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EmployeeCompensation

Chapter 4

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Employee Compensation

All forms of compensation (including salaries, wages, bonuses, tips, and fringe benefits) are taxable as ordinary income to employees unless specifically excluded by a provision in the Code

Employers can deduct all compensation expenses

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Payroll Taxes for Employees

FICA rate is 7.65% 6.2% for Social Security + 1.45% for

MedicareSocial security portion is only charged on

the first $106,800 for 2009

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Employer withholds FICA tax from employee; employer matches employee FICA and forwards total to government

Employer can deduct employer’s share of taxNo deduction for employee’s share of

tax

Payroll Taxes for Employers

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Other Payroll Taxes

Employers are also required to pay other types of payroll taxes such as federal and state unemployment taxes

FUTA rate is 6.2% on first $7,000 State unemployment taxes vary These taxes are all deductible by the

employer paying them

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Employee vs.Independent Contractor

Independent contractors (and other self-employed individuals) pay their own Social Security and Medicare taxesThis is called the self-employment tax

Workers considered employees (instead of an independent contractor) if the employer has the right to control and direct the end result and the means by which the result is accomplishedRev. Rul. 87-41 provides 20-factor test

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Timing of Compensation

Salaries and bonuses are usually deductible by the employer when accrued

ExceptionsCompensation accrued but not paid within

2½ months of year-end is not deductible until paid

Compensation accrued to cash-basis related party not deductible until paid

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Related Parties

Related parties include:Family members (brothers, sisters, spouse,

ancestors, and lineal descendants, but not in-laws)

A taxpayer and a corporation in which the taxpayer directly or indirectly owns more than 50% of the stock (indirect ownership includes stock owned by family members)

Other relationships such as partners/partnerships and beneficiaries/trusts

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Reasonable Compensation

Reasonable compensation – amount similar business would pay for the services under similar circumstances

If a shareholder-employee’s salary is considered unreasonable, the excess can be reclassified by IRS as a nondeductible dividend

If unreasonable compensation is paid to a party related to a shareholder, the excess can be reclassified as a nondeductible dividend to the shareholder

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Excessive Compensation

Deductible compensation paid to CEO and 4 highest-paid officers of publicly-held corporations is limited to $1 million per year

This compensation limit does not include amounts that representCompensation based on individual performance

goals (if approved in advance by outside directors)Compensation paid on a commission basisEmployer contributions to a qualified retirement plan Tax-free employee benefits

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S Corporations & Low Salaries

There is an incentive for an S corporation to pay an unreasonably low salary to a controlling shareholder-employee to minimize payroll taxes, as S corporation profits are not subject to payroll taxes

IRS can reclassify some of S corporation’s distribution as salary, requiring payment of additional employment taxes

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Employing Children

Compensation paid to children is deductible if reasonable for the services actually performed Wages paid to an employer’s child under age

18 are not subject to employment taxes (if not paid by a corporation)

Standard deduction for a single individual is $5,700 in 2009; this amount can be paid to a child without tax consequences

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Fringe Benefits

Tax-free fringe benefits are not taxable as income to the employee but are deductible by the employer

Most tax-free benefits are limited in dollar amount

If an employer pays an amount in excess of the limit (or pays for something that is not a qualified tax-free benefit), it is treated as taxable compensation (income to the employee and deductible by the employer)

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Group Term Life Insurance

Premiums on the first $50,000 of employer-paid group term life insurance coverage may be excluded from employee's gross income

Excess over $50,000 is included in income Amount determined from IRS table based

on employee's age at year end, rather than cost

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Group Term Life InsuranceMonthly amount per $1,000 of taxable coverage

Employee’s Age Monthly Amount

Under 25 $.05

25 to 29 .06

30 to 34 .08

35 to 39 .09

40 to 44 .10

45 to 49 .15

50 to 54 .23

55 to 59 .43

60 to 64 .66

65 to 69 1.27

70 and above 2.06

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Group Term Life Insurance

If the insurance plan is discriminatory, key employees must report gross income equal to the greater ofEmployer’s actual premiums paid orBenefit determined from the table

(without $50,000 exclusion)

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Health and Accident Insurance

Value of insurance premiums paid by employers on behalf of employees and their families are tax-freeSelf-insured discriminatory plans may result

in taxable income to highly-compensated employees

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Dependent Care Benefits

An employer can provide up to $5,000 ($2,500 if MFS) for the care of an employee's dependents during working hours through an on-site or off-site facility Highly-compensated employees cannot

exclude benefits if they are discriminatory

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Cafeteria Plans

A qualified cafeteria plan allows an employer to offer employees the option of choosing cash or nontaxable fringe benefits Exception to constructive receipt doctrine

