[Code of Federal Regulations]
[Title 26, Volume 11]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.1348-3]

[Page 674-683]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.1348-3  Definitions.

    (a) Earned income--(1) In general. (i) For purposes of section 1348 
and the regulations thereunder, the term earned income means any item of 
gross income which is earned income within the meaning of section 
401(c)(2)(C) or 911(b) unless the item constitutes deferred compensation 
as defined in paragraph (b) of this section or is otherwise excluded by 
application of this paragraph. Thus, subject to such exceptions, the 
term includes:
    (A) Wages, salaries, professional fees, bonuses, amounts includible 
in gross income under section 83, commissions on sales or on insurance 
premiums, tips, and other amounts received, actually or constructively, 
as compensation for personal services actually rendered regardless of 
the medium or basis of payment.
    (B) Compensatory payments for personal services made prior to the 
time such services are actually rendered, provided such advance payments 
are not made for a purpose of minimizing Federal income taxes by reason 
of the application of section 1348, and are either customary in the 
particular profession, trade, or business, or are made for a bona fide 
business purpose.
    (C) Prizes and awards in recognition of personal services includible 
in gross income under section 74, amounts includible in gross income 
under section 79 (relating to group-term life insurance purchased for 
employees), and amounts includible in gross income under section 1379(b) 
(relating to contributions to qualified pension plans in the case of 
certain shareholder-employees); and
    (D) Gains (other than gain which is treated as capital gain under 
any provision of chapter 1) and net earnings derived from the sale or 
other disposition of, the transfer of any interest in,

[[Page 675]]

or the licensing of the use of property (other than good will) by an 
individual whose personal efforts created such property.

The term does not include such income as dividends (including an amount 
treated as a dividend by reason of section 1373(b) and Sec. 1.1373-1), 
other distributions of corporate earnings and profits, gambling gains, 
or gains which are treated as capital gains under any provision of 
chapter 1. The term also does not include amounts received for 
refraining from rendering personal services or engaging in competitive 
activity or amounts received as consideration for the cancellation of an 
employment contract.
    (ii) In the case of a nonresident alien individual, earned income 
includes only earned income from sources within the United States which 
is effectively connected with the conduct of a trade or business within 
the United States.
    (2) Earned income and employed assistants. The entire amount 
received as professional fees shall be treated as earned income if the 
taxpayer is engaged in a professional occupation, such as a doctor, 
dentist, lawyer, architect, or accountant, even though he employs 
assistants to perform part or all of the services, provided the patients 
or clients are those of the taxpayer and look to the taxpayer as the 
person responsible for the services performed.
    (3) Earned income from business in which capital is material. (i) If 
an individual is engaged in a trade or business (other than in corporate 
form) in which both personal services and capital are material income-
producing factors, a reasonable allowance as compensation for the 
personal services actually rendered by the individual shall be 
considered earned income, but the total amount which shall be treated as 
the earned income of the individual from such a trade or business shall 
in no case exceed 30 percent of his share of the net profits of such 
trade or business (which share shall include any guaranteed payment (as 
defined by Sec. 1.707-1(c)) received from a partnership). For purpose 
of the preceding sentence, the term net profits of the trade or business 
means the excess of gross income from such trade or business (including 
income from all sources, whether or not subject to Federal income tax, 
and without taking into account any deductions which may be allowable 
under section 1202) over the deductions attributable to such trade or 
business.
    (ii) Whether capital is a material income-producing factor must be 
determined by reference to all the facts of each case. Capital is a 
material income-producing factor if a substantial portion of the gross 
income of the business is attributable to the employment of capital in 
the business, as reflected, for example, by a substantial investment in 
inventories, plant, machinery, or other equipment. In general, capital 
is not a material income-producing factor where gross income of the 
business consists principally of fees, commissions, or other 
compensation for personal services performed by an individual. Thus, the 
practice of his profession by a doctor, dentist, lawyer, architect, or 
accountant will not, as such, be treated as a trade or business in which 
capital is a material income-producing factor even though the 
practitioner may have a substantial capital investment in professional 
equipment or in the physical plant constituting the office from which he 
conducts his practice since his capital investment is regarded as only 
incidental to his professional practice.
    (iii) This subparagraph does not apply to gains and net earnings 
derived from the sale or other disposition of, the transfer of any 
interest in, or the licensing of the use of property by an individual 
whose personal efforts created such property which are, by reason of 
subparagraph (1)(i) of this paragraph, treated as earned income. Thus, 
for example, a research chemist's substantial capital investment in 
laboratory facilities which he uses to produce patentable chemical 
processes from which he derives gains within the meaning of this 
subdivision would not be considered a material income-producing factor.
    (4) Income in respect of a decedent. An item of gross income in 
respect of a decedent includible in the gross income of a person 
described in section described in section 691(a)(1) shall be

