Tax Treatment of Parent Stock for a Subsidiary’s Employee
Learn how a parent's stock transfer to a subsidiary's employee is treated as a capital contribution that allows the subsidiary to claim a deduction.
When a parent corporation uses its own stock to compensate an employee of its subsidiary, specific tax rules are triggered for all parties. This common business practice creates a triangular relationship between the parent company, its subsidiary, and the subsidiary’s employee. The arrangement has distinct consequences that affect the parent’s investment basis, the subsidiary’s deductible expenses, and the employee’s taxable income.
The Transaction Scenario
This compensation structure involves a parent corporation (P), its subsidiary corporation (S), and an individual employee (E) who performs services for S. The parent company, P, holds a controlling interest in S. The transaction occurs when P transfers shares of its own stock directly to E in connection with the services E has provided to S. This uses the parent’s assets to satisfy a compensation obligation of its subsidiary.
Tax Consequences for the Companies
The parent corporation (P) does not recognize any gain or loss on the transfer of its own stock, a principle established under Internal Revenue Code Section 1032. This rule applies even if the stock has appreciated in value. The tax code treats this transaction as if P first made a contribution of capital to its subsidiary (S), so P increases its basis in the S stock by the fair market value of the shares transferred.
For the subsidiary corporation (S), the transaction results in a business expense deduction under Section 83. S can deduct an amount equal to the fair market value of the parent company stock that is included in the employee’s income. This allows S to claim a deduction for an expense it did not directly pay in cash and prevents a “zero basis” problem.
Tax Consequences for the Employee
The employee (E) who receives the stock must recognize the value of this compensation as ordinary income. The amount of income the employee must report is the fair market value of the parent company’s stock.
The timing of this income recognition is important. The employee includes the value of the stock in their gross income for the tax year in which the stock becomes “substantially vested.” Stock is considered substantially vested when it is either transferable or no longer subject to a substantial risk of forfeiture. At that point, the employee is taxed on the stock’s full fair market value, which then becomes the employee’s tax basis in the shares.