McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4 4 Employee Compensation Strategies

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-3 Owner Compensation - C Corporations Shareholder/Employees likely to pay themselves generously Salary is deductible while dividends are not Unreasonably high salary likely to be recharacterized as nondeductible dividend

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-4 Owner Compensation - S Corporations All income taxed once whether dividend or salary Compensation of owner/shareholders subject to payroll taxes while dividends are not

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-5 Owner Compensation - Partnerships All income taxed once whether distribution or salary Partner or LLC member is not considered an employee Any compensation received by partner or member is referred to as guaranteed payments

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-6 Employee Fringe Benefits Cost efficient since most can be purchased by group at lower price than if purchased individually Many are excludable from taxable income Medical insurance Life insurance Child care Educational programs

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-7 Employee Fringe Benefits - Owners 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 S Corporation shareholders owning 2% or more of S Corporation treated like partners

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-8 Deferred Compensation Arrangement where employee performs current services for future compensation No current income to employee

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-9 Qualified Plans Type of deferred compensation plan receiving favorable tax treatment No income to employee until received Current tax deduction for employer Income accumulated tax free Plans must be funded Penalty for premature withdrawals

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-10 Types of Qualified Plans 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 Profit sharing plans 401(k) Plans Employee Stock ownership plans Keogh Plan: Qualified plan for self-employed individuals

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-11 Nonqualified Plans Often used to avoid qualified plan rules on discrimination and benefit limits Employer does not receive tax deduction until employee picks up income Nonqualified deferred compensation generally not appropriate for pass-through entities due to loss of deduction. Owners will pay tax on deferred compensation through loss of deduction

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-12 Compensation in Employer stock Employer: No cash outflow by employer Stock may be nonvoting Current deduction equal to fair market value of stock Employee: Taxable income equal to value of stock Maybe more risky than cash

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-13 Restricted Stock Definition: Stock that is not transferable or subject to a substantial risk of forfeiture 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 No deduction if stock later forfeited

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-14 Employee Stock Options Option to purchase employer stock at a set price Strike price: price set to purchase stock Underwater options: strike price is higher than current market price

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-15 Nonqualified Options Any option other than incentive stock option 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

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-16 Incentive Stock Options Special type of option created by Internal Revenue Code Employee must hold stock for at least one year

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-17 Incentive Stock Options Tax Effects: No tax on grant No tax on exercise When underlying stock is sold, long term capital gain income equal to sales price less amount paid Employer gets no deduction

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-18 Phantom 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 Employee includes cash in income Employer get corresponding deduction

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-19 Stock Appreciation Rights 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

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-20 Partnership Interest for Services 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 Zero outside basis

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-21 Partnership Interest for Services 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

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 4-22 Partnership Interest for Services 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