[[Page 676]]

treated as earned income in the hands of such person for purposes of 
subparagraph (1) of this paragraph if such item of gross income would 
have constituted earned income of the decedent had he lived and received 
such amount. See Sec. 1.1348-2(d)(3)(vi) for rules relating to 
attribution of tax preferences by reason of an item of income in respect 
of a decedent.
    (5) Exceptions to definition of earned income. For purposes of 
section 1348 and the regulations thereunder, the term earned income does 
not include:
    (i) Any distribution to which section 72(m)(5), relating to certain 
amounts received by owner-employees from a trust described in section 
401(a) or under a plan described in section 403(a), applies,
    (ii) Any distribution to which section 402(e), relating to the 
treatment of certain total distributions from a trust described in 
section 401(a) or under a plan described in section 403(a), applies,
    (iii) Any distribution to which section 402(a)(2), relating to 
capital gains treatment of certain total distributions from a trust 
described in section 401(a), applies,
    (iv) Any distribution to which section 403(a)(2)(A), relating to 
capital gains treatment for certain distributions under a plan described 
in section 404(a)(2), applies, or
    (v) Any deferred compensation within the meaning of paragraph (b) of 
this section.
    (6) Examples. The application of this paragraph may be illustrated 
by the following examples:

    Example 1. A owns and operates an unincorporated laundering and dry 
cleaning business. A, assisted by his employees, devotes his entire time 
and attention to this business. Substantial capital is invested in the 
plant and equipment utilized in the laundering and dry cleaning of 
clothing for A's customers. Although personal services performed by A 
and his employees are a material income-producing factor in A's 
business, the capital investment in plant and equipment is not merely 
incidental to the performance of such services but is, as such, material 
to the production of business income. Therefore, A's laundering and dry 
cleaning business is one in which both personal services and capital are 
material income-producing factors within the meaning of paragraph (a)(3) 
of this section. A may treat as earned income for a taxable year a 
reasonable allowance as compensation for the personal services rendered 
by him in his business, but the amount so treated shall not exceed 30% 
of the net profits of his business for such year.
    Example 2. In his unincorporated business as a real estate broker, 
which he conducts on a full-time basis, A performs substantial personal 
services, including solicitation of home buyers and sellers, escorting 
prospective buyers on house visits, arranging appraisal, financing, and 
legal services, and other related tasks. In the course of conducting 
such business, A often finances sales of real estate with his own 
capital, makes all the necessary arrangements incident to such 
financing, and a substantial portion of the gross income of the business 
consists of interest income from such financing. Under these facts and 
circumstances, both personal services and capital are material income-
producing factors in A's real estate business within the meaning of 
paragraph (a)(3) of this section since the financing of real estate 
sales is an integral part of the entire business. Accordingly, A's 
earned income from his real estate business is limited to a reasonable 
allowance as compensation for the personal services A actually renders, 
but not in excess of 30% of the net profits from the business, including 
the interest income derived from financing sales of real estate.
    Example 3. For his taxable year ending on December 31, 1973, A, a 
radiologist, reports fees of $100x for professional services rendered to 
his own patients during 1973. Since 1970, A has maintained his own 
office in a small building that he purchased for $60x. In addition, A 
owns X-ray equipment with an original cost of $300x which he uses in his 
professional practice. The entire $100x of professional fees earned by A 
during 1973 is treated as earned income, notwithstanding that A has a 
substantial capital investment in professional equipment and the office 
from which he conducts his medical practice, because such capital 
investment is only incidental to the rendition of personal services in 
A's professional practice.

    (b) Deferred compensation--(1) In general. For purposes of section 
1348 and the regulations thereunder, the term deferred compensation 
means, except as otherwise provided in subparagraph (2) of this 
paragraph, any compensation which is deferred within the meaning of that 
concept in section 404, including any deferred compensation to which the 
provisions of section 404 and the regulations thereunder apply and any 
other compensation taxation of which is deferred in a manner similar to 
the treatment applicable to deferred

