees if the exercise price was equivalent 

to or greater than the market price on the grant date. Like FAS 123(R), FAS 123 defined a fair value 

method of accounting for employee stock options. Under FAS 123, except in extremely rare situations, 

the fair value determination of an option was made on the grant date. 

72 Certain limited exceptions apply. 
39

underlying shares, expected volatility of the price of the underlying shares, expected dividends, 

and the risk-free interest rates for the expected term of the option. FAS 123(R) allows the use of 

any option-pricing model that meets its requirements. Acceptable models include the binomial 

option-pricing model (a lattice model) and the Black-Scholes-Merton option pricing formula (a 

closed-form model). The estimate is determined as of the grant date and is not remeasured in 

subsequent periods. 

The cost must be recognized over the period during which the employee is required to 

provide service in exchange for the award (usually the vesting period). The total amount of 

compensation cost recognized for an award of stock options is based on the number of options 

that eventually vest. No compensation cost is recorded for options that do not vest (i.e., if the 

requisite service is not rendered). If compensation cost has been recorded in a prior period and 

the employee does not vest, such cost is reversed in the current period. Once an option vests no 

reversal of cost is permitted if the option was forfeited or expired. Thus, under 123(R), options 

can expire worthless and still result in an expense for the employer. 

If an equity award is modified after the grant date, incremental compensation cost is 

required to be recognized in an amount equal to the excess of the fair value of the modified 

award over the fair value of the original award before the modification. 

FAS 123(R) also requires any excess tax benefits to be recognized (i.e., any excess of the 

deduction for tax purposes over the compensation cost recognized on the income statement must 

be reported). 

FAS 123(R) also requires expense recognition of employee stock purchase plan options if 

certain criteria are not met. Under such criteria, any purchase discount may not exceed the pershare amount of share issuance costs that would have been incurred to raise a significant amount 

of capital by a public offering. A discount of five percent or less is deemed to satisfy this 

condition.73 Thus, expense recognition of employee stock purchase plan options may be 

required in the case of discounts in excess of five percent. 

5. Backdating stock options 

Recent press reports have focused on the issue of backdating stock options.74 The SEC is 

investigating several companies regarding this practice. In addition, the IRS has announced that 

it is examining the tax issues relating to backdating stock options for several public companies. 

Backdating stock options refers to the practice of backdating the grant date so that the 

price of the stock on the new (backdated) grant date is lower than the price on the actual date of 

grant.75 Because in most cases the exercise price of the option is determined as of the grant date, 

 73 Code section 423 allows a discount up to 15 percent. 

74 The issue of backdating stock options has been the subject of recent academic research. See 

Erik Lie, On the Timing of CEO Stock Option Awards, 51 MGMT. SCI. 5 (May 2005) at 802-812. 

75 Backdating the grant date appears to be the most common practice relating to backdating stock 

options. However, it appears that some companies have backdated the exercise date of the option. 
40

this results in a lower exercise price and the potential for more gain upon the exercise of the 

option. In the case of an increasing stock price, backdating results in an automatic option gain at 

the time of grant (generally referred to as an option that is “in the money”). 

Backdating stock options is not itself illegal, but there are several financial statement and 

securities and tax law implications. If the option backdating is adequately documented and 

disclosed and the stock options are properly accounted for and properly treated for tax purposes, 

the backdating may raise no legal issues. Issues arise when the appropriate requirements are not 

complied with.76

There are several tax law implications of backdating stock options. These include the 

rules for incentive stock options, the $1 million limitation on the deductibility of compensation, 

and nonqualified deferred compensation. The tax issues relate to whether the backdated stock 

option is treated correctly for tax purposes. 

As previously discussed, in order to qualify as an incentive stock option, the option 

exercise price must not be less than the fair market value on the date of grant.77 If the grant date 

of an option is backdated, this requirement is not satisfied and the option would not qualify as an 

incentive stock option. In the case of a backdated stock option that originally qualified as an 

incentive stock option, the option would have to be reclassified as a nonqualified stock option 

and would be subject to the tax treatment under section 83. 

