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Employee Compensation

Employee Compensation. Chapter 4. Employee Compensation. All forms of compensation (including salaries, wages, bonuses, tips, and fringe benefits) are taxable as ordinary income to employees unless specifically excluded by a provision in the Code Employers can deduct all compensation expenses.

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Employee Compensation

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  1. EmployeeCompensation Chapter4

  2. Employee Compensation • All forms of compensation (including salaries, wages, bonuses, tips, and fringe benefits) are taxable as ordinary income to employees unless specifically excluded by a provision in the Code • Employers can deduct all compensation expenses

  3. Payroll Taxes for Employees • FICA rate is 7.65% • 6.2% for Social Security + 1.45% for Medicare • Social security portion is only charged on the first $106,800 for 2010

  4. Payroll Taxes for Employers • Employer withholds FICA tax from employee; employer matches employee FICA and forwards total to government • Employer can deduct employer’s share of tax • No deduction for employee’s share of tax

  5. Other Payroll Taxes • Employers are also required to pay other types of payroll taxes such as federal and state unemployment taxes • FUTA rate is 6.2% on first $7,000 • State unemployment taxes vary • These taxes are all deductible by the employer paying them

  6. 2010 Payroll Tax Forgiveness • 2010 Hiring Incentives to Restore Employment Act allows employers who hire qualified new employees after 2/3/10 and before 1/1/11 to elect to be exempt from Social Security tax for these employees • Employee must not have been employed for more than 40 hours in the last 60 days prior to beginning the new job • Employer must still pay the Medicare tax

  7. Employee vs.Independent Contractor • Independent contractors (and other self-employed individuals) pay their own Social Security and Medicare taxes • This is called the self-employment tax • Workers considered employees (instead of an independent contractor) if the employer has the right to control and direct the end result and the means by which the result is accomplished • Rev. Rul. 87-41 provides 20-factor test

  8. Timing of Compensation • Salaries and bonuses are usually deductible by the employer when accrued • Exceptions • Compensation accrued but not paid within 2½ months of year-end is not deductible until paid • Compensation accrued to cash-basis related party not deductible until paid

  9. Related Parties • Related parties include: • Family members (brothers, sisters, spouse, ancestors, and lineal descendants, but not in-laws) • A taxpayer and a corporation in which the taxpayer directly or indirectly owns more than 50% of the stock (indirect ownership includes stock owned by family members) • Other relationships such as partners/partnerships and beneficiaries/trusts

  10. Reasonable Compensation • Reasonable compensation – amount similar business would pay for the services under similar circumstances • If a shareholder-employee’s salary is considered unreasonable, the excess can be reclassified by IRS as a nondeductible dividend • If unreasonable compensation is paid to a party related to a shareholder, the excess can be reclassified as a nondeductible dividend to the shareholder

  11. Excessive Compensation • Deductible compensation paid to CEO and 4 highest-paid officers of publicly-held corporations is limited to $1 million per year • This compensation limit does not include amounts that represent • Compensation based on individual performance goals (if approved in advance by outside directors) • Compensation paid on a commission basis • Employer contributions to a qualified retirement plan • Tax-free employee benefits

  12. S Corporations & Low Salaries • There is an incentive for an S corporation to pay an unreasonably low salary to a controlling shareholder-employee to minimize payroll taxes, as S corporation profits are not subject to payroll taxes • IRS can reclassify some of S corporation’s distribution as salary, requiring payment of additional employment taxes

  13. Employing Children • Compensation paid to children is deductible if reasonable for the services actually performed • Wages paid to an employer’s child under age 18 are not subject to employment taxes (if not paid by a corporation) • Standard deduction for a single individual is $5,700 in 2010; this amount can be paid to a child without tax consequences

  14. Fringe Benefits • Tax-free fringe benefits are not taxable as income to the employee but are deductible by the employer • Most tax-free benefits are limited in dollar amount • If an employer pays an amount in excess of the limit (or pays for something that is not a qualified tax-free benefit), it is treated as taxable compensation (income to the employee and deductible by the employer)

  15. Group Term Life Insurance • Premiums on the first $50,000 of employer-paid group term life insurance coverage may be excluded from employee's gross income • Excess over $50,000 is included in income • Amount determined from IRS table based on employee's age at year end, rather than cost

  16. Group Term Life InsuranceMonthly amount per $1,000 of taxable coverage

  17. Group Term Life Insurance • If the insurance plan is discriminatory, key employees must report gross income equal to the greaterof • Employer’s actual premiums paid or • Benefit determined from the table (without $50,000 exclusion)