[[Page 677]]

compensation to which such provisions apply. Thus, the term includes any 
amounts includable in gross income as compensation for personal services 
pursuant to a plan, or method having the effect of a plan, deferring the 
taxation of such payment to a taxable year later than that in which such 
services were rendered. For purposes of section 1348, the term deferred 
compensation is not limited to payments to common-law employees but also 
includes payments to self-employed individuals: nor is it material that 
no deduction is allowable in respect of all or part of such payments or 
that a deduction in respect thereof is allowable under some provision of 
the Code other than section 404. For example, amounts received by a 
retired partner pursuant to a written plan of the partnership of the 
kind described in section 1402(a)(10) constitute deferred compensation 
except as otherwise provided in subparagraph (2) of this paragraph. The 
term deferred compensation, as defined in this paragraph, shall have no 
application to a determination of the deductibility of any amount under 
section 162, 404, or any other provision of the Code.
    (2) Amounts not treated as deferred compensation. Notwithstanding 
the provisions of subparagraph (1) of this paragraph, any amount 
includible in gross income as compensation before the end of the taxable 
year following the first taxable year of the taxpayer in which his right 
to receive such amount is not subject to any requirement or condition 
which would be treated as resulting in a substantial risk of forfeiture 
within the meaning of section 83 and the regulations thereunder does not 
constitute deferred compensation for purposes of section 1348 and the 
regulations thereunder. For purposes of this subparagraph, a fractional 
part of a year which is a taxable year under sections 441(b) and 
7701(a)(23) shall be treated as a taxable year.
    (3) Application to certain compensation--(i) In general. This 
subparagraph provides rules for the application of the principles of 
subparagraphs (1) and (2) of this paragraph to certain types of 
compensation.
    (ii) Pension, etc., plans. (A) In accordance with subparagraph (1) 
of this paragraph, the taxable portion of distributions under a pension, 
annuity, profit-sharing, or stock bonus plan, whether or not such plan 
meets the requirements of section 401(a), or pursuant to a method having 
the effect of such a plan, generally constitutes deferred compensation. 
However, under subparagraph (2) of this paragraph, such portion 
constitutes earned income if includible in gross income before the end 
of the taxable year following the first taxable year of the taxpayer in 
which his right to receive such amount is not subject to a substantial 
risk of forfeiture. In the case of a distribution under a contributory 
plan, the preceding sentence applies only to that part of the taxable 
portion of the distribution which is attributable to employer 
contributions to the plan. For purposes of the preceding sentence, that 
part of the taxable portion of a distribution which is attributable to 
employer contributions is the amount of such part, multiplied by a 
fraction, the numerator of which is the employer contributions to the 
plan on behalf of the employee (determined in accordance with the 
principles of Sec. 1.402(a)-2), and the denominator of which is the sum 
of such employer contributions and the net employee contributions to the 
plan (as defined in paragraph (a)(2) of Sec. 1.402(a)-2). Thus, if the 
employer does not contribute to the plan, no part of any distribution 
thereunder constitutes earned income. Amounts included in gross income 
under section 402(b), 403(c), or 1379(b)(1) in respect of employer 
contributions to a plan described in this subdivision do not constitute 
deferred compensation.
    (B) If a recipient's rights to receive amounts pursuant to a plan 
cease to be subject to a substantial risk of forfeiture in more than one 
of his taxable years, each payment pursuant to such plan shall be 
considered to consist of a ratable portion of all of the amounts which 
are not subject to a substantial risk of forfeiture at the time of such 
payment. Thus, for example, if an employment contract provides in part 
that an employee or his estate is to receive in each of the fifteen 
years after the year in which he attains or would have attained age 65 
an amount equal to $2,000 times his years of service with the employer 
and if he had eighteen

[[Page 678]]

