ACIS+3314+Ch+12 1+Compensation

8/2/2019 ACIS+3314+Ch+12 1+Compensation

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Chapter 12

Compensation

ACIS 3314Tax Impact on Decisions


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Learning Objectives

1. Discuss and explain the tax implications ofcompensation in the form of salary and wages from theemployees and employers perspectives

2. Describe and distinguish the tax implications of variousforms of equity-based compensation from theemployers and employees perspectives

3. Compare and contrast taxable and nontaxable fringebenefits and explain the employee and employer taxconsequences associated with fringe benefits

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Salary and Wages

Employee Considerations for Salary andWages

Fixed amount of compensation for the current

year no matter how many hours worked Salaried employees eligible for bonuses

Employees receiving wages generally get paid bythe hour

Salary, bonus, and wages taxed as ordinaryincome

They report their wages on page 1, line 7 of the1040 federal tax return

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Salary and Wages

Withholding Taxes

Employees complete a Form W-4 to supply the

information the firm needs to withhold the correct

amount of tax and also to indicate Whether to withhold at the single rate or at the lower

married rate

The number of withholding or personal allowances

the employee chooses to claim

Whether the employee wants an additional amount of

tax withheld each period above the amount based on

the number of allowances claimed

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Salary and Wages

Form W-2 Summarizes an employees taxable salary and

wages

Provides annual federal and state withholding

information Generated by employer on an annual basis

Form W-4

Supplies an employees withholding information

to employer Generated by employee

Remains constant unless employee makeschanges

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FICA (Payroll Taxes) Paid on employees wages

Consists of both Social Security and Medicarecomponent

Social Security tax paid at 6.2 percent on wage baseand Medicare tax at 1.45 percent on wages

Wage base limitation

Social Security tax is $106,800 in 2009

No wage base for the Medicare component

Salary and Wages

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FICA Tax Question

Mike was paid a salary of $70,000 for the current

year. How much FICA and Medicare tax does he pay? Social Security:

Medicare:

Total Taxes:

Assume now that Mike earned $170,000 for the

current year. How much FICA and Medicare tax does

he pay? Social Security:

Medicare:

Total Taxes:

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General Rule for Deductibility Employers computing taxable income under

Cash method of accounting generally deduct salary and

wages when they pay the employee

Accrual method generally deduct wages payable to

employees as the employees earn the wages (i.e., when

employer incurs liability and services are performed).

Timing of Employers Deduction

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Exceptions 2 month rule. If not paid within 2 months of

employers year-end, then considered to be part of

a non-qualified deferred compensation plan and,

therefore, deductible only when actually paid.

Year-end bonus

Accrued vacation pay


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Exceptions Related parties Matching of Accounting Method:

Accrued expenses and interest owed to a related

party are deductible by the accrual-basis payer only

when actually paid to the cash-basis payee

[267(a)(2)]

This rule effectively converts the accrual-basis payer

to the cash-basis for purposes of these transactions.


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After-Tax Cost of Salary Question

XYZ, Inc. paid one of its employees $80,000 in

2009. They are in the 35% tax bracket. What

is the after-tax cost of the salary to XYZ, Inc.?

(Dont forget FICA taxes)

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After-tax Cost of Salary Solution

Total Cost = Salary + FICA taxes paid

FICA taxes =

Total cost =

After-tax cost =

So after-tax cost =

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Limits on Salary Deductibility

162(a)(1) applies reasonableness requirement tocompensation.

Compensation in excess ofa reasonable amount is not

deductible.

Facts and circumstances test involves

considering the duties of the employee

complexities of the business,

salary amount compared to overall profits, etc.

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Limits on Salary Deductibility

162(m): Effective for years beginning on or after1/1/1994

Publicly-traded corporations cannot deductcompensation in excess of $1 million per executive

per year.

Disallowance applies only to CEO and four highestpaid officers.

Exception: Certain types ofperformance-basedcompensation are not treated as executivecompensation for purposes of this limitation.

Stock Options are performance based.


