Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Principles of Taxation Chapter 14 Compensation and Retirement

Slide 14-2 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Objectives  employees versus self-employed  family compensation planning  nontaxable employee fringe benefits  stock options  employee-related expenses  qualified versus nonqualified retirement plans  deferred compensation

Slide 14-3 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Employee versus contractor  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.

Slide 14-4 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Salaries  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.

Slide 14-5 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Foreign Earned Income Exclusion  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.

Slide 14-6 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Employee Fringe Benefits  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)

Slide 14-7 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Employee Fringe Benefits  Why are these advantageous  Often lower cost than employee can obtain  Nontaxable  Cafeteria plans allow broader employee choices among same-cost options for employer.

Slide 14-8 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Specific fringe benefit examples  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 bs/pubs/p htm for an IRS summary of other nontaxable fringe benefits.

Slide 14-9 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Employee Stock Options -BIG $$$’s  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.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Stock options - grant date  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).

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Employee Stock Options - nonqualified stock option (NSO)  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).

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 NSO Example  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?  no tax effect to either party  CFO salary income $1,500, salary deduction $1500  capital gain $500, no company deduction.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 NSO Example (you do it)  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?

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Employee Stock Options - Incentive Stock Option (ISO)  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.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 ISO Example  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?  no effect.  no effect (except AMT)  $2000 capital gain, no corporate deduction.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 ISO Example (you do it)  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?

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Employee stock options - thinking  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?

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Employee expenses  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.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Moving expenses  Unreimbursed moving expenses are deducted in computing AGI. Form 3903 flows to Line 25 of  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).

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Retirement Planning  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

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Attributes - qualified plans  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

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Tax Advantages of typical qualified plan  Formula: {$1 / (1-tp 0 )} x (1+R) n x (1-tp n )  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.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Employer plans - qualified  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).

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Employer plans - qualified  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!

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Employer plans - nonqualified  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!

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Self-employed plans - Keogh  Contribute up to the lesser of  20% of earned income from self- employment  $30,000 in  Must not discriminate. If owner has employees then he/she must provide retirement benefits to them.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Individual Retirement Accounts  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).

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 IRA Withdrawals  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

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Roth IRA  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.