McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Principles of Taxation: Advanced Strategies Chapter 3 Chapter 3 Employee Compensation Strategies Employee Compensation Strategies Slide 3-1

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Owner Compensation – C Corporations Shareholder/Employees likely to pay themselves generously Shareholder/Employees likely to pay themselves generously Salary is deductible while dividends are not Salary is deductible while dividends are not Unreasonably high salary likely to be recharacterized as nondeductible dividend Unreasonably high salary likely to be recharacterized as nondeductible dividend Slide 3-2

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Owner Compensation – S Corporations Slide3-3 All income taxed once whether dividend or salary All income taxed once whether dividend or salary Compensation of owner/shareholders subject to payroll taxes while dividends are not Compensation of owner/shareholders subject to payroll taxes while dividends are not

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Owner Compensation – Partnerships All income taxed once whether distribution or salary All income taxed once whether distribution or salary Partner or LLC member is not considered an employee Partner or LLC member is not considered an employee Any compensation received by partner or member is referred to as guaranteed payments Any compensation received by partner or member is referred to as guaranteed payments Slide 3-4

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Employee Fringe Benefits Cost efficient since most can be purchased by group at lower price than if purchased individually Cost efficient since most can be purchased by group at lower price than if purchased individually Many are excludable from taxable income Many are excludable from taxable income  Medical insurance  Life insurance  Child care  Educational programs Slide 3-5

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Employee Fringe Benefits – Owners No special rule for C Corporation Shareholders No special rule for C Corporation Shareholders Partners and Limited Liability Company members are not employees and are not eligible for most tax free fringe benefits Partners and Limited Liability Company members are not employees and are not eligible for most tax free fringe benefits S Corporation shareholders owning 2% or more of S Corporation treated like partners S Corporation shareholders owning 2% or more of S Corporation treated like partners Slide 3-6

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Qualified Plans Type of deferred compensation plan receiving favorable tax treatment Type of deferred compensation plan receiving favorable tax treatment  No income to employee until received  Current tax deduction for employer  Income accumulated tax free Slide 3-7

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Types of Qualified Plans Defined Benefit Plan – Employer provides a predetermined benefit payable monthly after retirement Defined Benefit Plan – Employer provides a predetermined benefit payable monthly after retirement Defined Contribution – Each participant has an account balance which increase due to employer contributions, employee contributions and earnings Defined Contribution – Each participant has an account balance which increase due to employer contributions, employee contributions and earnings  Profit sharing plans  401(k) Plans  Employee Stock ownership plans Slide 3-8

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Nonqualified Plans Slide 3-9 Often used to avoid qualified plan rules on discrimination and benefit limits Often used to avoid qualified plan rules on discrimination and benefit limits Employer does not receive tax deduction until employee picks up income Employer does not receive tax deduction until employee picks up income  Nonqualified deferred compensation generally not appropriate to pass-through entities due to loss of deduction. Owners will pay tax on deferred compensation through loss of deduction

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Compensation in Employer Stock Employer: Employer:  No cash outflow by employer  Current deduction equal to fair market value of stock Employee: Employee:  Taxable income equal to value of stock  Maybe more risky than cash Slide 3-10

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Restricted Stock Definition: Stock that is not transferable or subject to a substantial risk of forfeiture Definition: Stock that is not transferable or subject to a substantial risk of forfeiture General rule: No income to employee until restrictions lapse General rule: No income to employee until restrictions lapse  Includable in income at fair market value at that time Section 83(b) election: Employee elects to include fair market value of stock in income at time of transfer Section 83(b) election: Employee elects to include fair market value of stock in income at time of transfer  No deduction if stock later forfeited Slide 3-11

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Employee Stock Options Option to purchase employer stock at a set price Option to purchase employer stock at a set price Strike price - price set to purchase stock Strike price - price set to purchase stock Underwater options - strike price is higher than current market price Underwater options - strike price is higher than current market price Slide 3-12

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Nonqualified Options Any option other than incentive stock option Any option other than incentive stock option Tax effects: Tax effects:  No income on grant  Ordinary income on exercise equal to fair market value of stock less amount paid  Employer gets deduction equal to income picked up by employee Slide 3-13

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Incentive Stock Options Special type of option created by Internal Revenue Code Special type of option created by Internal Revenue Code Employee must hold stock for at least one year Employee must hold stock for at least one year Slide 3-14

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Incentive Stock Options Slide 3-15 Tax Effects: Tax Effects:  No tax on grant  No tax on exercise. Bargain element is AMT adjustment  When underlying stock is sold, long term capital gain income equal to sales price less amount paid  Employer gets no deduction

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Phantom Stock Employee receives deferred compensation based upon a hypothetical amount invested in employer stock Employee receives deferred compensation based upon a hypothetical amount invested in employer stock At end of period employee receives in cash hypothetical value of stock At end of period employee receives in cash hypothetical value of stock Employee includes cash in income Employee includes cash in income Employer get corresponding deduction Employer get corresponding deduction Slide 3-16

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Stock Appreciation Rights Employee receives right to a cash payment representing increase in value of a certain predetermined amount of employer stock Employee receives right to a cash payment representing increase in value of a certain predetermined amount of employer stock Same tax effects as phantom stock Same tax effects as phantom stock Slide 3-17

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Partnership Interest for Services Tax effects depend upon type of interest service provider will receive Tax effects depend upon type of interest service provider will receive  Future profits interest. Service provider does not get current share of assets but shares in future partnership profits  No current income. Income taxable as profits earned by partnership Slide 3-18

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Partnership Interest for Services Capital interest received by service provider Capital interest received by service provider  Service provider deemed receive fair market value of his or her share of partnership as compensation income  Partnership entitled to compensation deduction allocated to existing partners Slide 3-19

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Partnership Interest for Services Restricted Interest Restricted Interest  Service provider receives same tax treatment as recipient of restricted stock  Deduction to other partners  May result in deemed sale of a portion of the partnership’s assets Slide 3-20