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Equity-Based Compensation

Stock Options - Terminology Incentive stock options - provide favorable tax

treatment to employees

Nonqualified stock options - options that dont

meet the requirements for being classified asincentive stock options

Grant date - Date on which employees are initiallyallocated stock options

Exercise date - Date that employees purchasestock using their options

Exercise price - Amount paid to acquire shares withstock options

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Bargain element - Difference between the fair

market value of stock and the exercise price on

the exercise date

Vesting date - Time when stock options grantedcan be exercised

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Qualification Requirements for ISOs

ISO plan approved by shareholders Not exercisable > 10 years after grant date

Grantee owns 10% of employers voting stock

X Pg Sale > 2 years after grant and > 1 year after

exercise

FMV of stock (measured at grant date) limitedto $100,000 per year per individual

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Employee Considerations for Stock Options Nonqualified stock options

When exercising NQOs, employees report ordinary

income equal to the total bargain element on theshares of stock acquired (whether they hold theshares or sell them immediately)

Taxpayers basis in NQOs acquired is the fair marketvalue on the date of exercise

Basis includes the exercise price plus the ordinaryincome the taxpayer recognizes on the bargainelement

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Incentive stock options

Basis in shares acquired with ISOs is the exercise price

Holding period for stock acquired with NQOs and ISOs beginson the exercise date

Here bargain element is added to taxpayers alternativeminimum taxable income

For either type of options, employees experience no taxconsequences on the grant date or vesting date

Any future appreciation or depreciation of the stock will betreated as either short-term or long-term capital gain or lossdepending on the holding period (begins on the date ofexercise)


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Employer Considerations for Stock Options

Nonqualified options

No tax consequences on grant date

On exercise date, bargain element is treated asordinary (compensation) income to employee

Employee holds stock with holding period beginning

on date of exercise

Employers deduct bargain element ascompensation expense on exercise date


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Incentive stock options No tax consequences on grant date and exercise date (if employee

holds for two years after grant date and one year after exercisedate)

If holding requirements are not met (if there is a disqualifyingdisposition), option becomes an NQO

When employee sells stock, employee recognizes long-term capitalgain

No deduction for employers unless employee doesnt meet

holding requirements Employers typically dont view ISOs as favorable as NQOs, because:

ISOs dont provide them with the same tax benefits (no taxdeduction)

IRS regulatory requirements for ISOs can be cumbersome

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Firms with high marginal tax rates may lose significant taxbenefits by issuing ISOs rather than NQOs

On the other hand, start-up companies or firms with netoperating losses may actually benefit by issuing ISOs instead

of NQOs Accounting Issues

For tax purposes, employer deducts bargain element onexercise date

For GAAP purposes, employer expenses the estimated valueof the option pro rata over the vesting period


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Tax Treatment of Stock Options

ISO NQO

Employee Grant

Exercise

Sale

No Income

No Income

LTCG = PsX

No Income

Ordinary = PeX

CG = PsPe

Employer No Deduction Ever Deduction at Exercise =

PeX

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Same Amount, Same Time

Option Granted Option Exercised Stock Sold

Pg X Pe Ps


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Stock Options Questions

Mary is offered 7,000 options on Jan. 1st, 2009. They veston Jan. 1st 2012. The exercise price is $10 per share. OnJan. 1st 2012 she exercises all 7,000 options when the

price is $17 per share. She holds the stock for two yearsand sells all 7,000 shares for $20 per share. She is in the30% tax bracket. What is her tax liability on the grantdate, exercise date, and date of sale? If the options are ISOs?

If the options are NQOs?

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Stock Options Solution

If the options are ISOs:

Grant date:

Exercise Date:

Sale Date: Because she held the stock for 1 year

after exercise date she will be taxed on the full

appreciation from the exercise price atpreferential rates.

Tax liability =

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Stock Options Solution

If options are NQOs:

Grant date:

Exercise date:

Sale date:

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Employee is given stock, generally at zero cost

However, stock is restricted (i.e. cannot be sold orotherwise treated as owned until the vesting date).

IRC 83(a): General rules for Employee

Timing of income recognition = tax year in which propertybecomes transferable (i.e. fully vested) or not subject to asubstantial risk of forfeiture.

Amountof income recognition = Excess of propertys FMV

(determined when property becomes transferable) overamount paid (if any)

83(h): Amount & timing ofemployers deduction tied toemployees income recognition.

Restricted Stock Awards


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IRC 83(b): Employees election to recognize income

in year of grant.

Non-revocable election by employee

Must be made within 30 days of grant date.

Starts employees holding period at grant date.

