Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
What is it?
• Cash that employee receives in the year that it was
earned
• Forms basis
– of comparison with other forms of benefits
– for deciding level of some types of pension or life insurance
plans
Copyright 2009, The National Underwriter Company
1
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
When is it indicated?
When it is advantageous
– “C” corporation offers greater opportunity to plan
cash compensation
– unincorporated businesses and “S” corporations
pass all income and loss directly through to
owners
Copyright 2009, The National Underwriter Company
2
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Advantages
1. Provides certainty for employee
2. Sets employee’s status in company and community
3. Important part of financial planning for shareholderemployees of closely held corporations
4. Easy to budget, known costs
5. Avoid administrative complexity
Copyright 2009, The National Underwriter Company
3
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Disadvantages
1. Cash paid currently is subject to current taxation
2. Cash compensation must meet reasonableness test
for various tax issues
Copyright 2009, The National Underwriter Company
4
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Tax Implications:
Reasonableness of Compensation
•Employer’s tax deduction for employee pay is
disallowed if employee compensation fails IRS
reasonableness test
•Generally, no deduction for compensation in excess of
$1,000,000 in publicly held corporation to CEO or 1 of 4
highest compensated company officers
Copyright 2009, The National Underwriter Company
5
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Tax Implications:
Reasonableness of Compensation
If amounts paid (and deductions taken) are
relatively high, wise to:
– determine compensation level before earned
– write and sign employment contracts
– document salary decisions in minutes of director’s
meetings
– document relevant factors in deciding
compensation level
Copyright 2009, The National Underwriter Company
6
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Tax Implications: Factors in Determining
Reasonableness of Compensation
• Compensation paid to executives in comparable
positions for comparable employers
• Employee qualifications for job
• Nature and scope of duties
• Size and complexity of business
Copyright 2009, The National Underwriter Company
7
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Tax Implications: Factors in Determining
Reasonableness of Compensation
• Comparison of compensation paid with company
income
• Company compensation policy for all employees
• Economic conditions
• Dividend distributions to shareholders
Copyright 2009, The National Underwriter Company
8
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Tax Implications:
Treatment of Disallowed Compensation
• Generally, disallowance of a deduction for
compensation results in taxable income for employee
• Specific treatment depends on circumstances, e.g. if payments primarily to shareholders, IRS deems as
dividends
Copyright 2009, The National Underwriter Company
9
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Tax Implications: Reimbursement Agreements
• An agreement to repay excess compensation if IRS
disallows deduction for compensation
• ‘Red flag’ to IRS auditor
• Rarely in best interest of employee
Copyright 2009, The National Underwriter Company
10
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Tax Implications:
Timing of Income and Deductions
• Timing of income and deductions faces complex tax
rules
• Under cash method of accounting, cannot take
deduction for compensation before the year
compensation actually paid
Copyright 2009, The National Underwriter Company
11
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Tax Implications:
Timing of Income and Deductions
• No employer (under cash or accrual method of
accounting) can take a deduction for compensation
for services not yet rendered by end of the taxable
year for which deduction claimed
• Any compensation paid in advance must be
deducted pro rata over period that services are
actually rendered
Copyright 2009, The National Underwriter Company
12
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Tax Implications: Timing of Corporate
Deductions for Compensation Payments
Current compensation
can deduct in year in which it is properly accrued to corporation
under tax accounting accrual rules
Deferred compensation
cannot deduct until taxable year of corporation that ends the
taxable year in which amount includable in employee’s income
IRS allows 2½ month ‘safe harbor’ for regular employee
(disallowed if employee is related to corporation)
Copyright 2009, The National Underwriter Company
13
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Alternatives
1.
Noncash compensation plans
some defer taxation:
– nonqualified deferred compensation plans
– qualified pension, profit sharing, or similar plans
– stock option and restricted stock option plans
Copyright 2009, The National Underwriter Company
14
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Alternatives
1.
Noncash compensation plans (cont’d)
some are tax free:
–
health, accident, and disability income plans that meet
certain criteria
–
dependent care and educational assistance plans
–
group term life up to $50,000 face value
–
pure death benefit from life insurance
2.
Provide employee compensation in form that is
both tax deferred to employee and deductiondeferred to employer
Copyright 2009, The National Underwriter Company
15
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
How is the Plan Set Up?
• Cash compensation is typically simple
• Complex agreements involving cash and other forms
of compensation or situations that may violate
reasonableness of compensation should use experts
– tax accountant
– tax attorney
– financial planner specializing in employee benefits and
compensation planning
Copyright 2009, The National Underwriter Company
16
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
True or False?
1. Cash compensation is not as important in closelyheld corporations than it is in other forms of corporate
organization.
2. Use of cash compensation avoids complex IRS rules,
unlike other forms of compensation.
3. The IRS does not usually question reasonableness of
compensation if salaries are not particularly high
Copyright 2009, The National Underwriter Company
17
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
True or False?
4. Excessive payments for salaries or compensation
become taxable as ordinary income to the recipient.
5. Reimbursement agreements are an effective way to
avoid the IRS’s reasonableness of compensation
issue.
Copyright 2009, The National Underwriter Company
18
Cash Compensation
Planning
Chapter 31
Employee Benefit & Retirement Planning
Discussion Question
If an executive’s compensation is based on profits or
sales, will it be deemed unreasonable (and therefore
nondeductible) if the employer has an unusually good
year and the payment is therefore very high?
What impact does corporate structure (C, S, or
unincorporated) have on your answer?
Copyright 2009, The National Underwriter Company
19