What is it?

1. What is it? • Cash that employee receives in the year that it was earned • Forms basis • of comparison with other forms of benefits • for deciding level of some types of pension or life insurance plans

2. When is it indicated? When it is advantageous • “C” corporation offers greater opportunity to plan cash compensation • unincorporated businesses and “S” corporations pass all income and loss directly through to owners

3. Advantages • Provides certainty for employee • Sets employee’s status in company and community • Important part of financial planning for shareholder-employees of closely held corporations • Easy to budget, known costs • Avoid administrative complexity

4. Disadvantages • Cash paid currently is subject to current taxation • Cash compensation must meet reasonableness test for various tax issues

5. Tax Implications:Reasonableness of Compensation • Employer’s tax deduction for employee pay is disallowed if employee compensation fails IRS reasonableness test • Generally, no deduction for compensation in excess of $1,000,000 in publicly held corporation to CEO or 1 of 4 highest compensated company officers

6. Tax Implications:Reasonableness of Compensation If amounts paid (and deductions taken) are relatively high, wise to: • determine compensation level before earned • write and sign employment contracts • document salary decisions in minutes of director’s meetings • document relevant factors in deciding compensation level

7. Tax Implications: Factors in Determining Reasonableness of Compensation • Compensation paid to executives in comparable positions for comparable employers • Employee qualifications for job • Nature and scope of duties • Size and complexity of business

8. Tax Implications: Factors in Determining Reasonableness of Compensation • Comparison of compensation paid with company income • Company compensation policy for all employees • Economic conditions • Dividend distributions to shareholders

9. Tax Implications: Treatment of Disallowed Compensation • Generally, disallowance of a deduction for compensation results in taxable income for employee • Specific treatment depends on circumstances, e.g. - if payments primarily to shareholders, IRS deems as dividends

10. Tax Implications: Reimbursement Agreements • An agreement to repay excess compensation if IRS disallows deduction for compensation • ‘Red flag’ to IRS auditor • Rarely in best interest of employee

11. Tax Implications: Timing of Income and Deductions • Timing of income and deductions faces complex tax rules • Under cash method of accounting, cannot take deduction for compensation before the year compensation actually paid

12. Tax Implications: Timing of Income and Deductions • No employer (under cash or accrual method of accounting) can take a deduction for compensation for services not yet rendered by end of the taxable year for which deduction claimed • Any compensation paid in advance must be deducted pro rata over period that services are actually rendered

13. Tax Implications: Timing of Corporate Deductions for Compensation Payments Current compensation can deduct in year in which it is properly accrued to corporation under tax accounting accrual rules Deferred compensation cannot deduct until taxable year of corporation that ends the taxable year in which amount includable in employee’s income IRS allows 2½ month ‘safe harbor’ for regular employee (disallowed if employee is related to corporation)

14. Alternatives • Noncash compensation plans some defer taxation: • nonqualified deferred compensation plans • qualified pension, profit sharing, or similar plans • stock option and restricted stock option plans

15. Alternatives • Noncash compensation plans (cont’d) some are tax free: • health, accident, and disability income plans that meet certain criteria • dependent care and educational assistance plans • group term life up to $50,000 face value • pure death benefit from life insurance • Provide employee compensation in form that is both tax deferred to employee and deduction-deferred to employer

16. How is the Plan Set Up? • Cash compensation is typically simple • Complex agreements involving cash and other forms of compensation or situations that may violate reasonableness of compensation should use experts • tax accountant • tax attorney • financial planner specializing in employee benefits and compensation planning

17. True or False? • Cash compensation is not as important in closely-held corporations than it is in other forms of corporate organization. • Use of cash compensation avoids complex IRS rules, unlike other forms of compensation. • The IRS does not usually question reasonableness of compensation if salaries are not particularly high

18. True or False? • Excessive payments for salaries or compensation become taxable as ordinary income to the recipient. • Reimbursement agreements are an effective way to avoid the IRS’s reasonableness of compensation issue.

19. Discussion Question If an executive’s compensation is based on profits or sales, will it be deemed unreasonable (and therefore nondeductible) if the employer has an unusually good year and the payment is therefore very high? What impact does corporate structure (C, S, or unincorporated) have on your answer?