4703 Solutions Defcomp 04

CHAPTER 11

DEFERRED COMPENSATION

SOLUTIONS TO PROBLEM MATERIALS

Question/Problem Topic

1 Minimum coverage 2 Advantages of qualified plan 3 Section 401(k) plan versus pension plan 4 Vesting 5 Vesting 6 Tax on early distribution 7 Tax on lump-sum distribution 8 Maximum benefits: defined benefit plan 9 Maximum benefits: defined benefit plan10 Deductible amount: profit sharing plan11 Maximum contribution: profit sharing plan12 Section 401(k) plan13 SIMPLE § 401(k) plan14 Keogh plan15 Keogh plan16 IRA and SIMPLE IRA and active participant17 SIMPLE IRA and § 401(k) plans18 IRA: spousal and active participant19 Roth IRA: distributions20 Conversion of a traditional IRA into a Roth IRA21 Traditional IRA versus Roth IRA22 SIMPLE IRA and vesting23 CESA24 Spousal IRA25 Distributions and rollovers26 Timing of bonus

11-1

11-2 2004 Annual Edition/Solutions Manual

Question/Problem Topic

27 NQDC and constructive receipt28 Golden parachute payments29 Section 83(b) election30 Restricted property31 Nonqualified stock options versus cash bonus32 Restricted property33 Incentive stock options34 Nonqualified stock options35 SEP versus § 401(k) plan36 Cafeteria plan

BridgeDiscipline Problem

1 ESOPs2 Stock options

ResearchProblem

1 Excessive rent payments2 IRA and divorce3 Money purchase pension plan and profit sharing plan4 Divorce and stock options5 Phantom stock plan6 Internet activity7 Internet activity8 Internet activity

PROBLEM MATERIAL

1. This plan does not meet the coverage standard. A total of 43 percent of the non-highly compensated employees are covered (300/700) [i.e., fails the percentage test]. In addition, the plan fails the ratio test [i.e., there must be 47 percent covered (200/300 X .70)]. pp. 11-8, 11-9 and Digging Deeper 1

2. a. Yes, for certain lump-sum distributions related to pre-1974 service. pp. 11-12 and 11-13

b. Yes. p. 11-12

c. No. After-tax dollars only. p. 11-12

d. Yes. p. 11-12

e. Yes. p. 11-13

f. Yes. § 402(e)(4)(L). p. 11-13

3. A § 401(k) plan is a defined contribution plan and a pension plan is usually a defined benefit plan. An instructor may use Concept Summary 11-2 and compare the numerous differences.

4. Table 11-1 provides the nonforfeitable percentage for these participants:

NonforfeitableParticipant Years of Service PercentageMary 2 0%Sam 4 40%Peter 6 80%Heather 7 100%

pp. 11-10 and 11-11

5. See the table for two- to six-year graded vesting in Digging Deeper 1 for the nonforfeitable percentage for these participants:

NonforfeitableParticipant Years of Service PercentageMelton 2 20%Carl 3 40%Donald 5 80%Stacey 6 100%

p. 11-10

6. A 10% additional tax is imposed on the full amount of the premature distribution. Thus, Dana would have a $24,000 ($240,000 X 10%) premature distribution penalty tax. pp. 11-13 and 11-14

11-1


7. Raabe, Willis, Maloney, and Smith, CPAs5191 Natorp Boulevard

Mason, OH 45040

September 6, 2003

Ms. Yvonne Blair209 Barretts StreetLaramie, WY 82071

Dear Ms. Blair:

In response to your request concerning the tax consequences of your lump-sum distribution from a qualified plan, your taxable amount of $110,000 is calculated as follows:

Total lump-sum distribution $165,000Less:

Employee contributions $25,000Unrealized appreciation 30,000 (55,000 )

Taxable amount $110,000

Since you attained age 50 before January 1, 1986, you are eligible to elect capital gain treatment as follows:

$110,000 X 11 months (service before 1974)= $20,16760 months (total service months)

The separate tax on the $20,167 capital gain portion is $4,033 ($20,167 X 20%).

