Income Tax Chapter 9 Employee Expenses and Deferred Compensation Accounting 421 Income Tax Chapter 9 Employee Expenses and Deferred Compensation 9/22/05 Chapter 9

Employee v Independent Contractor What is at stake? income tax and FICA withholding treatment of expenses, Schedule C or A employee fringe benefit participation and discrimination civil rights - discrimination protection - race, ethnicity, religion, gender, disability and age IRA, retirement plan deduction family leave allowance workers’ compensation unemployment compensation workplace safety protections other 9/22/05 Chapter 9

Employee v Independent Contractor Who controls the performance of the work? Employees are supervised and controlled in the way they perform work Independent contractors perform the work without supervision or control - only the end product is considered The employer and employee may not elect independent contractor status - they must live it by reference to the above rule 9/22/05 Chapter 9

Employee v. Independent Contractor The 20 factor test Instructions training integration who performs services hiring, firing, etc continuing relationship full time set hours Order or sequence of work reports pay by the hour, week or by the job furnish tools profit or loss possible investment hold out to public right to quit 9/22/05 Chapter 9

Employee Expenses Substantiation of expenses the general rule regarding substantiation is that the taxpayer must prove the correctness of items on a tax return when asked by the IRS. Estimates per Cohan. Sec 274 creates an important exception to the general rule in the case of travel, transportation, and entertainment expenses these expenses must be substantiated as a condition of taking the expense sustantiation requires contemporaneous record keeping and corroborated with receipts for items over $75 9/22/05 Chapter 9

Employee Expenses Travel away from home overnight on business deductible as business travel are transportation, lodging, meals, entertainment, taxis, laundry and incidental expenses. Meals and entertainment expenses need not be consumed with business associates to be deductible meals and entertainment must be reduced by 50% 9/22/05 Chapter 9

Employee Expenses Travel spouse and dependents travel only if they are employed by the company travel as education is not deductible travel for education for investment activity only is not deductible special rules apply for foreign conventions and luxury water travel (cruise ships) 9/22/05 Chapter 9

Employee Expenses Travel temporary v indefinite term must expect to gone less than one year must actually be gone less than one year or, tax home shifts to place of work - or if taxpayer moves about constantly, taxpayer’s tax home may be wherever the taxpayer is at any point in time special importance to construction, trucking and consulting industries 9/22/05 Chapter 9

Employee Expenses Transportation airfare, train, bus, taxi, auto expenses no deduction for commuting expenses - commuting is personal home to workplace between workplaces (2 jobs) or between customers’ offices etc. is business transportation auto expenses actual or mileage allowance - $ substantiation may be with use of a sample 9/22/05 Chapter 9

Employee Expenses Meals and Entertainment must meet either the directly related to business test, or the associated with business meeting test rigorous substantiation - all elements of the expense, who, what, when, how much, and business purpose special rules for entertainment facility (yachts, hunting lodge, etc.) and skyboxs - basically all these expenses are not deductible 9/22/05 Chapter 9

Employee Expenses Business gifts Other business expense $25 per donee ceiling amount Other business expense dues and subscriptions union dues uniform costs - see eligibility rules investment expenses tax preparation fees safe deposit box rental expenses 9/22/05 Chapter 9

Employee Expenses Reimbursed v unreimbursed for agi v from agi as miscellaneous itemized deduction subject to 2% floor accountable plan v nonaccountable plan accountable plan - no tax withholding, no income, no deduction nonaccountable plan - withholding of income tax and FICA, deductions from agi 9/22/05 Chapter 9

Employee Business Expense Reimbursements Accountable Plans Business purpose for the expense Meet the substantiation requirement through accounting to employer Requirement to repay employer for any advance or reimbursement of amounts in excess of the amount substantiated 9/22/05 Chapter 9

Employee Expenses Accountable plans substantiate all elements of the expenses to employer who, what, when, how much and business purpose with the use of adequate contemporaneous records - a diary or log of expenses made close in time to the date of the expenditure corroborate the records with documentary evidence including receipts for all items over $75 and for lodging per diem arrangements provide some relief from the burden of the substantiation rules. But, even per diem plans require proof of travel (away from home overnight) and business purpose of travel 9/22/05 Chapter 9

Employee Expenses Moving expenses Business related move distance test: 50 miles, measured from the old house to the old workplace, and then old house to new workplace time test: 39/52 or 78/104 for self-employed this test is waived if the next move is employment related deductible moving expenses are the costs of moving family and possessions to new home, the cost of lodging in route - but not meals. Moving mileage is $. /mile deduction is for agi 9/22/05 Chapter 9

Employee Expenses Education expenses generally education expenses are personal expenses to maintain or improve required skills expenses to meet requirements imposed by law or by the employer for retention of employment, rank, or compensation rate a self-employed person may deduct on Schedule C an employee on Schedule A as Misc Itemized subject to 2% Note don’t confuse these rules with the gross income exclusion rules for education assistance plans and reimbursements of education expenses 9/22/05 Chapter 9

Employee Expenses Office in the home principal place of business, regular place for meeting customers, patients, clients etc. or a separate structure Soliman (USSupCt) managerial function, no other office available salespersons, inventory and product sample storage, garage space for company car - square foot allocation exclusive office, allocate square footage depreciation is ordinary gain on sale 9/22/05 Chapter 9

Employee Expenses Generally, employee business expenses are reported on Form 2106 no reporting if expenses are reimbursed under an accountable plan 9/22/05 Chapter 9