If employee chooses cash, the cash is taxable

If employee chooses nontaxable fringe benefits, they are excludable

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Cafeteria Plans

Benefits can be funded with employer contributions or by employees voluntarily electing to reduce their salaries (allowing employees to obtain fringe benefits with before-tax dollars)

These plans are sometimes called flexible spending arrangements (FSA)

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Cafeteria Plans

Some nontaxable benefits that can be offered include coverage for medical and dental care, group-term life insurance up to $50,000, and dependent care assistance

Any amounts set aside in a flexible spending plan must be used before the end of the year or they are lost

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Meals and Lodging

Value of meals and lodging provided by an employer to an employee are excluded if:

1) Provided for the employer's convenience and2) Provided on the employer's business premises

and3) Employee required to occupy the lodging to

perform employment duties If an employee is given a choice between

additional compensation or meals and lodging, the value of any meals and lodging is taxable

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No-Additional-Cost Services

When an employer provides services for its employees and incurs no substantial additional cost (excess capacity services), employees can exclude the value of the services from gross incomeExample: Free or discounted seats on an

airplane when the employee does not displace a paying customer

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No-Additional-Cost Services

This exclusion applies only to services received, not property

Only employees who work in the line of business that renders similar services are allowed to exclude the benefits (baggage handlers who work for an airline can fly free)

In addition to current employees, the exclusion is available to former employees, as well as spouse and dependents

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Employee Discounts

Property or services provided to employee at below FMV treated as taxable income to employee, unless within the qualified employee discount limitsOnly property and services offered to

customers in the ordinary course of the employer's business qualify

Full discount excluded if discount does not exceed gross profit percentage times price charged to customers

For services, discount can’t exceed 20%

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Employee Awards

Employee awards generally are treated as taxable compensation

Exceptions for length of service or safety awardsQualifying employee awards must be

made with tangible property (no cash)Average cost of qualified plan awards

limited to $400, but individual awards can be as much as $1,600

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De Minimis Fringe Benefits

Employees who receive “de minimis” (very small in value) property or services from their employers can exclude the value from gross income

An amount is considered de minimis when the value is so small that accounting for it is unreasonable or impractical Examples: coffee & doughnuts, company

picnics, limited use of copy machine, etc.

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Transportation & Parking

Exclusions limited: Free or discounted parking (up to $230

per month in 2009) Transit passes and special carpool

commuting expenses (combined value of up to $230 per month)

Reimbursement of up to $20 per month for costs of commuting by bicycle

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Athletic Facilities

Employees (and their families) who use employer-provided athletic facilities that are located on the employer’s business premises can exclude the value of the benefit from gross income

Facilities include tennis courts, gymnasiums, and swimming pools

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Working ConditionFringe Benefits

Working condition fringe benefits can be excluded from the employee’s gross income if the employee would have been entitled to a tax deduction if he had actually paid the expense Examples: job-related education, professional

membership dues Discriminatory benefits can still be excluded

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Employee Use ofCompany-Owned Cars

The value of an employee’s personal use of a company car is a taxable fringe benefit

In determining the amount of income to be taxed to the employee for personal use, there are 3 methods: Lease value (from table)Cents per mile rate (55¢ in 2009)Commuting method (valued at $1.50 per one-

way trip)

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Relocation Expenses

Qualified direct moving expenses include the reasonable cost of moving household belongings and family members from the old home to the new home by the shortest and most direct routeNo dollar limit (but mileage rate if driving

limited to 27¢ per mile)Indirect expenses such as house-hunting or

temporary living expenses do not qualify

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Relocation Expenses

Moving expenses are deductible if they are related to assuming duties at a new place of business and both the distance and time requirements are metDistance test - distance from old residence to

new job must be at least 50 miles greater than the distance from old residence to old job

Even though a taxpayer is required to relocate, no deduction is allowed if the distance test is not met

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Relocation Expenses

Time Test - taxpayer must work as an employee at the new location for 39 weeks during the 12 months following arrival Self-employed person must work for 78 weeks

during the 24 months following arrivalExceptions allowed in event of death,

disability, involuntary separation, or transfers for the employer’s benefit

Qualified moving expenses that are not reimbursed are deductible for AGI by employee

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Education Assistance Plans

Up to $5,250 a year of employer-provided educational assistance benefits can be excluded