Calculation of the portion of the separate tax for the ordinary income part of the distribution using ten-year averaging is as follows:

Taxable amount $110,000Less:Minimum distribution allowance

1/2 of $110,000 (up to $20,000) $10,000Reduced by 20% ($110,000 – $20,000) (18,000) -0-

Taxable amount subject to averaging $110,000

Computation of tax:($110,000 – $20,167) X 1/10 = $8,983 + $2,480 (zero bracket amount) =$11,463

Tax on $11,463 using 1986 tax rate schedule for single taxpayer = $1,268. Ten times this amount is $12,680.

The total tax liability is:Initial separate tax on ordinary income portion $12,680Separate tax on capital gain portion 4,033Total tax liability $16,713

Deferred Compensation 11-5

However, your tax is less using ten-year averaging without LTCG treatment:

1/10 ($110,000) = $11,000$11,000 + $2,480 = $13,480Tax on $13,480 = $1,627 X 10 = $16,270

Therefore, your lowest tax payable is $16,270.

If we can be of further service, please contact me.

Sincerely,

Sam Sanders, CPATax Partner

pp. 11-13 and Digging Deeper 2

8. a. The limitation is the smaller of: $160,000 in 2003 (indexed each year) or 100% of the average of his three highest annual salaries:

$55,000 + $90,000 + $100,000 = $81,667 maximum allowable benefit3

pp. 11-14 and 11-15

b. Smaller of: $160,000 in 2003 (indexed each year) or 100% times highest three years average, or $142,000. Thus, $142,000 is Wade’s maximum allowable benefit. pp. 11-14 and 11-15

9. a. $80,000 in 2003. The maximum annual benefits payable to Quincy from a defined benefit plan is the smaller of $160,000 in 2003 (indexed each year) or 100% of his average compensation for the highest three years of employment. pp. 11-14, 11-15, and Digging Deeper 3

b. $110,000 in 2003. The defined benefit plan must reduce Wendy’s maximum benefit payable [i.e., $160,000 in 2003 (indexed each year)] by one-tenth for each year of participation under 10 years (i.e., $160,000 X 9/10 = $144,000). Thus, the $110,000 average compensation amount is below the ceiling. pp. 11-14, 11-15, and Digging Deeper 3

10. 20%. An employer with participants earning $200,000 or more can maximize their annual additions to the plan by a 20% profit sharing contribution ($200,000 X 20% = $40,000). Note that, for 2003, the $200,000 is the maximum compensation that can be taken into account and the $40,000 is the maximum annual contribution to a defined contribution plan. Concept Summary 11-2

11. The maximum contributions for the three employees are:

Samuel: $40,000 ($200,000 X .20)Helen: $27,600 ($138,000 X .20)Larry: $ 8,200 ($ 41,000 X .20)


p. 11-14

12. a. The maximum amount for which Amber can elect § 401(k) plan salary deferral for 2003 in $12,000.

b. Her tax liability for 2003 would be reduced by $3,600 ($12,000 X 30%) as a result of the salary deferral election.

c. $12,000 maximum amount. The election of the maximum amount reduces Amber’s tax liability and also maximizes her contribution to her retirement fund.

pp. 11-15 and 11-16

13. The deduction limitation for a SIMPLE § 401(k) plan in 2003 is $8,000. Miguel contributes $6,300. Thus, his taxable salary is $83,700 ($90,000 – $6,300). p. 11-16 and Digging Deeper 6

14. An owner-employee owns the entire interest in an unincorporated business. § 401(c)(3)(A)

a. $40,000. Limit also is $40,000 (20% X $200,000). pp. 11-17, 11-18, and Example 13

b. Contributions in excess of the allowable amount under § 415 are not deductible, and may be subject to a 10% excise tax. p. 11-17

c. No, Susan may not begin receiving payments until age 59.5 without incurring a 10% penalty. § 72(m)(5). p. 11-17

