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Principles of Taxation

Chapter 14Compensation and

Retirement

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Objectives

Employees versus self-employed Family compensation planning Nontaxable employee fringe benefits Stock options Employee-related expenses Qualified versus nonqualified retirement

plans Deferred compensation

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Employee versus Contractor

Who cares? Why would an employer rather treat the

worker as a contractor? Why would the IRS rather treat the worker as

an employee? What will the worker prefer?

How to decide? Regulations, rulings and court cases See

www.irs.ustreas.gov/prod/bus_info/emp_tax/index.html for information about employment tax.

What are some characteristics of employees?

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Salaries

Employers may deduct wages if they are ordinary business expenses.Exception: cash compensation >

$________________ to a top-5 officer is not deductible unless it is performance based.

Wages are taxable to employees at ordinary rates.

Family salary issues are a review of Chapter 9 and 10. Why does the IRS care if a family corporate pays too much salary to its owners?

What are the factors in deciding reasonable compensation?

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Foreign Earned Income Exclusion

What are Expatriates?

Exclude $__________ (2001 limit) from taxation in the U.S.

Can an employee claim a foreign tax credit (see Chapter 12) on excluded income?

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Employee Fringe Benefits

General rule: Fringe benefits are taxable.

Exclusions of fringe benefits are usually:A social welfare benefit (health, life

ins, child care),Hard to enforce anyway (de minimis

rules, cisounts),Non-discriminatory, orNecessary for job (moving expenses,

supplies at work).

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Employee Fringe Benefits

Why are these advantageous to employees?

Cafeteria plans allow broader employee choices among same-cost options for employer.

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Specific Fringe Benefit Examples

When is health insurance or coverage nontaxable?

Only cost to provide group term life insurance benefits > $___________ is taxable.

Dependent care assistance up to $______________ is excluded.

See http://www.irs.ustreas.gov/prod/forms_pubs/pubs/p5350404.htm for an IRS summary of other nontaxable fringe benefits.

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Employee Stock Options -BIG $$$’s

Stock option defined: The right to buy stock in the future for a set price (called the exercise price).

General attributes: When the stock option is granted, the option price is the FMV at the date of the grant.

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Stock Options - Grant Date

GAAP rules: Must disclose compensation element due to FMV of option at grant date.Black Scholes option pricing method.

Tax rules: NO tax owed at date of grant. Tax at exercise and sale depends on whether a NonQualified Stock Option (NSO) or Incentive Stock Option (ISO).

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Employee Stock Options - Nonqualified Stock Option

(NSO) Employee has salary income equal to

difference in _________________ and__________________.

Employee’s new basis in stock is_____________________.

Employer gets tax deduction equal to______________________.

When employee sells stock in future, he generates a capital gain (loss) = _______________- basis (= $FMV date of____________).

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NSO Example

The CFO is granted 100 options (NSOs) in 1990 at a price of $10 per share, when the stock is trading at $10 per share. In 1994, he exercises these shares when the FMV of the stock is $25 per share. In 1996, he sells these shares at $30 per share.

What is the amount, character, and timing of the CFO’s income and the corporation’s deduction? 1990 - no tax effect to either party 1994 - CFO salary income $1,500, salary deduction $1500 1996 - capital gain $500, no company deduction.

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NSO Example (You Do It)

The Treasurer is granted 100 options (NSOs) in 1990 at a price of $10 per share, when the stock is trading at $10 per share. In 1995, she exercises these shares when the FMV of the stock is $30 per share. In 1998, she sells these shares at $36 per share.

What is the amount, character, and timing of the Treasurer’s income and the corporation’s deduction?

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Employee Stock Options - Incentive Stock Option (ISO)

Employee has no salary income on exercise. AMT adjustment = untaxed bargain element.

Does the employer get a wage deduction? Employee has basis in stock equal

to_______________________. When employee sells stock in future, he

generates at capital gain (loss) = _________-___________.

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ISO Example

The CFO is granted 100 options (ISOs) in 1990 at a price of $10 per share, when the stock is trading at $10 per share. In 1994, he exercises these shares when the FMV of the stock is $25 per share. In 1996, he sells these shares at $30 per share.

What is the amount, character, and timing of the CFO’s income and the corporation’s deduction?