Courses do not need to be job-related. Excludable benefits are payments for tuition,

fees, books, supplies, and equipment

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Job-Related Education

No dollar limit if education expenses are related to the current job of the employeeQualified educational expenses include tuition, fees,

books, and transportation from job to class Expenses that meet the minimum education

requirements for the taxpayer’s job or qualify taxpayer for a new profession do not qualify for exclusion

If employee pays for expenses and is not reimbursed, employee can deduct qualified expenses as miscellaneous itemized deductions

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Other Education Provisions

Qualified Tuition ReductionSchools can provide a tuition waiver for employees

and their immediate family membersOnly undergraduate tuition can be waived as a tax-

free benefit; graduate tuition waivers are taxable

Other education provisions discussed in Ch. 11Deduction for up to $4,000 of tuitionAmerican opportunity credit ($2,500 maximum)Lifetime learning credit ($2,000 maximum)

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Substantiating Expenses

Accountable Plan - an employee provides adequate accounting to the employer and refunds to the employer any excess payments Adequate Accounting - provides details

concerning the time, date, place, business purposes, and the amount of the expense

If an employee makes an adequate accounting, and the reimbursement exceeds the deductible expenses, the employee must include the excess in income

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Substantiating Expenses

Nonaccountable plan does not require the employee to substantiate expenses or refund excess advanced fundsEmployer must report all of the reimbursed

expenses on employee’s W-2Employees who receive advances in a

nonaccountable plan must report details of both the reimbursement and the expenses

Employee’s deductions are subject to 2% AGI floor for miscellaneous itemized deductions

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Restricted Stock

Value not taxed until stock vestsEmployee recognizes ordinary income = FMV

of stock when vestedDividends taxed as ordinary income prior to

vesting Election to accelerate income made by

recognizing income = FMV in year of receiptNo deduction for loss if forfeited

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Stock Options

Option – right to purchase stock at guaranteed strike price for a specific time

Grant date – date option offered to individual Exercise date – date option used to purchase

stock Bargain element – difference between strike

price and FMV of stock

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Nonqualified Stock Options

Employee recognizes ordinary income equal to the bargain element on the date the NQSO is exercised Employer gets matching compensation

deduction for bargain elementEmployee’s basis for stock is cash paid +

income recognized

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Incentive Stock Options

ISOs provide more favorable treatment for employee ISOs do not trigger any income recognition at

the date of grant or exercise Income is recognized only upon the sale of

the stock, usually as long-term capital gain But bargain element is an individual AMT

adjustment Employer receives no compensation

deduction

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Phantom Stock and SARs

Phantom stock plan - deferred compensation is hypothetically invested in shares of company’s stock At the end of deferral period (such as at retirement), the

employer pays the employee the FMV of the phantom shares

Stock appreciation right (SAR) plan - employees are given the right to receive a cash payment equal to the appreciation in value of employer’s stock for a certain period of time Employees recognize income only when rights are

exercised

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Qualified Deferred Compensation Plans

Funded plans that receive favorable tax treatment: Employer contributions are deducted as they

are paid into the trust Earnings on these contributions accumulate

tax-free until withdrawn Benefits are taxable to the employee only

when actually received

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Distributions

When funds are withdrawn, taxes must be paid by employee onAll earningsAll employer contributionsAll pre-tax (deductible) employee contributions

Employee must begin distributions by age 70½

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Distributions

Premature withdrawals - 10% penalty (in addition to income tax) for taking distributions before age 59½

A taxpayer may roll over all or part of a distribution within 60 days without paying any tax or penalty on the distribution Lump sum distributions are subject to 20%

withholding unless there is a direct trustee to trustee transfer

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Types of Plans

Defined Benefit – provides fixed benefit at retirement Employer assumes the risk that the plan

assets will be sufficient to pay benefits Defined Contribution - amounts contributed

are determined according to a formula Employee’s benefit is dependent upon

employer’s contributions and the actual earnings in the individual account

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401(k) Plans

Employees can elect to have employer contribute part of their salary to plan on pretax basis In 2009, up to $16,500 plus extra $5,500 if age 50

or older Flexibility - employee can elect each year to have

a different amount contributed Employer may match some of the contributions

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Other Plans

Employee stock ownership plans (ESOPs) Simplified employee pension plans (SEPs) Savings incentive match plans for employees

(SIMPLE) SIMPLE 401k plans

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Nonqualified Deferred Compensation

Advantages - no dollar limits and can be offered on a discriminatory basis

Employer receives a deduction only upon the actual payment of benefits to the employee