  18. Health and Accident Insurance • Value of insurance premiums paid by employers on behalf of employees and their families are tax-free • Self-insured discriminatory plans may result in taxable income to highly-compensated employees

  19. Dependent Care Benefits • An employer can provide up to $5,000 ($2,500 if MFS) for the care of an employee's dependents during working hours through an on-site or off-site facility • Highly-compensated employees cannot exclude benefits if they are discriminatory

  20. Cafeteria Plans • A qualified cafeteria plan allows an employer to offer employees the option of choosing cash or nontaxable fringe benefits • Exception to constructive receipt doctrine • If employee chooses cash, the cash is taxable • If employee chooses nontaxable fringe benefits, they are excludable

  21. Cafeteria Plans • Benefits can be funded with employer contributions or by employees voluntarily electing to reduce their salaries (allowing employees to obtain fringe benefits with before-tax dollars) • These plans are sometimes called flexible spending arrangements (FSA)

  22. Cafeteria Plans • Some nontaxable benefits that can be offered include coverage for medical and dental care, group-term life insurance up to $50,000, and dependent care assistance • Any amounts set aside in a flexible spending plan must be used before the end of the year or they are lost

  23. Meals and Lodging • Value of meals and lodging provided by an employer to an employee are excluded if: • Provided for the employer's convenience and • Provided on the employer's business premises and • Employee required to occupy the lodging to perform employment duties • If an employee is given a choice between additional compensation or meals and lodging, the value of any meals and lodging is taxable

  24. No-Additional-Cost Services • When an employer provides services for its employees and incurs no substantial additional cost (excess capacity services), employees can exclude the value of the services from gross income • Example: Free or discounted seats on an airplane when the employee does not displace a paying customer

  25. No-Additional-Cost Services • This exclusion applies only to services received, not property • Only employees who work in the line of business that renders similar services are allowed to exclude the benefits (baggage handlers who work for an airline can fly free) • In addition to current employees, the exclusion is available to former employees, as well as spouse and dependents

  26. Employee Discounts • Property or services provided to employee at below FMV treated as taxable income to employee, unless within the qualified employee discount limits • Only property and services offered to customers in the ordinary course of the employer's business qualify • Full discount excluded if discount does not exceed gross profit percentage times price charged to customers • For services, discount can’t exceed 20%

  27. Employee Awards • Employee awards generally are treated as taxable compensation • Exceptions for length of service or safety awards • Qualifying employee awards must be made with tangible property (no cash) • Average cost of qualified plan awards limited to $400, but individual awards can be as much as $1,600

  28. De Minimis Fringe Benefits • Employees who receive “de minimis” (very small in value) property or services from their employers can exclude the value from gross income • An amount is considered de minimis when the value is so small that accounting for it is unreasonable or impractical • Examples: coffee & doughnuts, company picnics, limited use of copy machine, etc.

  29. Transportation & Parking • Exclusions limited: • Free or discounted parking (up to $230 per month in 2010) • Transit passes and special carpool commuting expenses (combined value of up to $230 per month) • Reimbursement of up to $20 per month for costs of commuting by bicycle

  30. Athletic Facilities • Employees (and their families) who use employer-provided athletic facilities that are located on the employer’s business premises can exclude the value of the benefit from gross income • Facilities include tennis courts, gymnasiums, and swimming pools

  31. Working ConditionFringe Benefits • Working condition fringe benefits can be excluded from the employee’s gross income if the employee would have been entitled to a tax deduction if he had actually paid the expense • Examples: job-related education, professional membership dues • Discriminatory benefits can still be excluded

  32. Employee Use ofCompany-Owned Cars • The value of an employee’s personal use of a company car is a taxable fringe benefit • In determining the amount of income to be taxed to the employee for personal use, there are 3 methods: • Lease value (from table) • Cents per mile rate (50¢ in 2010) • Commuting method (valued at $1.50 per one-way trip)

  33. Relocation Expenses • Qualified direct moving expenses include the reasonable cost of moving household belongings and family members from the old home to the new home by the shortest and most direct route • No dollar limit (but mileage rate if driving limited to 16.5¢ per mile) • Indirect expenses such as house-hunting or temporary living expenses do not qualify

  34. Relocation Expenses • Moving expenses are deductible if they are related to assuming duties at a new place of business and both the distance and time requirements are met • Distance test - distance from old residence to new job must be at least 50 miles greater than the distance from old residence to old job • Even though a taxpayer is required to relocate, no deduction is allowed if the distance test is not met

