1. McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 15 Compensation and Retirement Planning McGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 15-2Objectives  Employees versus self-employed  Family compensation planning  Nontaxable employee fringe benefits  Stock options  Employee-related expenses  Qualified versus nonqualified retirement plans  Deferred compensation including Keoghs and IRAs

3. 15-3 Employee versus Contractor  Employee is an individual  Whose duties are controlled – as to how, when, and where – by an employer  Who works according to a regular schedule in return for periodic payments

4. 15-4 Employee versus Contractor  Independent Contractor is a self-employed individual  Who performs services for money  Who controls the way the services are performed  Whose work relationship is temporary and  Who can have many clients at the same time

5. 15-5 Employee versus Contractor  Why is the distinction important?  Employer avoids FICA, w/h taxes, and employee benefit expense on independent contractors (IC); ICs are also easier to dismiss  IRS more likely to collect taxes from employees because employers report W-2 wages and remit both w/h and employment taxes to the Treasury  Clients issue Form 1099-MISC to ICs stating the compensation paid; ICs report this amount on Schedule C as business income less related deductions

6. 15-6 Employee versus Contractor  Self-employed individuals have a relatively low level of compliance because they either fail to file or they understate income  For this reason, the IRS takes an aggressive stance regarding worker classification  How is worker classification decided?  Regulations, rulings and court cases involving  Degree of supervision  Materials and  Person versus job

7. 15-7Salaries  Employers may deduct wages if they are ordinary business expenses; factory direct labor is capitalized  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

8. 15-8 Salaries  Family salary issues are a review of Chapters 11 and 12  Compensation must be “reasonable” - remember risk of constructive dividend treatment  Reasonable – only such amount as would ordinarily be paid for like services by like enterprises under like circumstances

9. 15-9 Salaries  5 factors relevant to “reasonableness” of employee compensation  Shareholder/employee’s role in the business  External comparisons with other companies  Financial condition of the corporate employer  Employee’s degree of control over dividend policy in capacity as shareholder  Internal consistency of the corporation’s compensation system throughout employee ranks

10. 15-10 Salaries  C corporations have an incentive to pay unreasonably large salaries in order to maximize deductions  S corporations have an incentive to pay unreasonably low salaries in order to minimize payroll taxes

11. 15-11 Foreign Earned Income Exclusion  Expatriates are U.S. citizens (or permanent residents) who reside and work overseas on an extended basis  Can exclude $87,600 (2008) from taxation in the U.S.  Cannot claim foreign tax credit (see chapter 13) on excluded income

12. 15-12 Employee Fringe Benefits  General rule: fringe benefits are taxable  Exclusions of fringe benefits are usually  Providing a social welfare benefit such as  Health insurance  Life insurance  Child care benefits  Hard to enforce  Non-discriminatory, or  Necessary for job such as  Moving expenses  Supplies at work

13. 15-13 Specific Fringe Benefit Examples  Health and accident insurance or coverage is not taxable if nondiscriminatory  Only cost of premiums to provide group term life insurance benefits > $50,000 is taxable  Dependent care assistance up to $5,000 is excluded  Self-employed persons can deduct 100% of medical insurance costs

14. 15-14 Employee Stock Options -BIG $$$’s  Stock option: the right to buy stock in the future for a set price (called the exercise or strike price) for a given period of time  General attributes: when the stock option is granted, the option price is the FMV at the date of the grant  Stock options are a form of compensation that requires no cash outlay

15. 15-15 Stock Options - Grant Date  Under GAAP, firms must record compensation expense equal 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)

16. 15-16 Employee Stock Options - Nonqualified Stock Option (NSO)  Employee has salary income equal to difference in FMV of stock and exercise price at date of exercise  Employee’s new basis in stock is FMV at exercise date  Employer gets tax deduction equal to employee income at date of exercise  When employee sells stock in future, he generates a capital gain (loss) = selling price - basis (FMV date of exercise)

17. 15-17 NSO Example  The CFO is granted 100 options (NSOs) in 1999 at a price of $10 per share, when the stock is trading at $10 per share. In 2002, he exercises the options when the FMV of the stock is $25 per share. In 2008, 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?  1999 - no tax effect to either party  2002 - CFO salary income $1,500, salary deduction $1,500  2008 - capital gain $500, no company deduction

18. 15-18 Employee Stock Options - Incentive Stock Option (ISO)  Dual advantage of ISO compared to NSO  Extension of the tax deferral period until the year of sale  The conversion of the option’s bargain element from ordinary income to capital gain

19. 15-19 Employee Stock Options - Incentive Stock Option (ISO)  Employee has no salary income on exercise, but AMT adjustment = untaxed bargain element  Employer has no salary deduction ever  Exception - early disposition of stock (w/in 2 years of grant or w/in 1 year of exercise)  Employee has basis in stock equal to exercise price  When employee sells stock in future, he generates capital gain (loss) = selling price - exercise price

20. 15-20 ISO Example  The CFO is granted 100 options (ISOs) in 1999 at a price of $10 per share, when the stock is trading at $10 per share. In 2002, he exercises the options when the FMV of the stock is $25 per share. In 2008, 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?  1999 - no effect  2002 - no effect (except possible AMT)  2008 - $2,000 capital gain, no corporate deduction

21. 15-21 Employee Expenses  When employers reimburse employees for employment-related expenses, the employee neither reports the cash reimbursement as income nor deducts the expense

22. 15-22 Employee Expenses  Unreimbursed expenses are deductible to the extent they exceed 2% of AGI  These are miscellaneous itemized deductions  2% limit, combined with itemized requirement, means most employees can’t take the deduction!