Employee recognizes income upon the actual receipt of these benefits

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Nonqualified Deferred Compensation

Employer accrues liability on financial statements, but no cash is set aside

If the employer’s business fails, the employee is merely an unsecured creditor

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Individual Retirement Accounts (IRA)

Individuals can contribute up to $5,000 ($6,000 if age 50 or older) or earned income if less

A married taxpayer can contribute for a nonworking spouse

Qualified contributions are deductible for AGI Deductions not allowed if the individual is a

participant in an employer-sponsored retirement plans, unless AGI is below certain limits

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IRA Phaseout Limits

Deductible contribution phased out in 2009 for AGI over a range Single $55,000 - $65,000 Married filing jointly $89,000 - $109,000

Zero if married filing separately

If spouse an active participant, phaseout over AGI of $166,000 - $176,000

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Roth IRA

Taxpayers may make nondeductible contributions to a Roth IRA

Contributions phase out if AGI between$105,000 - $120,000 if single$166,000 -$176,000 if married filing joint return

Contributions to Roth and the regular IRA cannot exceed a total of $5,000 ($6,000 if age 50 or older)

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Roth IRA

Primary advantage of Roth IRA – able to withdraw earnings & contributions tax-free

Distributions from Roth IRAs are not subject to minimum distribution rulesDo not have to begin by age 70½But cannot be made for first 5 years and taxpayer

must usually be at least age 59½

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Self-Employment Taxes

Self-employed individuals must pay both the employer’s and the employee’s share of FICA taxes for a combined rate of 15.3%12.4 % (6.2% x 2) for Social Security on

income up to $106,800 in 20092.9% (1.45% x 2) for Medicare – no income

limit

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Self-Employment Taxes

Tax computed on Schedule SE Self-employed individuals are also allowed

a deduction for AGI for the employer’s half of self-employment taxesCalculated by multiplying net income from self-

employment by 92.35% (100% - 7.65%) before calculating SE tax

There is no deduction for the employee’s half of the taxes

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Fringe Benefits forSelf-Employed

Self-employed individuals (including sole proprietors, partners, and greater than 2% shareholders of S corporations) do not qualify for most fringe benefits on a tax-free basis

Special deduction for AGI applies to health insurance for self-employed individuals

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Retirement Plans for Self-Employed

Keogh (HR 10) plan has limits on contributions similar to corporate retirement plans

Contributions are deductible for AGI

Extending return due date also extends deadline for making contributions to plan

Earnings and deductible contributions fully taxed when withdrawn

May also contribute to an IRA unless limitations apply

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Foreign Earned Income

Qualifying earned income includes most income earned from working in a foreign country including salary, bonuses, allowances and noncash benefitsU.S. government employees not eligible

Exclusion is $91,400 per year for 2009 Taxpayer must be a bona fide resident of a

foreign country for entire year or be physically present in a foreign country for 330 full days during a period of 12 consecutive months

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Foreign Housing Exclusion

A taxpayer who qualifies for the foreign earned income exclusion may also exclude a portion of excess housing costs provided by the employerHouse costs in excess of a base amount (16% of

the maximum foreign earned income exclusion) are eligible

The upper limit is 30% of the foreign earned income exclusion

For 2009, up to $12,796 of housing costs can be excluded

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Foreign Tax Credit

Employees who do not qualify for the exclusion include the income in taxable income and claim a tax credit (or a deduction) for taxes paid to the foreign governmentThe foreign tax credit cannot exceed the amount

of U.S. tax that would have been paid on the foreign income

The foreign tax credit is generally more advantageous than the deduction

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Tax Reimbursement Plans

To encourage employees to accept foreign assignments, some employers agree to pay the employee’s taxes as part of their compensation package

If the employer pays any of the employee’s taxes, this results in additional compensation income for the employee

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Tax Reimbursement Plans

Typical reimbursement arrangements includeTax Protection Plans – the employee is reimbursed

for any U.S. or foreign taxes paid in excess of the tax liability that would have been incurred had the employee remained in the U.S.The employer pays any excess tax but the employee

benefits from any tax savings from low-tax countriesTax Equalization Plans – the employee will pay the

same net tax liability that would have been paid had the employee stayed in the U.S.The employer pays any excess tax but also keeps any

tax savings from low-tax countries

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Tax Treaties

Treaties generally provide tax exemptions to residents of one treaty country on short-term assignments to the other countryA typical treaty allows no more than 183 days

presence in a year before being subject to taxTreaties frequently exempt teachers and students

from foreign income tax

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The End