years of service with the employer, each $36,000 payment would be 
considered to consist of 18 payments of $2,000, his right to receive one 
of which ceased to be subject to a substantial risk of forfeiture upon 
completing his first year of service with the employer, his right to 
receive another of which ceased to be subject to a substantial risk of 
forfeiture upon completing his second year of service with the employer, 
etc. Therefore, if the employee's last year of service with the employer 
was completed in the year in which he attained age 65, $2,000 of the 
first payment in the next year would not be deferred compensation under 
subparagraph (2) of this paragraph, and the remaining $34,000 of that 
payment and all of the other fourteen payments of $36,000 would be 
deferred compensation. If the employee's last year of service was 
completed in an earlier year, all fifteen payments would constitute 
deferred compensation in full.
    iii) Income attributable to options. (A) Ordinary income realized by 
a taxpayer upon a disqualifying disposition of stock acquired pursuant 
to the exercise of a statutory option (as defined in Sec. 1.421-7(b)) 
is not deferred compensation for purposes of subparagraph (1) of this 
paragraph and, therefore, constitutes earned income.
    (B) Ordinary income realized by a taxpayer upon the transfer of 
property pursuant to the exercise, or sale or other disposition, of an 
option which is not a statutory option (as defined in Sec. 1.421-7(b)) 
and which was granted on or before December 15, 1971, is not deferred 
compensation for purposes of subparagraph (1) of this paragraph and, 
therefore, constitutes earned income. Ordinary income realized by a 
taxpayer upon the transfer of property pursuant to the exercise, or sale 
or other disposition, of an option which is not a statutory option (as 
defined in Sec. 1.421-(b)) and which is granted after December 15, 1971 
constitutes earned income rather than deferred compensation if such 
option cannot, by its terms, be exercised more than three months after 
termination (for any reason other than death) of the grantee's 
employment by the grantor of the option. If the terms of such an option 
granted after December 15, 1971 permit the exercise of the option more 
than three months after termination (for any reason other than death) of 
the grantee's employment by the grantor, ordinary income realized by a 
taxpayer upon the transfer of property pursuant to exercise, or sale or 
other disposition, of the option constitutes earned income rather than 
deferred compensation only if such income is realized in a taxable year 
no later than that following the taxable year in which the option was 
granted. In the case of the grantee's death within a period during which 
ordinary income realized upon the transfer of property pursuant to his 
exercise, or sale or other disposition, of an option described in this 
subdivision would have constituted earned income as provided in this 
subdivision had the grantee lived, ordinary income realized subsequently 
upon the transfer of property pursuant to exercise, or sale or other 
disposition, of an option described in this subdivision, by the 
grantee's legal represedntatives or beneficiary constitutes earned 
income only if such exercise or sale or other disposition, occurs on a 
date no later than the date twelve months following that of the 
grantee's death. For purposes of this subdivision, the term employment 
by the grantor includes employment by a related corporation as defined 
in Sec. 1.421-7(i), and by a corporation which is considered a related 
corporation under Sec. 1.421-7(h)(3). Therefore, the transfer of an 
employee from the grantor corporation to such a related corporation or 
from one related corporation to another related corporation or to the 
grantor corporation will not be treated as a termination of employment 
by the grantor.
    (C) For purposes of (B) of this subdivision, if an option described 
therein and granted after December 15, 1971 is exercisable only 
following completion of a specified period of employment, the taxable 
year in which such period of employment is completed shall be treated as 
the taxable year in which the option was granted. Further, if the terms 
of an option described in (B) of this subdivision and granted after 
December 15, 1971 are modified, such modification shall not be 
considered as

[[Page 679]]

the granting of a new option for purposes of (B) in determining the 
taxable year in which such option was granted.
    (D) For purposes of (B) of this subdivision, an option will not be 
considered exercisable by its terms more than three months following 
termination (for any reason other than death) of the grantee's 
employment by the grantor solely because the terms of such option 
permit, in the event of such grantee's death within three months 
following termination of such employment, exercise of the option by the 
grantee's legal representative or beneficiary during or following such 
three-month period.
    (4) Examples. The application of this paragraph may be illustrated 
by the following examples, in each of which it is assumed that any 
amounts paid as described therein constitute salaries or other 
compensation for personal services actually rendered rather than a 
distribution of earnings and profits:

    Example 1. (i) On January 1, 1965, Corporation X and E, an 
individual, execute an employment contract under which E is to be 
employed by X for a period of 10 years. Under the contract, E is 
entitled to a stated annual salary and to additional compensation of 
$10x for each year. This additional compensation is to be credited as of 
December 31 of each year to a bookkeeping reserve account and will be 
deferred, accumulated, and paid only upon termination of the employment 
contract, E's becoming a part-time employee of X, or E's becoming 
partially or totally incapacitated. Under the terms of the contract, X 
is merely under a contractual obligation to make the payments when due, 
and neither X nor E intends that the amounts in the reserve be held by X 
in trust for E. The contract provides that if E shall fall or refuse to 
perform his duties, X will be relieved of any obligation to make further 
credits to the reserve but not of the obligation to distribute amounts 
previously credited to the reserve. In the event E should die prior to 
his receipt in full of the balance in the account, the remaining balance 
is distributed to his personal representative.
    (ii) Having completed the terms of his employment contract, E 
retires from the employment of X on December 31, 1974, and on January 
15, 1975, receives a total distribution of $100x from his reserve 
account. Of this distribution of $100x to E, only $10x, representing the 
credit made to E's reserve account in 1974, constitutes earned income. 
No other credits to E's reserve account are taken into account for this 
purpose because they were made to the reserve account and became 
nonforfeitable in a year earlier than the year preceding that in which 
the $100x distribution was made to E.
    Example 2. (i) Corporation X follows a policy of permitting 
employees to elect before the beginning of any calendar year to defer 
the receipt of either 5 percent or 10 percent of their stated annual 
salary to be earned in that year. E, an employee, elects for each of 10 
years of employment to defer receipt of $5x of his stated annual salary. 
The total so deferred, or $50x, is paid to E on January 15, 1974.
    (ii) Since the salary which E elects to defer is includible in his 
gross income only in the taxable year in which actually received by him, 
then to the extent E receives any such deferred salary payment after the 
end of the taxable year following the taxable year from which such 
payment was deferred, such payment does not constitute earned income 
since such payment is deferred compensation under this paragraph (b). 
Accordingly, of the $50x distribution to E, only $5x, representing the 
salary deferral from 1973, constitutes earned income.
    Example 3. (i) E is an officer of Corporation X, which has a plan 
for making future payments of additional compensation for current 
services to certain employees. The plan provides that a fixed percentage 
of the annual net earnings in excess of $400x is to be designated for 
division among the participants. This amount is not currently paid to 
the participants; but X has set up on its books a separate account for 
each participant, including E, and each year it credits thereto the 
dollar amount of his participation for the year. Distributions are to be 
made from the account when the employee reaches the age of 60, is no 
longer employed by X, including cessation of employment due to death, or 
becomes totally unable to perform his duties, whichever occurs first. 
X's liability to make these distributions is contingent upon the 
employee's refraining from engaging in any business competitive to that 
of X, making himself available to X for consultation and advice after 
retirement or termination of his services, unless disabled, and 
retaining unencumbered any interest or benefit under the plan. In the 
event of his death, either before or after the beginning of payments, 
amounts in an employee's account are distributable to his designated 
beneficiaries of heirs-at-law. Under the facts and circumstances, E's 
rights to distributions from his account pursuant to the terms of the 
plan are not subject to a substantial risk of forfeiture within the 
meaning of section 83(c)(1). Under the terms of the compensation plan, X 
is under a merely contractual obligation to make the payments when due, 
and the parties did not intend that the amounts in each account be held 
by X in trust for the participants.

[[Page 680]]

    (ii) Cash or property includable in gross income by E which is 
attributable to a credit to his account in a taxable year earlier than 
the year immediately preceding the year on onclusion does not constitute 
earned income since it is deferred compensation within the meaning of 
this paragraph (b). See subparagraph (3) of this paragraph (b) for rules 
for determining that portion of distributions from E's acount which are 
attributable to credits to his account in a taxable year immediately 
preceding the year in which such distributions are made.
    Example 4. (i) Corporation X has an annual incentive bonus plan for 
its employees. Under this plan, X has the sole discretion to defer all 
or any part of any employee's incentive bonus award. In addition, no 
employee has any right to receive any incentive bonus for any year 
(whether to be paid currently or to be deferred) until such time, if 
any, as X makes an award to him. No employee has any election as to the 
amount or time of payment of his award for any year. Furthermore, the 
last of any payments under an award must be paid no later than 10 years 
from the normal retirement date of the employee. In addition, the 
obligations of X under the plan are merely contractual and are not 
funded or secured. The awards are nonassignable. However, in the case of 
death the awards are payable to the employee's designated beneficiary. 
Once made, a bonus award under the plan is not subject to any 
substantial risk of forfeiture.
    (ii) In each of the years 1967, 1968, 1969, and 1970, X awards E a 
deferred bonus of $100x. E retires on June 30, 1971. Beginning in 1971, 
X pays to E the total of $400x of deferred bonus awards in 5 annual 
installments of $80x each. With respect to the $80x payment made to E in 
1971, $20x, representing the ratable portion of the payment ($100x/
$400xx$80x) allocable to the 1970 bonus award, is earned income because 
it was received in a year no later than the year following that (1970) 
in which E's right to receive such amount was no longer subject to a 
substantial risk of forfeiture. The balance of the $80x payment made in 
1971 and all payments made subsequently constitute deferred 
compensation.
    Example 5. (i) Under the terms of a nonqualified bonus planfor its 
executive employees, Corporation M contributes each year to a bonus 
reserve a given percentage of its net earnings for the year. M makes 
bonus awards each year from the reserve in cash or stock of M, or a 
combination of both, to such executive employees, and in such amounts, 
as M may determine. The bonus award so determined to be made to a 
beneficiary is paid to him in installments: 20 percent of the award at 
the time that the award is made and the remaining installments in 
January of each succeeding year (until the full amount of the award is 
paid). Such amounts are payable in succeeding years but only if earned 
out by the employee by continuing service to M, at the rate of \1/12\th 
of the amount of the first installment for each complete month of 
service beginning with the year of determination. If the beneficiary 
voluntarily terminates his employment, is discharged for cause, or 
conducts himself in a manner inimical to the best interests of M, he 
forfeits the rights to receive any portion of his bonus award previously 
earned out but undelivered to him and to continue earning out his bonus 
award. Upon retirement a beneficiary retains the right to earn out an 
unearned bonus award but forfeits the right to continue earning out the 
award if he conducts himself in a manner inimical to M's best interests 
or engages in an activity which is in competition with an activity of M. 
If a beneficiary dies while earning out a bonus award, any unpaid and 
undelivered portion of his award is paid and delivered to his estate or 
heirs at such time and in such manner as if the beneficiary were living.
    (ii) On January 1, 1971, M makes a cash bonus award to A of $100x. 
On January 15, 1971, $20x, representing representing the first 
installment of the award, is paid to A. On January 15, 1972, $20x, 
representing the portion of the award earned out by A during the 
calendar year 1971 is paid to him. On January 1, 1972, A retires from 
employment with M and, having satisfied the conditions to continue 
earning out his bonus award, receives $20x on January 15, 1975.
    (iii) Under the facts and circumstances, the conditions that A not 
conduct himself in a manner inimical to the best interests of M and 
refrain from activity competitive to that of M are not considered to 
result in a substantial risk of forfeiture of the bonus award. The total 
installments of $40x paid to A in 1971 and 1972 constitute earned 
income. The installment of $20x earned out by A in 1972 and paid to him 
in 1973 also constitutes earned income for the taxable year 1973 because 
it was includible in gross income by A before the end of the taxable 
year of A following the first taxable year (the year of his retirement, 
i.e., 1972) in which his right to receive the installment was not 
subject to a substantial risk of forfeiture. The installments paid to A 
in 1974 and 1975, however, do not constitute earned income because they 
were paid in a year later than the year following the year of A's 
retirement. Had the conditions that A not conduct himself in a manner 
inimical to the best interests of M and refrain from activity 
competitive to that of M constituted a substantial risk of forfeiture, 
the installments paid to A in 1974 and 1975 would have constituted 
earned income.
    Example 6. On January 15, 1968, Corporation M, under the terms of a 
nonqualified bonus plan for its employees, grants to A, an employee, 
5,000 dividend units, which entitle A to receive, for the period during 
which the

