8-1 Compensation and Tax Planning  Recall the three types of tax planning:  Converting income from one type to another  Shifting income from one time period to another  Shifting income from one pocket to another  Applications to compensation:  Cash versus non-cash forms of compensation  Current versus deferred compensation  Pension income versus other deferred compensation (Chapter 9)

8-2 Compensation Questions  Why not pay all compensation now, in cash?  Why pay compensation in non-cash forms (either current or deferred)?  Why promise future payments in return for current effort?  When wouldn’t an employee prefer to simply receive cash now?  Both tax and non-tax reasons apply

8-3 Cash versus Non-Cash Compensation  When is it value-maximizing for the employer to provide non-cash benefits to employees rather than paying employees cash to purchase the benefits themselves?  Employer after-tax cost to provide benefits may be less than employee after-tax cost to purchase directly How do taxes impact this cost comparison? –Either type of compensation is deductible by employer, but value of non-cash benefits may not be taxable to employee

8-4 Example: Cash Salary versus Fringe Benefits  Como Corporation wishes to hire Mr. Job. Como’s marginal tax rate is 35% and Mr. Job’s marginal tax rate is 40%.  If Como pays Mr. Job $200,000 of salary, what is Como’s after-tax cost? What is Mr. Job’s after-tax income? If Mr. Job pays $5,000 to purchase health insurance, how much of his after-tax cash flow remains? If Como pays Mr. Job $195,000 of salary and pays $5,000 to provide his health insurance, is Mr. Job better off? Is Como? What if comparable health insurance only costs Como $3,500?

8-5 Current versus Deferred Compensation  What are some non-tax reasons for deferred compensation arrangements, defined as payment to be made in the future in exchange for services rendered currently?  Forced savings for retirement  Deferred compensation contingent on long- term outcomes provides incentives for performance

8-6 Current versus Deferred Compensation continued  Benefits of deferral depend on relative tax rates and after-tax rates of return on investment for employer and employee  When can tax advantages be gained by deferring compensation?  Typically most effective when either: Employer’s tax rate will be higher in future, or Employee’s tax rate will be lower in future, or Both Conditions under which these rate changes are likely to occur?

8-7 Current versus Deferred Compensation continued  Employer preferences:  Employer is indifferent between paying $1 of current compensation and paying D n dollars of deferred compensation in n periods, where D n = (1+r cn ) n (1-t c0 )/(1-t cn ) r cn is the employer’s annualized after-tax rate of return on investments of n periods t c0 is the employer’s tax rate today t cn is the employer’s tax rate in n periods

8-8 Current versus Deferred Compensation continued  Employee preferences:  Employee prefers to receive $1 of current compensation rather than receiving D n dollars of deferred compensation in n periods, if $1(1-t p0 )(1+r pn ) n > D n (1-t pn ) Or (1-t p0 )(1+r pn ) n > (1-t co ) (1-t pn )(1+r cn ) n (1-t cn ) Where r pn is the employee’s annualized after-tax rate of return on investments of n periods t p0 is the employee’s tax rate today t pn is the employee’s tax rate in n periods

8-9 Example: Current versus Deferred Compensation  Employer with MTR of 35% and an after- tax rate of return of 8% can offer current compensation of $1,000 or defer payment for one year  How much does the employer’s after-tax cash flow increase by not paying $1,000 of compensation now?  How much can the employer pay in one year and be indifferent between current and deferred compensation, if its MTR doesn’t change?  What if its MTR next year is 40%? 30%?

8-10 Example continued  Employee with MTR of 40% and an after- tax rate of return on investments of 6%  What is the employee’s after-tax cash flow from $1,000 of current compensation? What will that receipt be worth in one year if invested by the employee, if employee’s MTR next year is 40%? 30%? 20%?  Would the employee prefer the deferred compensation offered by the employer under each of its potential future tax rates, for each of the employee’s potential future tax rates?

8-11 Stock Options  Options are a form of deferred compensation whose future value is linked to firm performance  Impact on employer: no cash outflow, possible tax deduction  Impact on employee: future value only if stock price increases, value taxable in future at either ordinary income or capital gains rates  Two types of options for tax purposes: Incentive stock options (ISOs) Nonqualified stock options (NQSOs)

8-12 Stock Options continued  Nonqualified Stock Options  If value is readily ascertainable when option granted (exercise price < market price on date of grant), such value is taxed to recipient and deductible by employer Rarely true for employee stock options  If value not ascertainable when granted (exercise price > market price on date of grant), bargain element (difference between exercise price and FMV) when exercised is taxed to recipient as ordinary income Bargain element deductible by employer

8-13 Stock Options continued  Incentive Stock Options  General criteria for qualification: Granted under a written, formal plan authorized by shareholders Issued only to employees who must remain employees from the date the option is granted until 3 months before exercise Must be exercisable within ten years of of grant Aggregate stock value covered by ISOs is limited to $100,000 per year per employee

8-14 Stock Options continued  Incentive Stock Options continued  Bargain element at exercise not taxed to recipient for regular tax purposes, but increases alternative minimum taxable income and potential AMT liability  Recipient pays capital gains tax when stock is sold, on difference between exercise price and FMV on date of sale (if held at least 1 year after date of exercise and 2 years after date of grant)  No tax deduction for employer (unless employee makes disqualifying disposition)

8-15 Stock Options continued  Incentive Stock Options continued  ISOs provide employee with opportunity to shift income from one time period to another AND from one type to another  When would employer be willing to offer ISOs instead of NQSOs?

8-16 Tax Basis Issues  Options granted at no cost to an employee have zero tax basis  Tax basis of stock acquired through exercise of employee stock options = exercise price + compensation income recognized  NQSOs: basis of stock = exercise price + bargain element = FMV on date of exercise  ISOs: basis of stock = exercise price  Basis differences will affect gain/loss recognized on sale of stock

8-17 Example: Stock Options  On February 1, 1999, Jane was granted an option to purchase 100 shares of stock from her employer at $20 per share. On this date, the FMV of the company’s stock was $20 per share. Jane exercised the option on March 30, 2001, when the stock was worth $27 per share. On June 5, 2002, Jane sold the optioned stock for $32 per share.

8-18 Example continued  What are the tax consequences to Jane and her employer if the options are nonqualified?  What are the tax consequences to Jane and her employer if the options qualify as incentive stock options?  What if Jane had sold the stock on March 1, 2002, instead of June 5, 2002?

8-19 Other Stock Option Issues  Most options have a limited life (often 10 years)  Most unexercised options are forfeited if the employee quits the employer  At what point should the employee choose to exercise the options? At what point should the employee sell the optioned shares?  Depends on expectations regarding future stock value, expectations regarding continued employment, cash flow needs, providing cash to pay tax due on exercise, current versus future tax rates, risk diversification and other investment opportunities

8-20 Cashless Exercise of Stock Options  Popular alternatives:  Broker finances exercise, immediately selling shares acquired and paying profit to option holder  Pyramiding Option holder uses existing shareholdings to cover exercise price of options After such exercise, shareholdings increase, but not by as much as if options were exercised with cash

8-21 Some Interesting New Compensation Forms  Phantom stock  Intangible units paying an amount equal to the appreciation in value of the stock between the date of issue and some designated future date  Performance units  Stock appreciation rights  Usually issued with stock options, allowing employee to take appreciation in cash in lieu of exercising the options  Stock depreciation rights