Deferred Compensation Qualified and nonqualified retirement plans qualified under IRC Sections 401 to 415 immediate deduction for contribution by employer no current recognition of income on the economic benefit attributable to the employer’s contribution exclusion from income of amounts contributed by employee under a CODA earnings not currently taxed taxation is at time of distribution - sometimes at favorable rates 9/22/05 Chapter 9

Deferred Compensation Qualified retirement plans Profit sharing plans ESOPs IRAs and SEPs Pension plans defined benefit plan defined contribution plan 9/22/05 Chapter 9

Deferred Compensation Pension and Profit Sharing plans nondiscrimination requirement coverage test in eligibility and participation for the exclusive benefit of the employees rules for eligibility - over age 18 participation - 1000 hours of service/yr vesting - 3 year cliff vesting or 5-6 yr graduated funding - minimum funding standards for defined benefit plans distributions - lump sum or, if annuities are allowed, then one of the annuity options must be joint life with spouse 9/22/05 Chapter 9

Deferred Compensation Pension plans defined benefit the promise made is defined by reference to the benefit that will be paid ex. 1% of average high three years compensation for each year of service. Ed worked for 30 years with company and had an average high three years compensation of $90,000. Annual benefit will be $27,000 usually paid monthly subject to maximum benefit limits ($160,000) Note: who takes investment risk? 9/22/05 Chapter 9

Deferred Compensation Pension plans defined contribution type - called a money purchase pension plan the promise made is expressed as a percentage of the current compensation ex. 10% of compensation. Jennifer’s compensation is $85,000. The company must contribute $8,500/year promise can not exceed 25% of pay or $40,000 Note: who takes investment risk? 9/22/05 Chapter 9

Deferred Compensation Profit sharing plans defined contribution plans limits are 15% of pay or $44,000 discretionary contributions 401(k) plans are defined contribution plans but have the additional feature that allows,or in some cases requires, the employee to contribute to the plan. The employee’s contribution is generally made on a before tax basis. The employer’s contribution is often defined with a reference to the amount contributed by the employee 9/22/05 Chapter 9

Deferred Compensation SEPs and SIMPLEs both are IRA type employer retirement plans that allow companies to make a contribution to an employee’s IRA. These are popular with small business because they are less expensive to setup and maintain. There is little IRS reporting with either of these plans. 9/22/05 Chapter 9

Deferred Compensation Traditional IRA $4,000, or earned income if less, is deductible for agi individual may not be an active participant in an employer sponsored retirement plan active participants may contribute if their agi is less than threshold amounts - $34k, $54k; phase out to $44k and $64K otherwise contributions are nondeductible special rules for married couples where one is active participant in employer plan 9/22/05 Chapter 9

Deferred Compensation Traditional IRA distributions are taxed as ordinary income 10% penalty for most early withdrawals - before age 59 1/2 distributions must begin by 4/1 of year after individual reaches age 70 1/2 penalty of 6% for excess contributions penalty for late distributions 9/22/05 Chapter 9

Deferred Compensation Roth IRA nondeductible contributions limit on contributions of $4,000/y agi limitations on eligibility $95K - $110k - unmarried $150k - $160k - married no taxation on distributions if - 5 yr. Holding period distributions may not be made before age 59 1/2 unless due to a disability or to a beneficiary after individual’s death up to $10k may be distributed to first time homebuyers 9/22/05 Chapter 9

Deferred Compensation Rollover IRA May be used by an employee to take a distribution from an employer’s plan and “roll it over” to her own IRA. The rollover maintains the primary tax benefit of deferred taxation. The rollover feature facilitates employee mobility. Use “trustee to trustee” transfers in lieu of actual distribution and contribution rollovers (60 day and tax withholding problems may be eliminated) 9/22/05 Chapter 9

Deferred Compensation Nonqualified plans Called deferred compensation plans and contemplate an agreement between the employer and employee to pay an amount of compensation in a future period unfunded and nonforfeitable promise to pay an amount in the future restricted and nontransferable fully or partially funded plan (often funded with company stock) - subject to a substantial risk of forfeiture Issues are constructive receipt and economic benefit 9/22/05 Chapter 9

Deferred Compensation Stock option plans On January 2, 2005 Lindsey was granted an option to buy 8,000 shares of her company, XYZ Co, at $32/share. Under the option she may not exercise the option for at least two years, she will then have 10 years thereafter to do so. The stock is currently selling for $32/share readily ascertainable market value for option no readily ascertainable market value for option strike price grant date, date when restriction lifted, exercise date taxation at exercise date taxation at sale 9/22/05 Chapter 9

Deferred Compensation Incentive Stock Options - requirements option price equal or greater than current market price at date of grant exercisable and exercised within 10 years of grant nontransferable and exercisable only by employee employee may not own more than 10% of the voting power of stock of employer company immediately before the grant exercised limit of $100,000 in a year employee must not sell stock for at least two years from grant date and one year from exercise date employee must be employed at grant date and continue in employee to at least three months before exercise date 9/22/05 Chapter 9

Deferred Compensation ISOs tax implications no tax on date of exercise excess of fmv of stock over strike price is an AMT preference item capital gain on sale no employer deduction for compensation 9/22/05 Chapter 9

Deferred Compensation Coverdell Education Savings Plans – Sec 530 Non deductible contributions - $2,000 elementary and secondary education as well as higher ed may be used with Hope and Lifetime learning credits Compare to Sec 529 College Savings Plans 9/22/05 Chapter 9