[[Page 681]]

award remains in effect, a cash payment equal to the dividends declared 
andpaid by M on the equivalent of 5,000 shares of its capital stock. The 
award remains in effect for A's lifetime but is subject to forfeiture if 
A is dismissed or leaves the service of M for any reason other than his 
death or retirement, or if A, following his retirement, engages in any 
activity which is harmful to the interests of M. Under the particular 
facts and circumstances, the condition that A not engage in any harmful 
activity is not considered to amount to a substantial risk of forfeiture 
within the meaning of section 83(c)(1). A retires on January 1, 1971. In 
each of the calendar years 1971, 1972, 1973, and 1974. A receives cash 
payments of $5x under his bonus award. The payments totaling $10x to A 
in the years 1971 and 1972 constitute earned income because A received 
them before the end of the taxable year following the first taxable year 
(i.e., 1971, the year in which A retired) in which his right to receive 
such payments was not subject to a substantial risk of forfeiture. 
Payments totaling $10x to A in 1973 and 1974, however, constitute 
deferred compensation under paragraph (b) of this section.
    Example 7. Corporation M maintains an employees' profit sharing 
trust which is not exempt from tax under section 501(a). Under the terms 
of the trust agreement, the interest of the trust beneficiaries in each 
contribution made to the trust by M is subject to asubstantial risk of 
forfeiture for a period of 2 years from the date on which the particular 
contribution is made, except that upon a beneficiary's retirement, his 
entire interest in the trust vests immediately. Contributions are made 
on December 30 of each year. As of August 1, 1969, the total interest, 
forfeitable and nonforfeitable, of A, an employee of M, in the trust is 
$320x. On December 30 in each of the years 1969, 1970, and 1971, M makes 
a further contribution to the trust allocable to A's account equal to 
$60x. A retires on December 31, 1971, and becomes entitled to a total 
distribution from the trust of $500x, of which $320x represents M's 
contributions made prior to August 1, 1969, and $180x represents 
contributions made subsequent to such date. Beginning in 1972, the trust 
distributes to A $500x in 5 equal annual installments. Because M's 
contributions to A's account for the years subsequent to August 1, 1969, 
totaling $180x vested as of his retirement date, such contributions of 
$180x constitute earned income of A for the year 1971 by reason of Sec. 
1.402(b)-1(b). No portion of any annual installment of $100x which is 
includible in A's gross income constitutes earned income since it is 
attributable to the $320x, in all of which A's rights became 
nonforfeitable no later than December 30, 1970.
    Example 8. Corporation M maintains a qualified noncontributory 
pension plan for the benefit of its employees. Under the terms of the 
plan, no employee has a vested right to receive any distribution under 
the plan prior to his retirement from the employment of M upon reaching 
the age of 65. A, an employee of M, reaches age 65 on June 15, 1972, and 
retires on June 30, 1972. Under the terms of the pension plan, A becomes 
entitled to receive a monthly pension of $5x, beginning on July 1, 1972. 
A receives pension payments totalling $30x in 1972, $60x in 1973, $60x 
in 1974, $60x in 1975, and $60x in 1976. The pension payments received 
by A in 1972 and 1973 constitute earned income within paragraph 
(b)(3)(ii) of this section. The pension payments received by A in 1974, 
1975, and 1976 constitute deferred compensation.
    Example 9. (i) A is a participant in X Corporation's noncontributory 
qualified pension plan. The plan provides an annual benefit upon 
attaining age 65 of 2 percent of average compensation for each calendar 
year of participation in the plan. Average compensation is defined as 
the average of an employee's annual compensation over the last 5 
calendar years of service. The plan provides that an employee's rights 
in his accrued benefit are nonforfeitable after 15 years of 
participation in the plan. A attains age 65 on June 20, 1975 and begins 
to receive a pension on July 1, 1975. A's pension is based upon 30 years 
of participation in the plan. A's annual compensation for the period 
1969 through 1974, is as follows:

