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Chapter 15

Chapter 15. Compensation and Retirement Planning. Objectives. Employees versus self-employed Family compensation planning Nontaxable employee fringe benefits Stock options Employee-related expenses Qualified versus nonqualified retirement plans

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Chapter 15

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  1. Chapter 15 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 including Keoghs and IRAs

  3. Employee versus Contractor • Employee is an individual • Whose duties are controlled – as to how, when, and where – by an employer • Who works according to a regular schedule in return for periodic payments

  4. Employee versus Contractor • Independent Contractor is a self-employed individual • Who performs services for money • Who controls the way the services are performed • Whose work relationship is temporary and • Who can have many clients at the same time

  5. Employee versus Contractor • Why is the distinction important? • Employer avoids FICA, w/h taxes, and employee benefit expense on independent contractors (IC); ICs are also easier to dismiss • IRS more likely to collect taxes from employees because employers report W-2 wages and remit both w/h and employment taxes to the Treasury • Clients issue Form 1099-MISC to ICs stating the compensation paid; ICs report this amount on Schedule C as business income less related deductions

  6. Employee versus Contractor • Self-employed individuals have a relatively low level of compliance because they either fail to file or they understate income • For this reason, the IRS takes an aggressive stance regarding worker classification • How is worker classification decided? • Regulations, rulings and court cases involving • Degree of supervision • Materials and • Person versus job

  7. Salaries • Employers may deduct wages if they are ordinary business expenses; factory direct labor is capitalized • 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

  8. Salaries • Family salary issues are a review of Chapters 11 and 12 • Compensation must be “reasonable” - remember risk of constructive dividend treatment • Reasonable – only such amount as would ordinarily be paid for like services by like enterprises under like circumstances

  9. Salaries • 5 factors relevant to “reasonableness” of employee compensation • Shareholder/employee’s role in the business • External comparisons with other companies • Financial condition of the corporate employer • Employee’s degree of control over dividend policy in capacity as shareholder • Internal consistency of the corporation’scompensation system throughout employee ranks

  10. Salaries • C corporations have anincentive to pay unreasonablylarge salaries in order to maximize deductions • S corporations have an incentiveto pay unreasonably low salariesin order to minimize payroll taxes

  11. Foreign Earned Income Exclusion • Expatriates are U.S. citizens (or permanent residents) who reside and work overseas on an extended basis • Can exclude $80,000 from taxation in the U.S. • Cannot claim foreign tax credit (see chapter 13) on excluded income

  12. Employee Fringe Benefits • General rule: fringe benefits are taxable • Exclusions of fringe benefits are usually • Providing a social welfare benefit such as • Health insurance • Life insurance • Child care benefits • Hard to enforce • Non-discriminatory, or • Necessary for job such as • Moving expenses • Supplies at work

  13. Specific Fringe Benefit Examples • Health and accident insurance or coverage is not taxable if nondiscriminatory • Only cost of premiums to provide group term life insurance benefits > $50,000 is taxable • Dependent care assistance up to $5,000 is excluded • Self-employed persons can deduct 100% of medical insurance costs

  14. Employee Stock Options -BIG $$$’s • Stock option: the right to buy stock in the future for a set price (called the exercise or strike price) for a given period of time • General attributes: when the stock option is granted, the option price is the FMV at the date of the grant • Stock options are a form of compensation that requiresno cash outlay

  15. Stock Options - Grant Date • Under GAAP, firms must record compensation expense equal 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)

  16. Employee Stock Options - Nonqualified Stock Option (NSO) • Employee has salary income equal to difference in FMV of stock and exercise price at date of exercise • Employee’s new basis in stock is FMV at exercise date • Employer gets tax deduction equal to employee income at date of exercise • When employee sells stock in future, he generates a capital gain (loss) = selling price - basis (FMV date of exercise)

  17. NSO Example • The CFO is granted 100 options (NSOs) in 1999 at a price of $10 per share, when the stock is trading at $10 per share. In 2002, he exercises the options when the FMV of the stock is $25 per share. In 2007, 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? • 1999 - no tax effect to either party • 2002 - CFO salary income $1,500, salary deduction $1,500 • 2007 - capital gain $500, no company deduction

  18. Employee Stock Options - Incentive Stock Option (ISO) • Dual advantage of ISO compared to NSO • Extension of the tax deferral period until the year of sale • The conversion of the option’s bargain element from ordinaryincome to capital gain

  19. Employee Stock Options - Incentive Stock Option (ISO) • Employee has no salary income on exercise, but 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 capital gain (loss) = selling price - exercise price

  20. ISO Example • The CFO is granted 100 options (ISOs) in 1999 at a price of $10 per share, when the stock is trading at $10 per share. In 2002, he exercises the options when the FMV of the stock is $25 per share. In 2007, 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? • 1999 - no effect • 2002 - no effect (except possible AMT) • 2007 - $2,000 capital gain, no corporate deduction

  21. Employee Expenses • When employers reimburse employees for employment-related expenses, the employee neither reports the cash reimbursement as income nor deducts the expense

  22. Employee Expenses • Unreimbursed expenses are deductible to the extent they exceed 2% of AGI • These are miscellaneous itemized deductions • 2% limit, combined with itemized requirement, means most employees can’t take the deduction!

