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 All forms of compensation (including salaries, wages, bonuses, tips, and fringe benefits) are taxable as ordinary income to employees unless specifically excluded by a provision in the Code
 Employers can deduct all compensation expenses
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FICA rate is 7.65% (6.2% for Social Security
+ 1.45% for Medicare)
 Social security portion is only charged on the first $87,900 for 2004
Employer withholds the FICA tax from employee; employer matches employee FICA and then forwards total to government
Employer can deduct employer’s share of tax
 No deduction for employee’s share of tax
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 Employers are also required to pay other types of payroll taxes such as federal and state unemployment taxes
 FUTA rate is 6.2% on first $7,000
 State unemployment taxes vary
 These taxes are all deductible by the employer paying them
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 Independent contractors (and other self-employed individuals) pay their own Social Security and
Medicare taxes
 This is called the self-employment tax
 Workers considered employees (instead of an independent contractor) if the employer has the right to control and direct the end result and the means by which the result is accomplished
 Rev. Rul. 87-41 provides 20-factor test
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Salaries and bonuses are usually deductible by the employer when accrued
Exceptions
 Compensation accrued but not paid within
2½ months of year-end is not deductible until paid
 Compensation accrued to cash-basis related party not deductible until paid
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 Related parties include:
 Family members (brothers, sisters, spouse, ancestors, and lineal descendants, but not inlaws)
 A taxpayer and a corporation in which the taxpayer owns directly or indirectly more than 50% of the stock (indirect ownership includes stock owned by family members), and
 Other relationships such as partners/partnerships and beneficiaries/trusts
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 If a shareholderemployee’s salary is considered unreasonable, the excess can be reclassified by IRS as a nondeductible dividend
 If unreasonable compensation is paid to a party related to a shareholder, the excess can be reclassified as a nondeductible dividend to the shareholder
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 Deductible compensation paid to CEO and 4 highest-paid officers of publicly-held corporations is limited to $1 million per year
 This compensation limit does not include amounts that represent
 Compensation based on individual performance goals (if approved in advance by outside directors)
 Compensation paid on a commission basis
 Employer contributions to a qualified retirement plan
 Tax-free employee benefits
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 There is an incentive for an S corporation to pay an unreasonably low salary to a controlling shareholder-employee to minimize payroll taxes as S corporation profits are not subject to payroll taxes
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 Compensation paid to children is deductible if reasonable for the services actually performed
 Wages paid to an employer’s child under age
18 are not subject to employment taxes (if not paid by a corporation)
 Standard deduction for a single individual is
$4,850 in 2004; this amount can be paid to a child without tax consequences
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 Exclusion is $80,000 per year
 Exclusion calculated separately for each spouse
 Qualifying earned income includes most income earned from working in a foreign country including salary, bonuses, allowances and noncash benefits
 U.S. government employees not eligible
 Taxpayer must work outside the U.S. for entire year or 330 days during a period of 12 consecutive months
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 Employees who do not qualify for the exclusion include the income in taxable income and claim a tax credit (or a deduction) for the foreign taxes paid
 The foreign tax credit cannot exceed the amount of U.S. tax that would have been paid on the foreign income
 The foreign tax credit is generally more advantageous than the deduction
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Tax-free fringe benefits are not taxable as income to the employee but are deductible by the employer
Most tax-free benefits are limited in dollar amount
If an employer pays an amount in excess of the limit (or pays for something that is not a qualified tax-free benefit), it is treated as taxable compensation (income to the employee and deductible by the employer)
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 Premiums on the first $50,000 of employerpaid group term life insurance coverage may be excluded from an employee's gross income
 Excess over $50,000 is included in income with amount determined from a table based on employee's age at year end rather than cost
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Employee’s Age
Under 25
25 to 29
30 to 34
35 to 39
40 to 44
45 to 49
50 to 54
55 to 59
60 to 64
65 to 69
70 and above
Monthly Amount
$.05
.06
.08
.09
.10
.15
.23
.43
.66
1.27
2.06
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 If the insurance plan is discriminatory, key employees must report gross income equal to the greater of
 Employer’s actual premiums paid or
 Benefit determined from the table (without
$50,000 exclusion)
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 Employees are not taxed on value of insurance premiums paid for by their employers for health and accident plans for employees and their families
 Self-insured discriminatory plans may result in taxable income to highly-compensated employees
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 An employer can provide up to $5,000