------------------------------------------------------------------------
                       Year                         Annual Compensation
------------------------------------------------------------------------
1969.............................................                $75,000
1970.............................................                 80,000
1971.............................................                 80,000
1972.............................................                 85,000
1973.............................................                 85,000
1974.............................................                 90,000
------------------------------------------------------------------------

    (ii) Under the terms of the plan, A's accrued benefit as of December 
31, 1974, and his pension are $50,400 (0.02 x 30 x 1/5 ($80,000 + 
$80,000 + $85,000 + $90,000)). A's accrued benefit as of December 31, 
1973, is $46,980 (0.02 x 29 x 1/5 $85,000)). Since A's rights in $46,980 
of his accrued benefit had ceased to be subject to a substantial risk of 
forfeiture before 1974, only $285 (1/12 x ($50,400 - $46,980)) of each 
payment received during 1975 does not constitute deferred compensation. 
The balance of the amounts received during 1975 and all amounts received 
in 1976 constitute deferred compensation since they are paid after the 
end of the taxable year following A's first taxable year in which his 
right to receive any such amount was not subject to a substantial risk 
of forfeiture.
    Example 10. On January 15, 1971, Corporation M grants to A, an 
employee, an option to purchase 100 shares of stock of M at a price of 
$10x per share. Such option constitutes a qualified stock option 
constitutes a qualified stock option as defined in section

[[Page 682]]