  23. Application Problem 8 • Ms. A, an employee of WQR, paid $300 of union dues and $535 for small tools used on the job. In each of the following cases, compute her after-tax cost of these employment-related expenses. • WQR paid her an $835 reimbursement • Ms. A received no reimbursement. Her AGI is $13,000, she does not itemize deductions and her marginal tax rate is 10%

  24. Application Problem 8 (continued) • Ms. A received no reimbursement. Her AGI is $86,000, she does itemize deductions and her marginal tax rate is 28% • Ms. A received no reimbursement. Her AGI is $26,900, she does itemize deductions and her marginal tax rate is 15%

  25. Moving Expenses • Unreimbursed moving expenses are deducted in computing AGI (not an itemized deduction) • Costs to transport household goods and personal belongings including automobiles • Travel costs except meals • Requirements for moving expenses • New job meeting certain mileage and time of work requirements

  26. 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 deferral is big! • Withdrawal cannot begin before age 59 ½ (without 10% penalty) but must begin after 70 ½ • Basic types of qualified plans: a) employer-provided, b) self-employed (Keogh), c) IRAs for wage earners

  27. Attributes - Qualified Plans • Plan cannot be discriminatory; $ limits in law • Salary contributed to plan is not currently taxed (IRA, 401K, defined contribution plans) • Employer generally gets a deduction for funding the plan • The plan itself is tax exempt, soearnings are not taxed as theyaccumulate

  28. Attributes - Qualified Plans • Retiree is taxed on withdrawals of all amounts • Premature withdrawals are subject to a 10% excise tax. Exceptions • Owner becomes disabled • Owner reaches age 55 and becomes unemployed • Amounts withdrawn upon owner’s death

  29. Tax Advantages of Typical Qualified Plan • Contributions made with pre-tax dollars • Earnings accumulate tax free within the plan • Withdrawals taxed to beneficiary upon retirement, often at a lower tax rate than would have applied in year of contribution

  30. Employer Plans • Two policy objectives • Employer-provided plans should carry minimum risk for participating employees • Employer-provided plans should provide benefits in an equitable manner to all participating employees

  31. Employer Plans – 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 • $180,000 (in 2007)

  32. Employer Plans – 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 • 100% of annual compensation or • $45,000 (in 2007)

  33. Employer Plans – Defined Contribution • Types of Defined Contribution plans include • Profit-sharing plans – firms contribute a % of current earnings to a retirement trust • Employee Stock Ownership plans (ESOPs) – employer contributions are invested primarily in the employer’s own common stock • 401K plan - the employer and employee both contribute. Employee contribution limit = $15,500 in 2007

  34. Employer Plans - Nonqualified • Nonqualified deferred compensation - • Employee delays paying tax until she receives money • Employer delays deducting salary expense until it pays money • Employer accrues a liability but does not set aside any cash or property • Often used by top executives • Since nonqualified, these plans can discriminate!

  35. Self-Employed Plans - Keogh • Contribute up to the lesser of • 20% of earned income from self-employment • $45,000 in 2007 • Must not discriminate; if owner has employees then he/she must provide retirement benefits to them • Business earnings invested in Keogh plans are not taxable to employee and earnings are tax-exempt

  36. Individual Retirement Accounts • Individuals contribute the lesser of • $4,000 (in 2007) or • 100% of compensation (but each spouse may contribute $4,000 if combined earned income = $8,000) • A taxpayer reaching age 50 by year-end may make an additional $1,000 catch-up contribution • Deduction for contribution is limited • If taxpayer participates in a qualified plan (phase-out range for MFJ starts at $83,000 in 2007) • If spouse participates in a qualified plan (phase-out range for MFJ starts at $156,000)

  37. IRA Contribution Example • Indicate whether the following statements are true or false • The maximum amount that taxpayers under age 50 can contribute to an IRA is $4,000 • True • If a husband earns $4,000 and a wife earns $3,500, the maximum contribution the two can make to an IRA is $8,000 • False, the maximum contribution is $7,500

  38. IRA Contribution Example • If a husband earns $4,000 and a wife receives $5,000 in interest, the maximum contribution the two can make to an IRA is $4,000 • True. Interest is not earned income. Thus, the wife has no compensation and cannot contribute to an IRA.

  39. 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!

  40. Roth IRA • Roth IRA works differently from traditional IRA • NO deduction when contributed, but NO tax when distributed • Roth is better than traditional IRA if you expect tax rates to increase • Roth not available for high-income individuals - e.g. MFJ AGI>$166,000

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