($2,500 if MFS) for the care of an employee's dependents during working hours through an on-site or off-site facility
 Highly-compensated employees cannot exclude benefits if they are discriminatory
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 Are an exception to the doctrine of constructive receipt
 A qualified cafeteria plan allows an employer to offer employees the option of choosing cash or nontaxable fringe benefits
 If the employee chooses cash, the cash is taxable
 If nontaxable fringe benefits are chosen, they are excludable
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 Benefits can be funded with employer contributions or by employees voluntarily electing to reduce their salaries (allowing employees to obtain fringe benefits with before-tax dollars)
 These plans are sometimes called flexible spending arrangements (FSA)
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 Some of the nontaxable benefits that can be offered include coverage for medical and dental care, group-term life insurance up to
$50,000, and dependent care assistance
 Any amounts set aside in a flexible spending plan must be used before the end of the year or they are lost
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 Value of meals and lodging provided by an employer to an employee are excluded if
 Provided for the employer's convenience and
 Provided on the employer's business premises and
 Employee required to occupy the lodging to perform employment duties
 If an employee is given a choice between additional compensation or meals and lodging, the value of any meals and lodging selected is taxable
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 When an employer provides services for its employees and incurs no substantial additional cost (excess capacity services), employees can exclude the value of the services from gross income
 Example: Free or discounted seats on an airplane when the employee does not displace a paying customer
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 This exclusion applies only to services received, not property
 Only employees who work in the line of business that renders similar services are allowed to exclude the benefits (baggage handlers who work for an airline can fly free)
 In addition to current employees, the exclusion is available to former employees, as well as spouse and dependents
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 Property or services provided employee at below FMV results in income to employee unless within the qualified employee discount limits
 Only property and services offered to customers in the ordinary course of the employer's business qualifies
 Full discount excluded if discount does not exceed gross profit percentage times price charged to customers
 For services, discount can’t exceed 20%
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Employee awards generally are treated as taxable compensation
Exceptions for length of service or safety awards
 Qualifying employee awards must be made with tangible property (no cash)
 Average cost of qualified plan awards limited to $400, but individual awards can be as much as $1,600
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Employees who receive “de minimis” (very small in value) property or services from their employers can exclude the value from gross income
An amount is considered de minimis when the value is so small that accounting for it is unreasonable or impractical
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 Transit passes and special carpool commuting expenses (combined value of up to $100 per month)
 Free or discounted parking (up to $195 per month in 2004)
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Employees (and their families) who use employer-provided athletic facilities that are located on the employer’s business premises can exclude the value of the benefit from gross income
Facilities include tennis courts, gymnasiums, and swimming pools
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Working condition fringe benefits can be excluded from the employee’s gross income if the employee would have been entitled to a tax deduction if he had actually paid the expense
Discriminatory benefits can still be excluded
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The value of an employee’s personal use of a company car is a taxable fringe benefit
 In determining the amount of income to be taxed to the employee for personal use, there are 3 methods:
 Lease value (from table)
 Cents per mile rate (37.5¢ in 2004)
 Commuting method (valued at $1.50 per one-way trip)
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 Qualified direct moving expenses include the reasonable cost of moving household belongings and family members from the old home to the new home by the shortest and most direct route
 No dollar limit
 Indirect expenses such as house-hunting or temporary living expenses do not qualify
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 Moving expenses are deductible if they are related to assuming duties at a new place of business and both the distance and time requirements are met
 Distance test - distance from old residence to new job must be at least 50 miles greater than the distance from old residence to old job
 Even though a taxpayer is required to relocate, no deduction is allowed if the distance test is not met
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 Time Test - taxpayer must work as an employee at the new location for 39 weeks during the 12 months following arrival or as a self-employed person for 78 weeks during the 24 months following arrival
 Exceptions allowed in event of death, disability, involuntary separation, or transfers for the employer’s benefit
 Qualified moving expenses that are not reimbursed are deductible for AGI by employee
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 Up to $5,250 a year of employer-provided educational assistance benefits can be excluded
Courses do not need to be job-related.
