Deferred Stock Compensation: Tax Rules and Payout Options
Understand the financial mechanics of deferred stock, from the unique timing of tax obligations to the regulated process of scheduling future distributions.
Deferred stock compensation is a method of paying employees with company stock, or a cash equivalent, at a future date. Companies use these arrangements to attract and retain employees by linking their performance to shareholder value and aligning their financial interests with the company’s long-term growth.
Common Types of Deferred Stock Plans
Restricted Stock Units with a Deferral Feature
Restricted Stock Units (RSUs) are a promise of a certain number of company shares, subject to a vesting schedule. While vested RSUs are often delivered and taxed immediately, some plans have a deferral feature. This allows an employee to postpone receiving the vested shares to a later date, such as retirement.
This deferral changes the timing of ordinary income tax but not payroll taxes. The value of the compensation is tied to the market price of the stock on the date the shares are delivered.
Phantom Stock
Phantom stock is a deferred compensation arrangement that mimics the value of company stock without granting actual equity. An employee is awarded hypothetical units that track the company’s real stock. The plan specifies a future date or event, like separation from service, when the value of these units is paid out.
The payout is almost always in cash, providing the economic benefit of stock ownership without diluting the ownership of existing shareholders.
Stock Appreciation Rights
Stock Appreciation Rights (SARs) grant an employee the right to a payment equal to the increase in value of a specified number of shares over a set period. The employee does not pay an exercise price to receive this value. The SAR’s value is the spread between the stock’s market price at exercise and its price on the grant date.
Upon exercise, the employee receives this spread in cash, company stock, or a combination of both, as determined by the plan.
Key Tax Implications
Income Tax
A defining feature of deferred stock compensation is the timing of ordinary income tax. The taxable event occurs when the compensation is paid out or distributed, not when it is granted or vests. At that point, the fair market value of the stock or cash received is treated as ordinary income, subject to the employee’s marginal tax rate.
This value is reported as wages on the employee’s Form W-2, and the employer withholds the appropriate income tax.
FICA Taxes
The timing for Federal Insurance Contributions Act (FICA) taxes, which fund Social Security and Medicare, is different from income taxes. Under the special timing rule, FICA taxes are due when the award vests, even if the stock or cash is deferred to a future year. Vesting occurs when the employee’s right to the compensation is no longer subject to a substantial risk of forfeiture.
The employer handles withholding, which may require the employee to pay their share out-of-pocket or through a portion of the vested award.
Capital Gains Tax
When an employee receives shares from a deferred plan and pays ordinary income tax, that value establishes the cost basis for the shares. Any future increase in the stock’s value is a capital gain.
If the employee sells the shares more than one year after receiving them, the profit is a long-term capital gain taxed at preferential rates. If the shares are sold one year or less after receipt, the profit is a short-term capital gain taxed at ordinary income rates.
The Role of Section 409A
What 409A Governs
Internal Revenue Code Section 409A provides rules for most nonqualified deferred compensation plans. These regulations dictate the timing and form requirements that must be met to avoid immediate taxation and penalties. Section 409A was enacted to prevent employees from having too much control over when they receive their compensation, ensuring that a deferral is binding.
Adherence to these rules is necessary for the tax-deferral benefits of the plan to be recognized by the IRS.
Key Requirements
Section 409A imposes strict requirements on the timing of the initial deferral election. An employee must elect to defer compensation in the calendar year before the year the services are performed. A special rule allows the election within 30 days of a new grant, provided it has a vesting period of at least 12 months.
Distributions are only permitted upon specific events, including:
- Separation from service
- Disability
- Death
- A specified time or fixed schedule
- A change in control of the company
- An unforeseeable emergency
The anti-acceleration rule also prohibits speeding up payments once the schedule is set.
Penalties for Non-Compliance
Failure to comply with Section 409A results in significant tax consequences for the employee. If a plan violates the regulations, all compensation deferred under it for the current and all preceding years becomes immediately taxable as ordinary income. The employee is also subject to a 20% additional federal penalty tax on that amount.
An interest penalty, calculated at the IRS underpayment rate plus one percentage point, may also be assessed on the back taxes owed.
Making Deferral and Distribution Elections
The initial deferral election is a formal, irrevocable action made by submitting a company-provided form within the strict deadlines set by Section 409A. This election is the foundation of the deferred compensation arrangement.
When making the election, the employee must also decide on the form and timing of the future distribution. The form of payment typically offers a choice between a single lump sum or a series of scheduled installments over several years. Spreading payments out can have significant tax planning implications. The timing must be tied to a permissible event, such as a specific future date or upon separation from service.