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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Compensation and Compensation and Retirement PlanningRetirement Planning

Chapter 14Chapter 14

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ObjectivesObjectives

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 ContractorEmployee versus Contractor

Who cares? Employer avoids FICA on contractor, w/h taxes, employee

benefit. Easier to dismiss. 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.

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SalariesSalaries

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 ExclusionForeign Earned Income Exclusion

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

Exclude $80,000 (2002 limit) from taxation in the U.S.

Cannot claim foreign tax credit (see chapter 12) on excluded income.

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Employee Fringe BenefitsEmployee 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 Non-discriminatory, or Necessary for job (moving expenses, supplies at work)

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Employee Fringe BenefitsEmployee 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.

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Specific Fringe Benefit ExamplesSpecific 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.

Self-employed persons can deduct 70% of medical insurance costs.

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Employee Stock Options -BIG $$$’sEmployee Stock Options -BIG $$$’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 DateStock 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 Employee Stock Options - Nonqualified Stock Option (NSO)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 ExampleNSO Example

The CFO is granted 100 options (NSOs) in 1998 at a price of $10 per share, when the stock is trading at $10 per share. In 2001, he exercises these shares when the FMV of the stock is $25 per share. In 2004, 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? 1998 - no tax effect to either party 2001 - CFO salary income $1,500, salary deduction $1500 2004 - capital gain $500, no company deduction.

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NSO Example (you do it)NSO Example (you do it)

The Treasurer is granted 100 options (NSOs) in 1998 at a price of $10 per share, when the stock is trading at $10 per share. In 2001, she exercises these shares when the FMV of the stock is $30 per share. In 2004, she sells these shares at $28 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 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.

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ISO ExampleISO Example

The CFO is granted 100 options (ISOs) in 1998 at a price of $10 per share, when the stock is trading at $10 per share. In 2001, he exercises these shares when the FMV of the stock is $25 per share. In 2004, 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?

1998 - no effect. 2001 - no effect (except AMT) 2004 - $2000 capital gain, no corporate deduction.

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ISO Example (you do it)ISO Example (you do it)

The Treasurer is granted 100 options (ISOs) in 1998 at a price of $10 per share, when the stock is trading at $10 per share. In 2001, she exercises these shares when the FMV of the stock is $30 per share. In 2004, she sells these shares at $28 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 - ThinkingEmployee 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?

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Employee Expenses 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 ExpensesMoving Expenses

Unreimbursed moving expenses are deducted in computing AGI (not an itemized deduction). transport household goods travel costs except meals

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 PlanningRetirement 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 10% penalty) but must begin after 70 1/2.

Basic types of qualified plans: a) employer, b) self-employed (Keogh), c) IRAs

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Attributes - Qualified PlansAttributes - 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 deduction for funding plan. The plan itself is tax exempt, so earnings are not

taxed as they accumulate. Retiree is taxed on withdrawals of all amounts. Premature withdrawals 10% excise tax

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Tax Advantages of Typical Qualified PlanTax 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 the 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 - QualifiedEmployer 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 $160,000 (in 2004).

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Employer Plans - QualifiedEmployer 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 100% of annual compensation or $40,000 (in 2003).

401K plan - the employer and employee both contribute. Employee contribution limit = $13,000 in 2004. MY ADVICE - Start right away!

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Employer Plans - NonqualifiedEmployer 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 - KeoghSelf-Employed Plans - Keogh

Contribute up to the lesser of 20% of earned income from self-employment $40,000 in 2004.

Must not discriminate. If owner has employees then he/she must provide retirement benefits to them.

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Individual Retirement AccountsIndividual Retirement Accounts

Individuals contribute the lesser of $3,000 (in 2003) or 100% of compensation (but each spouse may contribute

$3000 if combined earned income = $6,000).

Deduction for contribution is limited if taxpayer participates in a qualified plan (phase-out

range for MFJ starts at $65,000 in 2004) if spouse participates in a qualified plan (phase-out range

for MFJ starts at $150,000).

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IRA WithdrawalsIRA 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 IRARoth 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.