Principles of Taxation
Chapter 14
Compensation and
Retirement
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©The McGraw-Hill Companies, Inc., 2000
Objectives
Slide 14-2
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 contractor
Slide 14-3
 Who cares?
 Employer avoids FICA on contractor, w/h taxes,
employee benefits
 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, who provides materials, hire
person versus job.
 Seewww.irs.ustreas.gov/prod/bus_info/emp_tax/
index.html for information about employment tax.
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Salaries
Slide 14-4
 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.
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Foreign Earned Income
Exclusion
Slide 14-5
 Expatriates are U.S. citizens (or permanent
residents) who reside and work overseas.
 Exclude $74,000 (1999 limit) from taxation in
the U.S.
 Cannot claim foreign tax credit (see chapter
12) on excluded income.
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Employee Fringe Benefits
Slide 14-6
 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 anyway (de minimis rules,
cisounts),
 Non-discriminatory, or
 Necessary for job (moving expenses,
supplies at work)
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Employee Fringe Benefits
Slide 14-7
 Why are these advantageous
 Often lower cost than employee can obtain
 Nontaxable
 Cafeteria plans allow broader employee
choices among same-cost options for
employer.
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Specific fringe benefit examples
Slide 14-8
 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.
 See
http://www.irs.ustreas.gov/prod/forms_pu
bs/pubs/p5350404.htm for an IRS summary
of other nontaxable fringe benefits.
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Employee Stock Options -BIG
$$$’s
Slide 14-9
 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.
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Stock options - grant date
Slide 14-10
 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).
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Employee Stock Options nonqualified stock option (NSO)
Slide 14-11
 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 Example
Slide 14-12
 The CFO is granted 100 options (NSOs) in 1990 at a
price of $10 per share, when the stock is trading at
$10 per share. In 1994, he exercises these shares when
the FMV of the stock is $25 per share. In 1996, 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?
 1990 - no tax effect to either party
 1994 - CFO salary income $1,500, salary deduction $1500
 1996 - capital gain $500, no company deduction.
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NSO Example (you do it)
Slide 14-13
 The Treasurer is granted 100 options (NSOs) in 1990
at a price of $10 per share, when the stock is trading
at $10 per share. In 1995, she exercises these shares
when the FMV of the stock is $30 per share. In 1998,
she sells these shares at $36 per share.
 What is the amount, character, and timing of the
Treasurer’s income and the corporation’s deduction?
Irwin/McGraw-Hill
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Employee Stock Options Incentive Stock Option (ISO)
Slide 14-14
 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).
 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 Example
Slide 14-15
 The CFO is granted 100 options (ISOs) in 1990 at a
price of $10 per share, when the stock is trading at
$10 per share. In 1994, he exercises these shares when
the FMV of the stock is $25 per share. In 1996, 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?
 1990 - no effect.
 1994 - no effect (except AMT)
 1996 - $2000 capital gain, no corporate deduction.
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
ISO Example (you do it)
Slide 14-16
 The Treasurer is granted 100 options (ISOs) in 1990 at
a price of $10 per share, when the stock is trading at
$10 per share. In 1995, she exercises these shares
when the FMV of the stock is $30 per share. In 1998,
she sells these shares at $35 per share.
 What is the amount, character, and timing of the
Treasurer’s income and the corporation’s deduction?
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Employee stock options thinking
Slide 14-17
 Which would employee prefer?
 ISO - delay taxation, all capital gain
 Which would employer prefer?
 NSO - claim salary deduction
 Do you expect preference has changed over
time?
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©The McGraw-Hill Companies, Inc., 2000
Employee expenses
Slide 14-18
 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.
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Moving expenses
Slide 14-19
 Unreimbursed moving expenses are deducted in
computing AGI. Form 3903 flows to Line 25 of 1040.
 This is more advantageous because you can take the
deduction even if you are using the standard
deduction.
 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).
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Retirement Planning
Slide 14-20
 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 penalty) but must begin after 70
1/2.
 Basic types of qualified plans: a) employer,
b) self-employed (Keogh), c) IRA
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Attributes - qualified plans
Slide 14-21
 Plan cannot be discriminatory; $ limits in law.
 Current earned income contributed to plan is
not currently taxed (IRA, 401K, Defined
contribution plans).
 Employer generally gets deduction for
funding plan.
 The plan is tax exempt, so earnings are not
taxed as they accumulate.
 Retired person is taxed on withdrawals of all
amounts.
 Premature withdrawals 10% excise tax
Irwin/McGraw-Hill
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Tax Advantages of typical
qualified plan
Slide 14-22
 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 tbe 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.
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Employer plans - qualified
Slide 14-23
 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
 $130,000 (in 1999).
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Employer plans - qualified
Slide 14-24
 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
 25% of annual compensation or
 $30,000 (in 1999).
 401K plan - the employer and employee both
contribute. Employee contribution limit = $10,000.
MY ADVICE - Start right away!
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Employer plans - nonqualified
Slide 14-25
 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!
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Self-employed plans - Keogh
Slide 14-26
 Contribute up to the lesser of
 20% of earned income from selfemployment
 $30,000 in 1999.
 Must not discriminate. If owner has
employees then he/she must provide
retirement benefits to them.
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Individual Retirement Accounts
Slide 14-27
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 Individuals contribute the lesser of
 $2,000 or
 100% of compensation (but each spouse
may contribute $2000 if combined earned
income = $4000).
 Deduction for contribution is limited
 if taxpayer participates in a qualified plan
(phase-out range for MFJ starts at $51,000
in 1999)
 if spouse participates in a qualified plan
(phase-out range for MFJ starts at
$150,000).
©The McGraw-Hill Companies, Inc., 2000
IRA Withdrawals
Slide 14-28
 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
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
Roth IRA
Slide 14-29
 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.
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000