15. Jesse’s allowable deduction is $7,388, calculated as follows:

Earned income from business $40,000Less: self-employed tax deduction

($40,000 X 1/2 X 0.153) (3,060 )$36,940 X 0.20

Deductible amount $ 7,388

pp. 11-17, 11-18, and Example 13

16. a. Only $1,800 can be deducted due to the phase-out provision for active participants in other retirement plans. Molly’s excess AGI is $4,000 ($44,000 – $40,000). Therefore, her IRA deduction phaseout of $1,200 is calculated as follows:

$10,000 – $4,000 X $3,000 = $1,200 phaseout$10,000

Although Molly can deduct only $1,800 ($3,000 – $1,200), she can contribute $3,000 to her traditional IRA. Example 15 and Table 11-2


b. Molly has elected to contribute $1,600 to her SIMPLE IRA account (4% X $40,000). Her employer will contribute $1,200 (3% X $40,000). Both amounts will vest immediately. pp. 11-16 and 11-17


17. a. Govind may contribute a total of $6,000 to his IRA and a spousal IRA, with a maximum of $3,000 to either account. The $6,000 is deductible on their joint return. pp. 11-19, 11-20, and Example 18

b. Danos may contribute $1,860 of elective deferrals (6% X $31,000) and his employer will contribute $1,240 (4% X $31,000). The amounts will vest immediately. pp. 11-16 and 11-17

18. a. $6,000. A homemaker may take a full $3,000 deduction to a traditional IRA. Juan and Agnes may each contribute $3,000. pp. 11-19 and 11-20

b. $6,000. Their combined earned income exceeds $6,000. Thus, each may contribute $3,000. pp. 11-19 and 11-20

c. Leo is allowed a deduction for an amount that is equal to the smaller of $3,000 or 100% of his compensation for the year, regardless of employer contributions to the SEP, because his AGI is less than $40,000. Thus, Leo may contribute $3,000 to a traditional IRA. pp. 11-16 and 11-17

19. $211,000. Assuming that Monica met the income limitation at the time of the contributions to a Roth IRA, all of the funds may be withdrawn tax free. She satisfies the five-year holding period for a Roth IRA and is over age 59½ at the time of the distribution. pp. 11-20 and 11-21

20. The entire amount of $125,000 is included in Peter’s gross income in 2003. Peter’s adjusted basis for his traditional IRA is $0 because he has deducted his $90,000 of contributions. pp. 11-25 and 11-26

21. a. Jane and Bill can each contribute $3,000 to their traditional IRA. However, neither Jane nor Bill can deduct their contributions to a traditional IRA because their AGI exceeds the phaseout ceiling of $70,000.

b. Both Jane and Bill may each contribute $600 to a Roth IRA, calculated as follows:

$158,000 AGI – $150,000 threshold = $8,000 excess AGI

$ 8,000 X $3,000 = $2,400 phaseout$10,000

$3,000 ceiling – $2,400 phaseout = $600 contribution ceiling

pp. 11-19 and 11-20

22. The vested amount is calculated as follows:

Heather’s contribution ($52,000 X 9%) $4,680Employer’s contribution ($52,000 X 3%) 1,560Total contributions $6,240

pp. 11-16, 11-17, and Digging Deeper 6


23. a. Since the entire $4,000 is used by Joyce to pay for qualified education expenses, $0 is included in Joyce’s gross income.

b. Since only $2,500 of the $4,000 is used by Joyce to pay for qualified education expenses, only 62.5% ($2,500/$4,000) of the earnings received in the $4,000 distribution is excludible from Joyce’s gross income.

The $4,000 distribution is allocated between contributions and earnings as follows:

Contributions: $ 7,000 X $4,000 = $2,800$10,000

Earnings: $ 3,000 X $4,000 = $1,200$10,000

The $2,800 is excluded from Joyce’s gross income because it represents a return of her contributions. Of the $1,200 representing earnings, $750 ($1,200 X 62.5%) is excluded from Joyce’s gross income and $450 ($1,200 X 37.5%) is included in Joyce’s gross income.