422(b). On August 1, 1971, A exercises his option, at which time the 
fair market value of the 100 shares of M Stock is $15x per share. On 
April 24, 1972, A sells the 100 shares of M stock acquired pursuant to 
exercise of his option at a price of $25x per share. Because the sale 
constitutes a disqualifying disposition within the meaning of section 
421(b), A realizes ordinary income of $500x and a capital gain of 
$1,000x in the taxable year 1972. The $500x of ordinary income so 
realized by A constitutes earned income.
    Example 11. On November 30, 1072, Corporation M grants to A, an 
employee, a nonqualified stock option to which section 421 does not 
apply and which has no readily ascertainable fair market value on that 
date. The option may, by its terms, be exercised by A at any time 
during, or following termination of, his employment. On March 30, 1974, 
A, while still employed by M, exercises his option and realizes 
compensation income at that time. Such compensation does not constitute 
earned income because the option is exercisable within a period that may 
extend beyond three months after A's termination of employment (other 
than by reason of death). See paragraph (b)(3)(iii)(B) of this section. 
Had A exercised his option at any time prior to January 1, 1974, the 
compensation realized by him by reason of such exercise would have 
constituted earned income.
    Example 12. On November 30, 1972, Corporation N grants to B, an 
employee, a nonqualified stock option to which section 421 does not 
apply and which has no readily ascertainable fair market value on that 
date. The option may by its terms, be exercised only within the period 
during which B is employed by N or within three months thereafter. On 
March 30, 1974, B exercises his option and realizes compensation at that 
time. Such compensation so realized by B constitutes earned income. See 
paragraph (b)(3)(iii)(B) of this section.
    Example 13. On May 9, 1973, and in connection with the performance 
of services by E, an employee, Corporation X transfers to E 100 shares 
of X stock. Under the terms of the transfer, E is subject to a binding 
commitment to return the stock to X if E leaves X's employment for any 
reason prior to the expiration of a 3-year period beginning on the date 
of transfer. Since E must perform substantial services for X before he 
may keep the X stock, E's rights in the stock are subject to a 
substantial risk of forfeiture under section 83(c)(1). Consequently, if 
such restriction lapses on May 9, 1976, the compensation realized at 
such time constitutes earned income. Had E elected to include an amount 
in his gross income in 1973 pursuant to section 83(b) and the 
regulations thereunder, the amount so included would also have 
constituted earned income.
    Example 14. On October 1, 1971, A, an author, and Corporation M, a 
publisher, executed an agreement under which A granted to M the 
exclusive right to print, publish and sell a book he had written. The 
agreement provides that M will pay to A specified royalties based on the 
actual cash received from the sale of the published work, render 
semiannual statements of the sales, and at the time of rendering each 
statement make settlement for the amount due. On the same day, another 
agreement was signed by A and M, mutually agreeing that, in 
consideration of, and notwithstanding, any contrary provisions contained 
in the first contract, M shall not pay A more than $100x in any one 
calendar year. Under this supplemental contract, sums in excess of $100x 
accruing in any one calendar year are to be carried over by M into 
succeeding years. For the calendar year 1971, royalties payable to A 
under the basic agreement amount to $100x and this sum is paid to A. For 
the calendar year 1972, royalties of $120x are payable to A under the 
basic agreement, but by reason of the supplemental agreement, only $100x 
of this sum is actually paid to A. For each of the calendar years 1973 
and 1974, royalties of $100x are payable to A under the basic agreement, 
and this sum is paid to A. For the calendar year 1975, royalties of $80x 
are payable to A under the basic agreement, and this sum, plus $20x 
carried over from 1972, or $100x, is paid to A. The $100x paid to A in 
each of the years 1971, 1972, 1973, and 1974, and $80x of the $100x paid 
to A in 1975 constitute earned income. The additional $20x carried over 
from 1972 and paid to A in 1975 constitutes deferred compensation under 
this paragraph (b) because it was paid to A later than the end of the 
year following the year (i.e., 1972) in which A's right to receive the 
amount was not subject to a substantial risk of forfeiture.
    Example 15. Corporation M is the producer and owner of a feature 
length motion picture which is distributed to exhibitors by Corporation 
N pursuant to a distribution agreement between M and N providing for 
current payments to M of a given percentage of the current net profits 
derived by N from the exhibition and exploitation of the picture. A was 
employed by M as the leading actor in the picture for fixed compensation 
payable at the rate of $10x per week during the production period plus 
additional compensation equal to a given percentage of the net profits 
derived from the exhibition and exploitation of the picture. A's 
additional compensation is payable at the time that M receives payments 
from N under the terms of the distribution agreement. The additional 
compensation paid to A does not constitute deferred compensation since 
it is attributable to and measured by current net profits derived from 
the use of property created in part by A's efforts.

[[Page 683]]

    Example 16. A, a boxer entered into an agreement with M boxing club 
to fight a particular opponent on June 19, 1971. The agreement provided 
in part, that for his performance A was to receive 16 percent of the 
gross receipts derived from the match. Simultaneously, A and M executed 
a separate agreement providing for payment of A's share of the receipts 
from the match as follows: 25 percent thereof not later than August 15, 
1971, and 25 percent thereof during each of the years 1972, 1973, and 
1974 in equal semiannual installments. A's share of the gross receipts 
derived from the match was $100x, of which 25 percent was paid to him in 
1971 and a total of $25x in each of the years 1972, 1973, and 1974. 
Under the particular facts and circumstances, A and M are not acting as 
partners or joint venturers. Thus, A is taxable upon his share of such 
gross receipts only in the years in which such share is actually paid to 
him under the terms of the separate agreement. The payments of $25x in 
each of the years 1971 and 1972 constitute earned income. The payments 
of $25x in each of the years 1973 and 1974 would not constitute earned 
income because they constitute deferred compensation received later than 
the end of the first taxable year (i.e., 1972) following the year in 
which A's right to receive such amounts was not subject to a substantial 
risk of forfeiture.

[T.D. 7446, 41 FR 55339, Dec. 20, 1976]

           Small Business Corporations and Their Shareholders