Excludable benefits are payments for tuition, fees, books, supplies, and equipment
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No dollar limit if education expenses are related to the current job of the employee
Qualified educational expenses include tuition, fees, books, and transportation from job to class
Expenses that meet the minimum education requirements for the taxpayer’s job or qualify taxpayer for a new profession do not qualify for exclusion
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 Accountable Plan - an employee provides an adequate accounting to the employer and refunds to the employer any excess payments
 Adequate Accounting - provides details concerning the time, date, place, business purposes, and the amount of the expense
 If an employee makes an adequate accounting, and the reimbursement exceeds the deductible expenses, the employee must include the excess in income
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 Nonaccountable plan does not require the employee to substantiate expenses or refund excess advanced funds
 Employer must report all of the reimbursed expenses on employee’s W-2
 Employees who receive advances in a nonaccountable plan must report details of both the reimbursement and the expenses
 Employee’s deductions are subject to 2% AGI floor for miscellaneous itemized deductions
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 Value not taxed until stock vests
 Employee recognizes ordinary income = FMV of stock when vested
 Dividends taxed as ordinary income prior to vesting
 Election to accelerate income made by recognizing income = FMV in year of receipt
 No deduction for loss if forfeited
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Option – right to purchase stock at strike price for a specific time
Grant date – date option offered to individual
Exercise date – date option used to purchase stock
Bargain element – difference between strike price and FMV of stock
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 Employee recognizes ordinary income equal to the bargain element on the date the NQSO is exercised
 Employer gets matching compensation deduction for bargain element
 Employee’s basis for stock is cash paid + income recognized
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 ISOs provide more favorable treatment for employee
 ISOs do not trigger any income recognition at the date of grant or exercise
 Income is recognized only upon the sale of the stock, usually as long-term capital gain
 But bargain element is an individual AMT adjustment
 Employer receives no compensation deduction
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Phantom stock plan - deferred compensation is hypothetically invested in shares of company’s stock
 At the end of deferral period (such as at retirement), the employer pays the employee the FMV of the phantom shares
Stock appreciation right (SAR) plan - employees are given the right to receive a cash payment equal to the appreciation in value of employer’s stock for a certain period of time
 Employees recognize income only when they exercise their SARs
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 Funded plans that receive favorable tax treatment
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Employer contributions are deducted as they are paid into the trust
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Earnings on these contributions accumulate tax-free until withdrawn
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Benefits are taxable to the employee only when actually received
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 When funds are withdrawn, taxes must be paid by employee on
 All earnings
 All employer contributions
 All pre-tax (deductible) employee contributions
 Employee must begin distributions by age
70 ½
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Taxpayers may not take distributions before age 59½ without paying a 10 percent penalty for premature distributions (in addition to the regular tax)
A taxpayer may roll over all or part of a distribution within 60 days without paying any tax or penalty on the distribution
 Lump sum distributions are subject to 20% withholding unless there is a direct trustee to trustee transfer
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 Defined Benefit - employer assumes the risk that the plan assets will be sufficient to pay benefits
 Defined Contribution - amounts contributed are determined according to a formula
 Employee’s benefit is dependent upon employer’s contributions and the actual earnings in the individual account
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 Employees can elect to have employer contribute part of their salary to plan on pretax basis
 In 2004, up to $13,000 plus extra $3,000 if age 50 or older
 Flexibility - employee can elect each year to have a different amount contributed
 Employer may match some of the contributions
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 Employee stock ownership plans (ESOPs)
 Simplified employee pension plans (SEPs)
 Savings incentive match plans for employees
(SIMPLE)
 SIMPLE 401k plans
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 Advantages - no dollar limits and can be offered on a discriminatory basis
 Employer receives a deduction only upon the actual payment of benefits to the employee
 Employee recognizes income upon the actual receipt of these benefits
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Employer accrues liability on financial statements, but no cash is set aside
If the employer’s business fails, the employee is merely an unsecured creditor
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 Individuals can contribute up to $3,000 ($3,500 if age 50 or older) or earned income if less
 A married taxpayer can contribute for a nonworking spouse
 Qualified contributions are deductible for AGI
 Deductions not allowed if the individual is a participant in an employer-sponsored retirement plans unless AGI is below certain limits
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 Deductible contribution phased out for AGI over a range
 Single $45,000 - $55,000
 Married filing jointly $65,000 - $75,000
 Zero if married filing separately
 If spouse an active participant, phaseout over AGI of $150,000 - $160,000
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 Taxpayers may make nondeductible contributions to a Roth IRA
 Contributions phase out if AGI
 $95,000 - $110,000 if single
 $150,000 -$160,000 if married filing joint return
 Contributions to Roth and the regular IRA cannot exceed a total of $3,000 ($3,500 if age 50 or older)
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 Primary advantage of the Roth IRA is that distributions are totally tax free
 Distributions from Roth IRAs are not subject to minimum distribution rules
 Do not have to begin by age 70½
 But cannot be made for first 5 years and taxpayer must usually be at least age 59½
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 Self-employed individuals must pay both the employer’s and the employee’s share of FICA taxes for a combined rate of 15.3%
 12.4 % (6.2% x 2) for Social Security on income up to $87,900 in 2004
 2.9% (1.45% x 2) for Medicare – no income limit
 Deduction for employer portion simulated by multiplying net income from self-employment by
92.35% (100% - 7.65%) before calculating SE tax
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 Tax computed on Schedule SE
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Self-employed individuals are also allowed a deduction for AGI for the employer’s half of self-employment taxes
There is no deduction for the employee’s half of the taxes
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 Self-employed individuals (including sole proprietors, partners, and greater than 2% shareholders of S corporations) do not qualify for most fringe benefits on a tax-free basis
 Special deduction for AGI applies to health insurance for self-employed individuals
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 Keogh (HR 10) plan is designed for self-employed persons and has limits on contributions similar to corporate retirement plans
 Contributions are deductible for AGI
 Extending return due date also extends deadline for making contributions to plan
 Earnings and deductible contributions fully taxed when withdrawn
 May also contribute to an IRA unless limitations apply
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