Digging Deeper 9

24. Both Gene and Beth may each contribute $3,000 for a total of $6,000. Gene will use the spousal IRA provision to enable a $3,000 contribution rather than a $1,500 contribution. pp. 11-22 and 11-23

25. a. Samuel is treated as having received a $25,000 distribution (i.e., the $20,000 received and the $5,000 withheld). The $25,000 is included in his gross income. Therefore, his tax liability on the distribution is $6,750 ($25,000 X 27%).

b. Investing the $20,000 in a traditional IRA within 60 days of the distribution will result in partial rollover treatment. Therefore, only the $5,000 not reinvested is included in Samuel’s gross income. The related tax liability is $1,350 ($5,000 X 27%).

c. Investing the $20,000 in a Roth IRA within 60 days of the distribution also will result in partial rollover treatment. However, in this case, the entire $25,000 is included in Samuel’s gross income. His basis for his Roth IRA is $25,000. The related tax liability is $6,750 ($25,000 X 27%). If he satisfies the 5-year rule, all of the subsequent distributions from the Roth IRA can be excluded from Samuel’s gross income.

d. Samuel could have received better tax consequences in two different ways. First, if he had contributed $25,000 (rather than only $20,000) to the traditional IRA, the transaction would be a complete rollover. Therefore, the amount included in his gross income would have been $0. Second, he could have used the direct rollover approach rather than the indirect rollover approach. Then, there would have been no withholdings, and he would not have had to fund the $5,000 (until he files his tax return and receives a refund of the $5,000 tax prepayment) as he did in the first option above.

pp. 11-24 to 11-26



26. Heather should elect to receive the bonus in 2003, even though the $110,000 is included in her 2003 gross income. If she elects to defer the receipt of the bonus until 2004, she will be treated as constructively receiving the bonus in 2003. Therefore, the bonus is included in her gross income for the year in which it is granted. She has earned the bonus irrevocably, and merely is deciding when to receive it. By electing the second alternative, she loses any income she could have earned on the bonus through the year 2004. Spring, Inc. can claim its deduction for the year in which the bonus was granted. pp. 11-27 to 11-29

27. a. Yes, taxable.

b. No, there is a substantial risk of forfeiture.

c. Yes, taxable.

d. No, because the agreement is entered into prior to performance of the services.

e. No, since not funded.

pp. 11-28 and 11-29

28. a. Nancy would be a disqualified individual under § 280G(a), which would result in this payment being classified as a golden parachute payment. There has been a change of ownership. However, the $590,000 payment does not equal or exceed three times the base amount of $200,000 [3 X $200,000 = $600,000]. Therefore, the payment is not a golden parachute payment and the entire $590,000 payment to Nancy is deductible to the bank (assuming the amount is reasonable) and is includible in her gross income. Since the payment is not classified as a golden parachute payment, Nancy is not liable for a 20% excise tax. p. 11-30

b. In this case, the $390,000 payment is treated as a golden parachute payment because the amount received by Nancy equals or exceeds three times the base amount of $110,000. Thus, $280,000 ($390,000 – $110,000) is not deductible by the employer, and Nancy will incur a nondeductible excise tax of $56,000 ($280,000 X 20%). In addition, Nancy must include the $390,000 in her gross income. p. 11-30

29. If a special election under § 83(b) is made, the employee recognizes immediately as ordinary income the fair market value of the stock in excess of the amount paid for the stock. The corporate deduction is taken at this time and in the same amount as is included in the employee’s gross income. Any appreciation after the employee recognizes ordinary income is capital gain instead of ordinary income upon the disposition of the stock. pp. 11-32 and 11-33

30. a. Because a § 83(b) election has not been made, there is no gross income for 2003, as the resell feature qualifies as a SRF. pp. 11-30 and 11-31

b. 100 shares X ($40 – $10) = $3,000 (ordinary income). pp. 11-30 to 11-31 and Example 32

c. Same as (b), $3,000. p. 11-32 and Example 33


d. Tim should not make the § 83(b) special election in 2003 unless (1) the bargain element is small, (2) substantial appreciation is expected in the future, and (3) there is high probability that the restrictions will be met. 100 shares X ($20 – $10) = $1,000 (ordinary income). pp. 11-32, 11-33, and Examples 33 and 34

e. $0. pp. 11-34, 11-35, and Examples 35 and 36

f. $6,500 – $4,000 (basis) = $2,500 LTCG. pp. 11-31, 11-32, and Example 32

g. Capital loss, equal to the amount of his investment, or $1,000 (100 X $10). p. 11-32

h. The amount that Hawk must include in gross income in the year which Tim resigns is $1,000. This amount is equal to the deduction that previously was taken by Hawk when Tim made the special § 83(b) election in 2003. Reg. § 1.83-6(c) and p. 11-33

