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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? Employer avoids FICA on contractor, w/h taxes,

employee benefits IRS more likely to collect tax because employees

report income. Contractor MAY have additional deductible

expenses, but often SE tax is higher.

How decide? Regulations, rulings and court cases involve: Degree of supervision, who provides materials,

hire person versus job. Seewww.irs.ustreas.gov/prod/bus_info/emp_tax/

index.html for information about employment tax.

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Salaries

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

$1,000,000 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. Compensation must be reasonable - remember risk of constructive dividend treatment.

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Foreign Earned Income Exclusion

Expatriates are U.S. citizens (or permanent residents) who reside and work overseas.

Exclude $74,000 (1999 limit) from taxation in the U.S.

Cannot claim 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:Providing 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 advantageousOften lower cost than employee can

obtainNontaxable

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

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Specific fringe benefit examples

Health insurance or coverage is not taxable if nondiscriminatory.

Only cost to provide group term life insurance benefits > $50,000 is taxable.

Dependent care assistance up to $5000 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 FMV of stock and exercise price.

Employee’s new basis in stock is FMV at exercise date.

Employer gets tax deduction equal to employee income.

When employee sells stock in future, he generates a capital gain (loss) = selling price - basis ($FMV date of exercise).

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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.

Employer has no salary deduction ever. Exception - early disposition of stock (w/in 2 years).

Employee has basis in stock equal to exercise price

When employee sells stock in future, he generates at capital gain (loss) = selling price - exercise price.

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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? ISO - delay taxation, all capital gain

Which would employer prefer?NSO - claim salary deduction

Do you expect preference has changed over time?

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Employee expenses

Unreimbursed expenses are deductible to the extent they exceed 2% 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: new job meeting certain mileage and time of work

requirements deduct cost of moving furniture and cars, moving

family (but not meals).

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Retirement Planning

This is COMPLICATED - we are only hitting 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 59 1/2 (without penalty) but must begin after 70 1/2.

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.

Current earned income contributed to plan is not currently taxed (IRA, 401K, Defined contribution plans).

Employer generally gets deduction for funding plan.

The plan is tax exempt, so earnings are not taxed as they accumulate.

Retired person is taxed on withdrawals of all amounts.

Premature withdrawals 10% 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 of100% of average three highest years’

wages$130,000 (in 1999).

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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 of25% of annual compensation or$30,000 (in 1999). 401K plan - the employer and employee both

contribute. Employee contribution limit = $10,000. MY ADVICE - Start right away!

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Employer plans - nonqualified

Nonqualified deferred compensation - Employee delays paying tax until

receive money.Corporation delays deducting salary

expense until pay money.Often used by top executives.Since nonqualified, these plans CAN

discriminate!

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Self-employed plans - Keogh

Contribute up to the lesser of20% of earned income from self-

employment$30,000 in 1999.

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$2,000 or100% 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 $51,000 in 1999)

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 % = unrecovered

investment / current year IRA value. Early withdrawals subject to 10% penalty,

except:$10,000 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>160,000.