23. 15-23 Application Problem18  Ms. C paid $500 of union dues and $619 for small tools used on the job. In each of the following cases, compute her after-tax cost of these employment-related expenses.  Ms. C’s employer paid her a $1,119 reimbursement  Ms. C received no reimbursement. Her AGI is $16,450, she does not itemize deductions and her marginal tax rate is 10%

24. 15-24 Application Problem 18 (continued)  Ms. C received no reimbursement. Her AGI is $70,150, she does itemize deductions and her marginal tax rate is 28%  Ms. C received no reimbursement. Her AGI is $25,300, she does itemize deductions and her marginal tax rate is 15%

25. 15-25 Moving Expenses  Unreimbursed moving expenses are deducted in computing AGI (not an itemized deduction)  Costs to transport household goods and personal belongings including automobiles  Travel costs except meals  Requirements for moving expenses  New job meeting certain mileage and time of work requirements

26. 15-26 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 deferral is big!  Withdrawal cannot begin before age 59 ½ (without 10% penalty) but must begin after 70 ½  Basic types of qualified plans: a) employer-provided, b) self-employed (Keogh), c) IRAs for wage earners

27. 15-27 Attributes - Qualified Plans  Plan cannot be discriminatory; $ limits in law  Salary contributed to plan is not currently taxed (IRA, 401K, defined contribution plans)  Employer generally gets a deduction for funding the plan  The plan itself is tax exempt, so earnings are not taxed as they accumulate

28. 15-28 Attributes - Qualified Plans  Retiree is taxed on withdrawals of all amounts  Premature withdrawals are subject to a 10% excise tax. Exceptions  Owner becomes disabled  Owner reaches age 55 and becomes unemployed  Amounts withdrawn upon owner’s death

29. 15-29 Tax Advantages of Typical Qualified Plan  Contributions made with pre-tax dollars  Earnings accumulate tax free within the plan  Withdrawals taxed to beneficiary upon retirement, often at a lower tax rate than would have applied in year of contribution

30. 15-30 Employer Plans  Two policy objectives  Employer-provided plans should carry minimum risk for participating employees  Employer-provided plans should provide benefits in an equitable manner to all participating employees

31. 15-31 Employer Plans – 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  $185,000 (in 2008)

32. 15-32 Employer Plans – 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  100% of annual compensation or  $46,000 (in 2008)

33. 15-33 Employer Plans – Defined Contribution  Types of Defined Contribution plans include  Profit-sharing plans – firms contribute a % of current earnings to a retirement trust  Employee Stock Ownership plans (ESOPs) – employer contributions are invested primarily in the employer’s own common stock  401K plan - the employer and employee both contribute. Employee contribution limit = $15,500 in 2008

34. 15-34 Employer Plans - Nonqualified  Nonqualified deferred compensation -  Employee delays paying tax until she receives money  Employer delays deducting salary expense until it pays money  Employer accrues a liability but does not set aside any cash or property  Often used by top executives  Since nonqualified, these plans can discriminate!

35. 15-35 Self-Employed Plans - Keogh  Contribute up to the lesser of  20% of earned income from self-employment  $46,000 in 2008  Must not discriminate; if owner has employees then he/she must provide retirement benefits to them  Business earnings invested in Keogh plans are not taxable to employee and earnings are tax-exempt

36. 15-36 Individual Retirement Accounts  Individuals contribute the lesser of  $5,000 (in 2008) or  100% of compensation (but each spouse may contribute $5,000 if combined earned income = $10,000)  A taxpayer reaching age 50 by year-end may make an additional $1,000 catch-up contribution  Deduction for contribution is limited  If taxpayer participates in a qualified plan (phase-out range for MFJ starts at $85,000 in 2008)  If spouse participates in a qualified plan (phase-out range for MFJ starts at $159,000)

37. 15-37 IRA Contribution Example  Indicate whether the following statements are true or false  The maximum amount that taxpayers under age 50 can contribute to an IRA is $5,000  True  If a husband earns $5,000 and a wife earns $3,500, the maximum contribution the two can make to an IRA is $10,000  False, the maximum contribution is $8,500

38. 15-38 IRA Contribution Example  If a husband earns $4,000 and a wife receives $5,000 in interest, the maximum contribution the two can make to an IRA is $4,000  True. Interest is not earned income. Thus, the wife has no compensation and cannot contribute to an IRA.

39. 15-39 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!

40. 15-40 Roth IRA  Roth IRA works differently from traditional IRA  NO deduction when contributed, but NO tax when distributed  Roth is better than traditional IRA if you expect tax rates to increase  Roth not available for high-income individuals - e.g. MFJ AGI>$169,000

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