Principles of Taxation

1. Principles of Taxation Chapter 14 Compensation and Retirement Planning

2. Objectives • employees versus self-employed • family compensation planning • nontaxable employee fringe benefits • stock options • employee-related expenses • qualified versus nonqualified retirement plans • deferred compensation

3. 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, materials, person versus job. • See http://www.irs.ustreas.gov/prod/bus_info • /emp_tax/index.html

4. 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.

5. Foreign Earned Income Exclusion • Expatriates are U.S. citizens (or permanent residents) who reside and work overseas. • Exclude $78,000 (2001 limit) from taxation in the U.S. • Cannot claim foreign tax credit (see chapter 12) on excluded income.

6. 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, or • Necessary for job (moving expenses, supplies at work).

7. Employee Fringe Benefits • Why are these advantageous? • Often lower cost than employee can obtain • Nontaxable • Cafeteria plans allow broader employee choices among same-cost options for employer.

8. 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.

9. 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.

10. 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).

11. 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).

12. 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.

13. 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?

14. 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 of grant or w/in 1 year of exercise). • 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.

15. 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.

16. 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?

17. Employee Stock Options - Thinking • Which would employee prefer? • ISO - delay taxation, all capital gain, net gain/loss(if any) • Which would employer prefer? • NSO - claim salary deduction • Do you expect preference has changed over time?

18. 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.

19. 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).

20. 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

21. 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.

22. 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.

23. 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 • 100% of average three highest years’ wages • $135,000 (in 2001).

24. 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 • 25% of annual compensation or • $30,000 (in 2001). • 401K plan - the employer and employee both contribute. Employee contribution limit = $10,500 in 2000. MY ADVICE - Start right away!

25. 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!

26. Self-Employed Plans - Keogh • Contribute up to the lesser of • 20% of earned income from self-employment • $30,000 in 2000 • Must not discriminate. If owner has employees then he/she must provide retirement benefits to them.

27. Individual Retirement Accounts • Individuals contribute the lesser of • $2,000 or • 100% 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).

28. 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.

29. 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.