31. The executive may prefer to receive a cash bonus from the corporation because of the relatively low individual tax rates currently in effect. However, since individual tax rates are scheduled to decrease, some advisors are recommending deferring income from 2003.

Even if the executive is in the 38.6% tax rate bracket, the bonus will produce an after-tax cash flow of $18,420 ($30,000 bonus – $11,580 tax). This slightly exceeds the $17,000 ($30,000 – $13,000) before tax benefit associated with receiving the securities under the NQSO plan.

p. 11-36

32. a. No gross income is recognized since the resell feature qualifies as a SRF. p. 11-32

b. Ordinary income of $19,000 [1,000 shares X ($24 – $5)]. pp. 11-31, 11-32, and Example 32

c. STCG of $7,000 [1,000 shares X ($31 – $24)]. The holding period for determining whether a gain is long term or short term commences with the date that the employee includes the ordinary income in gross income. p. 11-31

d. The same amount that Earl recognized as compensation income on July 2, 2005, or $19,000, can be deducted by Black Corporation in 2005. pp. 11-34, 11-35, and Example 35

e. Ordinary income of $9,000 on July 2, 2001 [1,000 shares X ($14 – $5)], $0 on July 2, 2005, and LTCG of $17,000 [1,000 shares X ($31 – $14)] on September 16, 2005. pp. 11-32, 11-33, and Example 32

f. The same amount that Earl recognized as ordinary income, or $9,000, is deductible by Black Corporation, and at the same time. pp. 11-33, 11-34, and Examples 35 and 36


33. a. 100 shares X ($140 – $100) = $4,000 LTCG; $0 ordinary income. pp. 11-34, 11-35, and Example 37

b. 100 shares X ($120 – $100) = $2,000 ordinary income (the spread), in addition to $2,000 STCG [100 shares X ($140 – $120)]. pp. 11-34, 11-35, and Example 39

c. The same amount that Rosa recognized as ordinary income ($2,000), and at the same time, may be deducted by Copper Corporation. p. 11-35 and Example 39

d. $1,500 LTCG [100 shares X ($115 – $100)]; $0 ordinary income. pp. 11-34 and 11-35

e. 100 shares X ($140 – $120) = $2,000 LTCG. Rosa also recognizes ordinary income of $2,000 [100 shares X ($120 – $100)] on the exercise date. p. 11-36 and Examples 40 and 41

f. 100 shares X ($140 – $110) = $3,000 LTCG. Rosa also recognizes ordinary income of $1,000 ($10 X 1,000 shares) on the grant date. p. 11-36 and Examples 40 and 41

34. a. None in 2001 on the grant date if it is assumed that the options have no readily ascertainable fair market value. p. 11-36

b. $100 ordinary income. [($10 – $9) X 100 shares = $100]. pp. 11-36, 11-37, and Examples 40 and 41

c. $150 short-term capital gain [($11.50 – $10) X 100 shares = $150]. pp. 11-36, 11-37, and Examples 40 and 41

d. $100 is deductible by Tan Company in 2002, the same amount that is taxable to Rex. pp. 11-36 and 11-37

e. $50 short-term capital loss [($9.50 – $10) X 100 shares = $50]. pp. 11-36 and 11-37

35. Raabe, Willis, Maloney, and Smith, CPAs5191 Natorp Boulevard

Mason, OH 45040

February 12, 2003

Ms. Sara Reid1000 Canal AvenueNew Orleans, LA 70148

Dear Ms. Reid:

This letter is in response to your request for a comparison of a § 401(k) plan and a simplified employee pension (SEP) plan for your small business. With your salary of approximately $45,000, you would be able to place $12,000 (in 2003) into a § 401(k) plan. This $12,000 figure is indexed each year, and it is calculated from the smaller of


$12,000 (in 2003) or approximately 100% of total earnings. The favorable 10-year averaging technique on distributions is not available.