As previously discussed, an exception from the $1 million limitation on deductibility of 

compensation of certain individuals exists for performance-based compensation.78 

Compensation attributable to a stock option is deemed to satisfy the performance-based 

requirement if (in addition to other requirements) the amount of compensation the employee 

could receive is based solely on an increase in the value of stock after the date of grant or 

award.79 In the case of an option granted with an exercise price that is less than the fair market 

value of the stock at the date of grant, none of the compensation under the grant is qualified 

performance-based compensation.80 Thus, an option granted at less than fair market value on the 

actual grant date would generally not qualify under the exception and compensation attributable 

to the stock option would be subject to the $1 million limitation. This could result in the loss of 

the company’s deduction for compensation attributable to the stock option. Section 162(m) also 

 76 Most of the stock option backdating reported in the press appears to have been done prior to 

the enactment of the Sarbanes-Oxley Act of 2002. Section 403 of Sarbanes-Oxley requires grants of 

stock options to be reported within two days of grant. The two-day reporting requirement may make 

stock option backdating more difficult. 

77 Sec. 422. The price must be 110 percent of the fair market value in the case of an option 

granted to an individual who, at the time the option is granted, owns stock possessing more than 10 

percent of the total combined voting power of all classes of stock of the employer. 

78 Sec. 162(m). 

79 Treas. Reg. sec. 162-27(e)(2)(vi). 

80 Id. 
41

requires that in the case of a stock option plan, the shareholders must approve the specific terms 

of the plan. If the option backdating is inconsistent with the terms of the shareholder-approved 

stock option plan, the shareholder approval requirement would not be satisfied. 

Another tax issue relates to the rules under section 409A governing the tax treatment of 

nonqualified deferred compensation. An option with an exercise price that is not less than the fair 

market value of the stock at the date of grant is not considered nonqualified deferred 

compensation under section 409A and is not subject to its requirements.81 An option with an 

exercise price below the fair market value of the stock at the date of grant is subject to the rules 

under section 409A.82 Thus, a backdated option would likely be treated as a nonqualified 

deferred compensation arrangement under section 409A and be subject to the requirements of 

section 409A, such as the timing of deferral elections and restrictions on when nonqualified 

deferred compensation can be paid. A backdated stock option is likely to violate these 

requirements. In that case, the individual would be subject to current income inclusion, a 20-

percent additional tax, and interest (if any) at the rate applicable to underpayments of tax plus 

one percentage point. As previously discussed, section 409A is effective for amounts deferred 

after December 31, 2004. Most of the stock option backdating that has been reported in the press 

may have been done prior to the effectiveness of section 409A. 

 81 Prop. Treas. Reg. sec. 1.409A-1(b)(5). 

82 An option with an exercise price lower than the fair market value at the date of grant is 

commonly referred to as a discounted option. 
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D. Other Examples of Stock-Based Arrangements 

1. In general 

Besides actual stock and stock options, compensation may include other arrangements 

that are based on or related to stock of the employer. To the extent that such an arrangement 

involves actual stock, the rules of section 83 may apply. However, some arrangements, such as 

stock appreciation rights and phantom stock plans, involve cash payments based on stock values, 

rather than actual stock, and are therefore taxed when actually or constructively received. 

2. Stock appreciation rights 

A stock appreciation right (“SAR”) is an arrangement under which the employee has the 

right to receive the amount of the increase in the value of employer stock during a specified 

period. The employee receives the increase in value by cashing out or exercising the SAR. For 

example, the employee may be granted stock appreciation rights with respect to 1,000 shares of 

employer stock at a time when the stock is valued at $100 a share, and the SAR may be 

exercisable for three years. As a result, the employee has the right at any time during the three 

years to receive cash in the amount of the increase in value of 100 shares of stock since the time 

the SAR was granted. Variations in the terms of an SAR may include limitations on the 

exercisability of the SAR until (or unless) certain stock value goals are met or allowing the 

proceeds of the SAR to be paid in the form of stock rather than cash. 

Because the employee has the right to receive on request the increase in stock value that 

has already occurred (i.e., the current increase in stock value), an SAR raises constructive receipt 

issues. However, under IRS revenue rulings issued before the enactment of section 409A, a 

substantial limitation on the employee’s ability to receive the current increase in stock value 

results from the fact that the employee must forego the right to benefit from additional increases 

in stock value during the SAR period (i.e., the employee must surrender a valuable right) in order 

to exercise the SAR. Under these rulings, the current increase in stock value is not considered 

constructively received. The amount received on exercise of the SAR is includible in income at 

that time. 

3. Phantom stock unit 

A phantom stock unit is a contractual obligation of the company equal in value to one 

share of the company which, until paid, is an unfunded bookkeeping credit on the records of the 

company. Upon the vesting of phantom stock units, the holder is generally entitled to payment 

in cash or in shares of common stock at the rate of one share of common stock for each phantom 

stock unit, plus dividends that have accrued from the grant date until vesting. Payments made in 

cash under a phantom stock plan are includible in gross income and wages when received. 