Amount of income = FMV at grant


Stock Grant Vesting Stock Sold

Pg Pv Ps


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Without 83(b) Election No tax consequences on grant

date

On vesting date

Employee recognizesordinary income = FMV

Holding period for stock

begins

Employer deductscompensation expense =FMV

Stock Grant Vesting Stock Sold

Pg P

v P

s

With83(b) Election On grant date

Employee recognizes ordinary

income = FMV

Holding period for stock begins

Employer deducts compensation

expense = FMV

No tax consequences on vestingdate

If employee never vests, no taxdeduction for basis in stock.


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Employer Considerations for Restricted Stock

Timing of the deduction is determined by theemployees decisions regarding the 83(b) election

Other non tax issues

For tax purposes, employers deduct the marketvalue of stock when the employee recognizesincome

For GAAP purposes, employers deduct the grantdate value over the vesting period


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Restricted Stock Question

James received 4,000 shares of restricted stock on June

1st, 2009 when the stock was valued at $3 per share. The

shares vest on June 1st 2010 when the shares are valued

at $8 per share. He sells the shares on the vesting date.

He is in the 30% tax bracket. What is his tax liability on

the grant date and vesting date?

If he doesnt make an 83(b) election?

If he makes an 83(b) election?

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Restricted Stock Solution

If 83(b) election not made:

Grant date:

Vesting date:

If 83(b) election is made:

Grant date:

Vesting date/sales date:

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Employers often provide noncash benefits toemployees in addition to their cash compensation

Ranges from common (health insurance) to the exotic

(use of a corporate aircraft)

In general, gross income includes all income from

whatever source derived, includingcompensation for

services, fees, commissions, fringe benefits, and

similar items Exceptions to this rule are non-taxable or qualified

fringe benefits Exclusions

Fringe Benefits


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Employees recognize gross income when employers pay lifeinsurance premiums for policies with death benefits >

$50,000

To compute the annual taxable benefit

Step 1: Subtract $50,000 from the policys death benefitStep 2: Divide the Step 1 result by $1,000

Step 3: Multiply the result from Step 2 by the cost per $1,000 of

protection for one month from the table provided in the

Treasury Regulations based on the taxpayers ageStep 4: Multiply the outcome of Step 3 by 12 (months)

Example: Group Term Life Insurance

E l T t t f T bl F i


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Pay the employers share of FICA taxes on thetaxable portion of benefits provided to

employees

Deduct employers cost of the benefit (not valueof benefit to employee)

Report taxable fringe benefit on employees W-2

Employer Treatment of Taxable Fringe

Benefits


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Specifically identified in the Code Employee excludes benefit from taxable income

Employer deducts cost when benefit is paid

Examples: Group-Term Life Insurance up to $50,000 (79)

Health and Accident Insurance and Benefits (106)

Meals & Lodging for the Convenience of the Employer (119)

Employee Educational Assistance (127) Dependent Care Benefits (129)

Other (132)

Nontaxable Fringe Benefits


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Certain Fringe Benefits132

No-Additional-Cost Services

Qualified Employee Discounts

Working Condition Fringe Benefits

De Minimis Fringe Benefits

Qualified Transportation Fringe

Qualified Moving Expense Reimbursement


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Cafeteria Plans125

Employer determines the total dollar amountit wishes to provide each employee

Employee then chooses how to spend those

dollars among a menu of nontaxable fringebenefits

If employee doesnt spend the entire

amount, employee receives the difference astaxable cash compensation


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Fringe Benefits

Tax Planning with Fringe Benefits

Example

Employer proposed to reimburse employee $200 a month for

his parking costs. What amount of this reimbursement wouldbe a nontaxable qualified transportation fringe to employee?

Answer: All $2,400. Employee can exclude up to $230 per

month ($2,760 per year) as a qualified transportation fringe

IRS publication 15-B Employers Tax Guide to FringeBenefits (available at www.IRS.gov) provides tax guidance for

employers providing fringe benefits

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http://www.irs.gov/http://www.irs.gov/


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Fringe Benefits

Fringe Benefits Summary

Both taxable and nontaxable, can make up a significant

portion of an employees compensation

Are taxable unless the tax laws specifically exclude

them from gross income

Taxable fringe benefits usually represent a luxury perk,

while nontaxable fringe benefits are generally excluded

for public policy reasons

At this point, you should be able to distinguish between

taxable and nontaxable fringe benefits

Documents

ACIS+3314+Ch+12 1+Compensation