With a SEP, you could contribute the smaller of $40,000 or 25% of your earned income. Thus, you would be limited to $10,500 (.25 X $42,000). The favorable 10-year averaging technique on distributions is not available.

Employers must keep records and monitor for compliance with anti-discrimination tests with a § 401(k) plan. Compliance cost is a factor with § 401(k) plans, whereas a SEP does not require an annual report to the IRS.

Should you hire other employees, contributions to a SEP are fully vested. Vesting can take place over a 3 - 7 year period for a § 401(k) plan.

Under your current circumstances, I would recommend a § 401(k) plan. Should you need more information, please contact me. As you requested, we did not include the SIMPLE § 401(k) plan in our analysis.

Sincerely,

Melissa White, CPAPartner

pp. 11-15, 11-16, 11-21, and 11-22

36. Under a cafeteria plan, an employee may choose between cash or employer provided fringe benefits. Excludible benefits include the accident and health plan coverage. If Lou elects to receive the $8,000 cash, he will pay $3,088 ($8,000 X 38.6%) of Federal income taxes and possibly some state income tax also. Thus, his net cash flow will be $4,912 ($8,000 – $3,088). The accident and health insurance premiums are not subject to Federal income taxes. Therefore, if he selects the accident and health insurance coverage, Lou will receive a benefit worth $6,500 with no resultant Federal income tax liability. Thus, a greater benefit is received in the form of the accident and health insurance coverage.

BRIDGE DISCIPLINE

1. Memo to Files – John Harris and Eagle Inc.Date: January 15, 2004Subject: Stock Sale – ESOP

John Harris should consider adopting a leveraged ESOP plan to meet his goals of diversification, employee ownership, and capital infusion. An ESOP would allow him to do the following:

Raise $5,000,000 of new capital by having the ESOP borrow the $5,000,000 and purchase this amount of newly issued corporate stock (4,000 shares). Of course John will need to take into consideration the amount of ownership dilution this will create. Eagle, Inc. would make annual contributions to the


ESOP plan to pay off the loan (part of the contribution based on 25% of compensation). In addition, Eagle, Inc. would contribute enough additional funds to pay any interest charges.

John can sell enough of his stock to the ESOP such that immediately after the sale the ESOP will own at least 30% of Eagle, Inc. The ESOP would also borrow the funds to accomplish this transaction. John could then use the proceeds to purchase qualified replacement stock and defer recognition of any realized gain. This will allow John to diversify his portfolio at no current tax cost and at the same time to create employee stock ownership.

Eagle, Inc. can make annual tax-deductible contributions of up to $1,250,000 to the plan for repayment of the plans loan and can make an additional contribution to pay any interest charges the plan incurs.

If the plan borrowed $10,250,000 ($5,000,000 to purchase the newly issued stock and $5,250,000 to purchase 50% of John’s stock, it would take only eight years to retire the loan based on the maximum allowable contribution.

John would also be able to defer recognition of the $5,237,500 ($5,250,000 – $12,500) gain by timely reinvesting the $5,250,000 in qualified replacement stock. This deferral would be allowed since the ESOP would own 51.25% of the stock immediately after the sale. John’s basis in the replacement stock would be only $12,500.

2. a. The student should generally discuss FAS 123. Under FAS 123, corporations generally only disclose employee stock options in a footnote, with no current charge to reported earnings.

b. The tax treatment of employee stock options will depend on the type of option awarded. Nonqualified stock options generally produce no deduction for the employer

and no income to the employee at the time of grant, since the option price is usually equal to the exercise price at the time the options are granted.

Incentive stock options produce no deduction for the employer and no income

to the employee at the time of grant.