Payments made in the form of stock are includible in income as provided under section 83. The 

structure of phantom stock plans in discussed in Part III.A.3., above, in connection with 

nonqualified deferred compensation. 
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E. Discussion of Issues 

Some argue that the use of stock-based compensation is an appropriate means of 

compensation because it aligns the interests of the shareholders and corporate executives and 

rewards performance. On the other hand, some argue that an increase in stock price or corporate 

earnings alone is not an appropriate measure of performance because such an increase may not 

be directly linked to an individual’s performance. 

Many companies believe that a great portion of executive compensation should be 

dependent on company performance. While some argue that linking shareholder and executive 

success is beneficial for shareholders, conflicts may arise. Linking compensation of executives 

to the performance of the company can result in executives taking measures to increase shortterm earnings instead of focusing on longer-term profitability and growth or to artificially inflate 

earnings. 

Stock options have become a very prevalent form of compensation. Before the 

effectiveness of FAS 123(R), many companies preferred the use of stock options because of the 

favorable accounting treatment under APB 25 (i.e., no compensation cost was required to be 

recorded in financial statements for stock options issued to employees if the exercise price was 

equivalent to or greater than the market price on the date of grant). Some have speculated that 

mandatory stock option expensing under FAS 123(R) will cause many companies to modify their 

compensation arrangements so that there is less emphasis on stock options. Others believe that 

use of stock options will remain prevalent especially as a means to meet the performance-based 

compensation exception to the $1 million deduction limitation. 

As previously discussed, the issue of backdating stock options has received much 

attention recently. While backdating stock options is not per-se illegal, several accounting, 

securities and tax law issues are involved. The SEC and IRS are investigating stock option 

backdating practices of many public companies. Many believe that the provisions of the 

Sarbanes-Oxley Act of 2002 and recently issued SEC executive compensation disclosure rules 

will make stock option backdating more difficult in the future. In addition, the tax treatment 

under section 409A may also make stock option backdating less advantageous in the future. 
44

V. TAXATION OF EXCESS PARACHUTE PAYMENTS 

In general

In some cases, the compensation agreement for a corporate executive may provide for 

payments to be made if the executive loses his or her job as a result of a change in control of the 

company. Such payments are referred to as “golden parachute payments.” The Code contains 

limits on the amount of such payments. Payments in excess of those limits (i.e., “excess 

parachute payments”) are not deductible by the corporation (sec. 280G). In addition, a 

nondeductible 20-percent excise tax is imposed on the recipient of any excess parachute payment 

(sec. 4999). 

Definition of parachute payment

A “parachute payment” is any payment in the nature of compensation to (or for the 

benefit of) a disqualified individual which is contingent on a change in the ownership or 

effective control of a corporation or on a change in the ownership of a substantial portion of the 

assets of a corporation (“acquired corporation”), if the aggregate present value of all such 

payments made or to be made to the disqualified individual equals or exceeds three times the 

individual’s “base amount.” 

The individual’s base amount is the average annual compensation payable by the 

acquired corporation and includible in the individual’s gross income over the five-taxable years 

of such individual preceding the individual’s taxable year in which the change in ownership or 

control occurs. 

The term parachute payment also includes any payment in the nature of compensation to 

a disqualified individual if the payment is made pursuant to an agreement which violates any 

generally enforced securities laws or regulations. 

Certain amounts are not considered parachute payments, including payments under a 

qualified retirement plan, and payments that are reasonable compensation for services rendered 

on or after the date of the change in control. In addition, the term parachute payment does not 

include any payment to a disqualified individual with respect to a small business corporation or a 

corporation no stock of which was readily tradable if certain shareholder approval requirements 

are satisfied. 

Disqualified individual

A disqualified individual is any individual who is an employee, independent contractor, 

or other person specified in regulations who performs personal services for the corporation and 

who is an officer, shareholder, or highly compensated individual of the corporation. Personal 

service corporations and similar entities are generally treated as individuals for this purpose. A 

highly compensated individual is defined for this purpose as an employee (or a former employee) 

who is among the highest-paid one percent of individuals performing services for the corporation 

(or an affiliated corporation) or the 250 highest paid individuals who perform services for a 

corporation (or affiliated group). 
45

Excess parachute payments

In general, excess parachute payments are any parachute payments in excess of the base 

amount allocated to the payment. The amount treated as an excess parachute payment is reduced 

by the portion of the payment that the taxpayer establishes by clear and convincing evidence is 

reasonable compensation for personal services actually rendered before the change in control.