Deferred compensation and stock options;

              Deferred Compensation
and Stock Options
This article is based on a talk which the author gave before
the 1962 University of Pennsylvania Tax Conference. It ap­peared
in substantially the same form in TAXES—The Tax
Magazine, January 1963. Mr. Scully cautions the reader that
the President has asked congress to exact legislation which
would substantially affect advantages of restricted stock op­tions
to employees.
(CONSIDER FOR A FEW MINUTES, if you will, that you are
a member of the Board of Directors of a medium-sized
corporation. In such capacity you are confronted with
the following problem. John Jones, one of the com­pany's
key executives, is currently earning $40,000 a
year base salary, plus a bonus computed on a percent­age
of net income which has varied between $1,000 and
$9,000 over the last five years. Although John has
earned a good salary for the last ten years, he can look
forward to retiring in 15 years with post-retirement in­come
of only $12,000 a year. Ten thousand dollars a
year of this $12,000 annual post-retirment income will
come from a company-sponsored qualified pension
plan. The Board of Directors has decided that if they
are to retain the services of J o h n Jones until retirement
they must increase his compensation. You, as a member
of the Board of Directors, have been asked to investi­gate
two of the possible ways in which this increase in
compensation may be granted to John. The two meth­ods
are a nonqualified deferred compensation plan1
and a stock option plan.2 Both of these plans are to be
investigated with a view toward increasing John's after­tax
earnings, assisting him in creating an estate, and at
the same time enabling the corporation to claim a de­duction
for amounts paid. Your knowledge of the com­pany's
qualified deferred compensation plan reveals
16
that John's benefits under the plan cannot be substan­tially
increased without, at the same time, increasing
the benefits to all other employees covered by the plan.
This would be too costly to the company and is not to
be considered.
Therefore, if a deferred compensation plan is to be
utilized, it will of necessity be a nonqualified plan. A
nonqualified plan may have one of several objectives.
It may attempt to defer part of John's current earnings
and spread them over a period of years while he is still
employed, or it may defer current income until after
his retirement. The first of these two objectives is in­corporated
into many executive profit-sharing plans.
Under such plans an executive's bonus is computed
based on current income of the corporation, but only a
fraction is paid out in the current year. T h e remainder
is prorated over the subsequent three to five years and
generally is payable only if the executive is still em­ployed
by the corporation. This type of profit-sharing
plan would serve a dual purpose in John's case. In­creases
in his compensation would be geared to increases
in profits of the corporation. The corporation would
obtain a deduction as the amounts were actually paid3
and John would pick them up as income only in the
years they were actually received. Spreading the pay­ments
over a period of years would be of a further ad­vantage
to John in that his earnings from one year to
the next would tend to be level from one year to the
1 IRC Sec. 404(a)(5).
2 IRC Sec. 421.
3 See footnote 1 and Reg. 1.404(a)-12.
THE QUARTERLY