Nonqualified stock options will produce a deduction to the employer at the time of exercise equal to the amount of ordinary income the employee must recognize. Generally this amount will equal the difference between the fair market value of the stock on the exercise date and the exercise price.

Incentive stock options produce no deduction for the employer and no income to the employee at the time of exercise. However, the employee will have an


AMT tax preference equal to the difference between the fair market value of the stock on the exercise date and the exercise price.

c. Student supported opinion. May want to discuss the FASB Exposure Draft on stock options.

d. General Electric announced on August 1, 2002 that they would count the value of employee stock option awards against earnings. There may be other corporations that have also adopted this method.

RESEARCH PROBLEMS

1.Raabe, Willis, Maloney, and Smith, CPAs

5191 Natorp BoulevardMason, OH 45040

September 3, 2003

Mr. Sanjay Baker63 Rose AvenueSan Francisco, California 94117

Dear Mr. Baker:

This letter is in response to your question with respect to the corporate rental deductions disallowed by the IRS. Our conclusion is based upon the facts as outlined in your August 14 letter. Any change in facts may cause our conclusion to be inaccurate.

You and your sister own and operate a mail-order business in corporate form. The corporation uses both of your homes for corporate mail-order activities. The corporation pays you and your sister rent for the use of the homes. The corporation deducted the rental payments and you each reported the payments as taxable income. The IRS has disallowed most of these deductions, contending that the rent is excessive.

In our opinion, these rent payments are deductible as rental expense or as compensation payments. The success of the corporation is due to your efforts, and both the Tax Court and the Ninth Circuit Court of Appeals have held that similar payments were reasonable and appropriate.

Should you need more information or need to clarify our conclusion, do not hesitate to contact me.

Sincerely yours,


Jeff G. Webster, CPAPartner

Raabe, Willis, Maloney, and Smith, CPAs5191 Natorp Boulevard

Mason, OH 45040

August 18, 2003

TAX FILE MEMORANDUM

FROM: Jeff G. Webster

SUBJECT: Sanjay Baker

Today I talked to Sanjay Baker with respect to his August 14, 2003 letter. He wishes to know if certain corporate rent payments may be disallowed as excessive by the IRS.

Both he and his sister own and operate a mail-order business in corporate form. The corporation uses both of their homes for corporate mail-order activities (i.e., assembling, storing inventory, etc.). The corporation paid Mr. Baker and his sister rent for the use of their homes. The corporation deducted the rental payments and both parties reported the payments as taxable income. The IRS disallowed the payments, contending that the rent was excessive.

At issue: Can the rental payments be deducted as rental expense or possibly as compensation expense? I told Mr. Baker that we would have an answer for him within two weeks. Alex Smith has been assigned the responsibility to research the answer and then prepare a letter to Mr. Baker. Alex is to finish the job within 7 days from today. I suggested he start with Henry J. Langer, T.C. Memo. 1990-268.

Conclusion: The facts in this problem are similar to a Tax Court Memorandum decision, in Langer. The Tax Court said that the success of the corporation was due to the efforts of the employees and allowed the excessive rent to be deductible as compensation. The Court felt that it was both reasonable and appropriate for the corporation to make substantial payments to them.

The memo decision cited Multnomah Operating Co., 57-2 USTC ¶ 9979, 52 AFTR 672, 248 F.2d 661 (CA-9, 1957). Here the Ninth Circuit Court of Appeals allowed some rental payments to be deductible as compensation for services.

Therefore, the rental payments should be deductible either as rent expense or as compensation payments.


2. The facts for Shelly and Austin are similar to a recent U.S. Tax Court decision: Michael G. Bunney, 114 T.C No. 259 (2000). Basically, the Tax Court held that the entire $125,000 is included in the husband’s gross taxable income based upon § 408(d)(1): “any amount paid or distributed out of an individual retirement plan shall be included in gross income by the payee or distributee… under section 72.” The Tax Court pointed out that § 408(a)(9) requires that § 408 be applied without regard to the community property laws. “Recognition of community property interests in an IRA for Federal income tax purposes would conflict with the application of § 408 in several ways.”