  35. Relocation Expenses • Time Test - taxpayer must work as an employee at the new location for 39 weeks during the 12 months following arrival • Self-employed person must work for 78 weeks during the 24 months following arrival • Exceptions allowed in event of death, disability, involuntary separation, or transfers for the employer’s benefit • Qualified moving expenses that are not reimbursed are deductible for AGI by employee

  36. Education Assistance Plans • Up to $5,250 a year of employer-provided educational assistance benefits can be excluded • Courses do not need to be job-related. • Excludable benefits are payments for tuition, fees, books, supplies, and equipment

  37. Job-Related Education • No dollar limit if education expenses are related to the current job of the employee • Qualified educational expenses include tuition, fees, books, and transportation from job to class • Expenses that meet the minimum education requirements for the taxpayer’s job or qualify taxpayer for a new profession do not qualify for exclusion • If employee pays for expenses and is not reimbursed, employee can deduct qualified expenses as miscellaneous itemized deductions

  38. Other Education Provisions • Qualified Tuition Reduction • Schools can provide a tuition waiver for employees and their immediate family members • Only undergraduate tuition can be waived as a tax-free benefit; graduate tuition waivers are taxable • Other education provisions discussed in Ch. 11 • American opportunity credit ($2,500 maximum) • Lifetime learning credit ($2,000 maximum) • Deduction for up to $4,000 of tuition (if extended)

  39. Substantiating Expenses • Accountable Plan - an employee provides adequate accounting to the employer and refunds to the employer any excess payments • Adequate Accounting - provides details concerning the time, date, place, business purposes, and the amount of the expense • If an employee makes an adequate accounting, and the reimbursement exceeds the deductible expenses, the employee must include the excess in income

  40. Substantiating Expenses • Nonaccountable plan does not require the employee to substantiate expenses or refund excess advanced funds • Employer must report all of the reimbursed expenses on employee’s W-2 • Employees who receive advances in a nonaccountable plan must report details of both the reimbursement and the expenses • Employee’s deductions are subject to 2% AGI floor for miscellaneous itemized deductions

  41. Restricted Stock • Value not taxed until stock vests • Employee recognizes ordinary income = FMV of stock when vested • Dividends taxed as ordinary income prior to vesting • Election to accelerate income made by recognizing income = FMV in year of receipt • No deduction for loss if forfeited

  42. Stock Options • Option – right to purchase stock at guaranteed strike price for a specific time • Grant date – date option offered to individual • Exercise date – date option used to purchase stock • Bargain element – difference between strike price and FMV of stock

  43. Nonqualified Stock Options • Employee recognizes ordinary income equal to the bargain element on the date the NQSO is exercised • Employer gets matching compensation deduction for bargain element • Employee’s basis for stock is cash paid + income recognized

  44. Incentive Stock Options • ISOs provide more favorable treatment for employee • ISOs do not trigger any income recognition at the date of grant or exercise • Income is recognized only upon the sale of the stock, usually as long-term capital gain • But bargain element is an individual AMT adjustment • Employer receives no compensation deduction

  45. Phantom Stock and SARs • Phantom stock plan - deferred compensation is hypothetically invested in shares of company’s stock • At the end of deferral period (such as at retirement), the employer pays the employee the FMV of the phantom shares • Stock appreciation right (SAR) plan - employees are given the right to receive a cash payment equal to the appreciation in value of employer’s stock for a certain period of time • Employees recognize income only when rights are exercised

  46. Qualified Deferred Compensation Plans • Funded plans that receive favorable tax treatment: • Employer contributions are deducted as they are paid into the trust • Earnings on these contributions accumulate tax-free until withdrawn • Benefits are taxable to the employee only when actually received

  47. Distributions • When funds are withdrawn, taxes must be paid by employee on • All earnings • All employer contributions • All pre-tax (deductible) employee contributions • Employee must begin distributions by age 70½

  48. Distributions • Premature withdrawals - 10% penalty (in addition to income tax) for taking distributions before age 59½ • A taxpayer may roll over all or part of a distribution within 60 days without paying any tax or penalty on the distribution • Lump sum distributions are subject to 20% withholding unless there is a direct trustee to trustee transfer

  49. Types of Plans • Defined Benefit – provides fixed benefit at retirement • Employer assumes the risk that the plan assets will be sufficient to pay benefits • Defined Contribution - amounts contributed are determined according to a formula • Employee’s benefit is dependent upon employer’s contributions and the actual earnings in the individual account

  50. 401(k) Plans • Employees can elect to have employer contribute part of their salary to plan on pretax basis • In 2010, up to $16,500 plus extra $5,500 if age 50 or older • Flexibility - employee can elect each year to have a different amount contributed • Employer may match some of the contributions

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