1990 - no effect 1994 - no effect (except AMT) 1996 - $2000 capital gain, no corporate deduction

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ISO Example (You Do It)

The Treasurer is granted 100 options (ISOs) in 1990 at a price of $10 per share, when the stock is trading at $10 per share. In 1995, she exercises these shares when the FMV of the stock is $30 per share. In 1998, she sells these shares at $35 per share.

What is the amount, character, and timing of the Treasurer’s income and the corporation’s deduction?

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Employee Stock Options - Thinking

Which would employee prefer?

Which would employer prefer?

Do you expect preference has changed over time?

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Employee Expenses

Unreimbursed expenses are deductible to the extent they exceed _____% of AGI.

These are ITEMIZED deductions. 2% limit, combined with itemized

requirement, means most employees can’t use.

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Moving Expenses

Unreimbursed moving expenses are deducted in computing AGI. Form 3903 flows to Line 25 of 1040.

This is more advantageous because you can take the deduction even if you are using the standard deduction.

Requirements for moving expenses:

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Retirement Planning

This is COMPLICATED - we are only covering highlights.

Main concepts to learn in this course:Qualified plans provide DEFERRAL

(sometimes exemption) of tax on earnings. The compounding effect of this is BIG.

Withdrawal cannot begin before age ________without penalty, but must begin after age___________

Basic types of qualified plans: a) employer, b) self-employed (Keogh), c) IRA

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Attributes - Qualified Plans

Plan cannot be discriminatory; $ limits in law.

Are current earnings of the plan taxable? (IRA, 401K, Defined contribution plans)

When does the employer usually get a deduction?

Are contributions taxable to the employee?

Retired person is taxed on withdrawals of all amounts.

Premature withdrawals _______ % excise tax.

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Tax Advantages of Typical Qualified Plan

Formula:{$1 / (1-tp0)} x (1+R)n x (1-tpn)

This means that the dollar after the benefit of the tax deduction in period 0, accumulates for n periods at tbe before tax rate, then the total is taxed at the rate in period n.

Having a higher rate in the year you contribute (tp0), and a lower rate in the year you withdraw (tpn) makes this worth more.

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Employer Plans - Qualified

Qualified plans cannot discriminate - have $ limits.

Defined benefit - Employer assumes risk and promises a certain retirement income stream. This is the type of plan that intermediate

accounting class pension rules deal with (SFAS87).

Annual pension limited to the lesser of______% of average _______ highest

years’ wages$___________ (in 2001).

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Employer Plans - Qualified

Defined contribution: The employer sets aside a certain defined amount each year. The employee bears the risk of what return the investment provides.

Yearly contribution limited to the lesser of______% of annual compensation or$__________ (in 2000). 401K plan - the employer and employee both

contribute. Employee contribution limit = $__________. MY ADVICE - Start right away!

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Employer Plans - Nonqualified

Nonqualified deferred compensation:Employee delays paying tax until

when?Corporation delays deducting salary

expense until when? Often used by top executives.Since nonqualified, these plans CAN

discriminate!

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Self-Employed Plans - Keogh

Contribute up to the lesser of____% of earned income from self-

employment$___________ in 2001.

Must not discriminate. If owner has employees then he/she must provide retirement benefits to them.

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Individual Retirement Accounts

Individuals contribute the lesser of$________ or______ % of compensation (but each

spouse may contribute $2000 if combined earned income = $4000).

Deduction for contribution is limited if taxpayer participates in a qualified

plan (phase-out range for MFJ starts at $53,000 in 2001).

if spouse participates in a qualified plan (phase-out range for MFJ starts at $150,000).

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IRA Withdrawals

Withdrawal is ordinary income if all contributions were deductible.

If some contributions were nondeductible:nontaxable withdrawal % =

_______________/___________________. Early withdrawals subject to 10% penalty,

except:$__________________ withdrawal for

“first-time homebuyer.”Funds to pay higher education

expenses.

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Roth IRA

Roth works differently from general rule. NO deduction when contribute, but NO

tax when distribute. Formula = $1 x (1+R)n Roth is better than regular if you expect

tax rates to increase. Roth not available for rich - e.g. MFJ

AGI>____________.