The Tax Court would not accept the taxpayer's argument that the distribution and transfer of his IRA proceeds pursuant to the dissolution judgment was a nonrecognition event under § 408(d)(6). According to the Tax Court, the taxpayer did not transfer the IRA to the former spouse. He merely cashed out his IRA’s interest and paid her some of the proceeds.

The Tax Court agreed with the IRS that the taxpayer was subject to the 10% additional tax on early withdrawals from an IRA under § 72(t). However, since this taxpayer had a reasonable basis for his position, he was not subject to the accuracy-related penalty for negligence under § 6662(a).

3. Section 411(d)(3) provides on the termination or partial termination of a plan that the rights of all affected parties accrue to the date of such termination or partial termination or the amounts in the employee’s accounts must be nonforfeitable.

Rev. Rul. 2002-42, I.R.B. No. 28,76 states that all of the covered employees in this example remain covered under the continuing profit sharing plan, that the money purchase pension plan (MPPP) assets and liabilities retain their characteristics under the profit sharing plan, and that the employees vest in the continuing profit sharing plan under the same vesting schedule that existed under the MPPP. Thus, no partial termination has occurred in this example. So under this ruling, full vesting is not required solely because of a merger of a MPPP into a profit sharing plan.

4. The IRS issued a Field Service Advice with respect to this issue (FSA 200005006). The Field Service Advice holds that the incentive stock options transferred to the ex-wife automatically became nonqualified stock options, taxable under Section 83, due to rules prohibiting transfers to ISOs. However, it appears the FSA is wrong because IRC § 424(c)(4)(A) states that ISO transfers between spouses that are incident to a divorce “shall not be treated as a disposition.”

Under IRC § 424(c)(4)(B), in a transfer in a divorce situation, the same tax treatment that would have applied to the transferor applies to the transferee. Even this FSA agreed that the spread on the gain was not taxable to the husband when the ex-wife subsequently exercised the NQSOs (e.g., not a taxable event to the husband).


5. A phantom stock plan is a form of long-term non-qualified deferred compensation which uses an employer’s stock as the measuring rod for determining the value of the compensation payment. An employee is given units called phantom stock, which incorporate a value equal to the price of the stock and/or dividends paid during a certain time period. The employee does not own the stock, but the employer makes an entry on the books as the stock price rises or dividends are paid. Eventually the accrued appreciation and/or dividends are paid in cash to the employee.

The employee is not taxed on the initial grant of the phantom stock shares. Instead, the employee is taxed in the year the cash is paid, and the employer receives an offsetting deduction at the same time.

A phantom stock plan is simple, helps retain employees, and does not create an actual equity interest in the company. The company does not have to file anything with the IRS and is not subject to the nondiscrimination rules. However, the employee receives an equity interest in the business without the risk of actual ownership, with no immediate taxation, and the employee is normally not required to make a cash outlay.

A phantom stock plan would qualify for the exception for performance-based compensation if (1) it is paid solely on account of the attainment of one or more performance goals, (2) the performance goals are established by a compensation committee consisting solely of two or more outside directors, (3) the material terms under which the compensation is to be paid, including the performance goals, are disclosed to and approved by the shareholders in a separate vote prior to payment, and (4) prior to payment, the compensation committee certifies that the performance goals and any other material terms were in fact satisfied.

6. The Internet Activity research problems require that the student access various sites on the Internet. Thus, each student’s solution likely will vary from that of the others.

You should determine the skill and experience levels of the students before making the assignment, coaching them where necessary so as to broaden the scope of the exercise to the entire available electronic world.

Make certain that you encourage students to explore all parts of the World Wide Web in this process, including the key tax sites, but also information found through the web sites of newspapers, magazines, businesses, tax professionals, government agencies, political outlets, and so on. They should work with Internet resources other than the Web as well, including newsgroups and other interest-oriented lists.

Build interaction into the exercise wherever possible, asking the student to send and receive e-mail in a professional and responsible manner.

7. See the Internet Activity comment above.


8. See the Internet Activity comment above.

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4703 Solutions Defcomp 04