1. Employee Compensation
Chapter 4
Employee Compensation

2. Employee Compensation
All forms of compensation (including salaries, wages, bonuses, tips, and fringe benefits) are taxable as ordinary income to employees unless specifically excluded by a provision in the Code
Employers can deduct all compensation expenses

3. Payroll Taxes for Employees
FICA rate is 7.65%
6.2% for Social Security % for Medicare
Social security portion is only charged on the first $90,000 for 2005

4. Payroll Taxes for Employers
Employer withholds FICA tax from employee; employer matches employee FICA and forwards total to government
Employer can deduct employer’s share of tax
No deduction for employee’s share of tax

5. Other Payroll Taxes
Employers are also required to pay other types of payroll taxes such as federal and state unemployment taxes
FUTA rate is 6.2% on first $7,000
State unemployment taxes vary
These taxes are all deductible by the employer paying them

6. Employee vs. Independent Contractor
Independent contractors (and other self-employed individuals) pay their own Social Security and Medicare taxes
This is called the self-employment tax
Workers considered employees (instead of an independent contractor) if the employer has the right to control and direct the end result and the means by which the result is accomplished
Rev. Rul provides 20-factor test

7. Timing of Compensation
Salaries and bonuses are usually deductible by the employer when accrued
Exceptions
Compensation accrued but not paid within 2½ months of year-end is not deductible until paid
Compensation accrued to cash-basis related party not deductible until paid

8. Related Parties Related parties include:
Family members (brothers, sisters, spouse, ancestors, and lineal descendants, but not in-laws)
A taxpayer and a corporation in which the taxpayer directly or indirectly owns more than 50% of the stock (indirect ownership includes stock owned by family members)
Other relationships such as partners/partnerships and beneficiaries/trusts

9. Reasonable Compensation
Reasonable compensation – amount similar business would pay for the services under similar circumstances
If a shareholder-employee’s salary is considered unreasonable, the excess can be reclassified by IRS as a nondeductible dividend
If unreasonable compensation is paid to a party related to a shareholder, the excess can be reclassified as a nondeductible dividend to the shareholder

10. Excessive Compensation
Deductible compensation paid to CEO and 4 highest-paid officers of publicly-held corporations is limited to $1 million per year
This compensation limit does not include amounts that represent
Compensation based on individual performance goals (if approved in advance by outside directors)
Compensation paid on a commission basis
Employer contributions to a qualified retirement plan
Tax-free employee benefits

11. S Corporations & Low Salaries
There is an incentive for an S corporation to pay an unreasonably low salary to a controlling shareholder-employee to minimize payroll taxes, as S corporation profits are not subject to payroll taxes
IRS can reclassify some of S corporation’s distribution as salary, requiring payment of additional employment taxes

12. Employing Children
Compensation paid to children is deductible if reasonable for the services actually performed
Wages paid to an employer’s child under age 18 are not subject to employment taxes (if not paid by a corporation)
Standard deduction for a single individual is $5,000 in 2005; this amount can be paid to a child without tax consequences

13. Foreign Earned Income
Qualifying earned income includes most income earned from working in a foreign country including salary, bonuses, allowances and noncash benefits
U.S. government employees not eligible
Exclusion is $80,000 per year
Taxpayer must work outside the U.S. for entire year or 330 days during a period of 12 consecutive months

14. Foreign Tax Credit
Employees who do not qualify for the exclusion include the income in taxable income and claim a tax credit (or a deduction) for taxes paid to the foreign government
The foreign tax credit cannot exceed the amount of U.S. tax that would have been paid on the foreign income
The foreign tax credit is generally more advantageous than the deduction

15. Fringe Benefits
Tax-free fringe benefits are not taxable as income to the employee but are deductible by the employer
Most tax-free benefits are limited in dollar amount
If an employer pays an amount in excess of the limit (or pays for something that is not a qualified tax-free benefit), it is treated as taxable compensation (income to the employee and deductible by the employer)

16. Group Term Life Insurance
Premiums on the first $50,000 of employer-paid group term life insurance coverage may be excluded from employee's gross income
Excess over $50,000 is included in income
Amount determined from IRS table based on employee's age at year end, rather than cost

17. Group Term Life Insurance Monthly amount per $1,000 of taxable coverage
Employee’s Age
Monthly Amount
Under 25
$.05
25 to 29
.06
30 to 34
.08
35 to 39
.09
40 to 44
.10
45 to 49
.15
50 to 54
.23
55 to 59
.43
60 to 64
.66
65 to 69
1.27
70 and above
2.06

18. Group Term Life Insurance
If the insurance plan is discriminatory, key employees must report gross income equal to the greater of
Employer’s actual premiums paid or
Benefit determined from the table (without $50,000 exclusion)

19. Health and Accident Insurance
Value of insurance premiums paid by employers on behalf of employees and their families are tax-free
Self-insured discriminatory plans may result in taxable income to highly-compensated employees

20. Dependent Care Benefits
An employer can provide up to $5,000 ($2,500 if MFS) for the care of an employee's dependents during working hours through an on-site or off-site facility
Highly-compensated employees cannot exclude benefits if they are discriminatory

21. Cafeteria Plans
A qualified cafeteria plan allows an employer to offer employees the option of choosing cash or nontaxable fringe benefits
Exception to constructive receipt doctrine
If employee chooses cash, the cash is taxable
If employee chooses nontaxable fringe benefits, they are excludable

22. Cafeteria Plans
Benefits can be funded with employer contributions or by employees voluntarily electing to reduce their salaries (allowing employees to obtain fringe benefits with before-tax dollars)
These plans are sometimes called flexible spending arrangements (FSA)

23. Cafeteria Plans
Some nontaxable benefits that can be offered include coverage for medical and dental care, group-term life insurance up to $50,000, and dependent care assistance
Any amounts set aside in a flexible spending plan must be used before the end of the year or they are lost

24. Meals and Lodging
Value of meals and lodging provided by an employer to an employee are excluded if:
Provided for the employer's convenience and
Provided on the employer's business premises and
Employee required to occupy the lodging to perform employment duties
If an employee is given a choice between additional compensation or meals and lodging, the value of any meals and lodging is taxable

25. No-Additional-Cost Services
When an employer provides services for its employees and incurs no substantial additional cost (excess capacity services), employees can exclude the value of the services from gross income
Example: Free or discounted seats on an airplane when the employee does not displace a paying customer

26. No-Additional-Cost Services
This exclusion applies only to services received, not property
Only employees who work in the line of business that renders similar services are allowed to exclude the benefits (baggage handlers who work for an airline can fly free)
In addition to current employees, the exclusion is available to former employees, as well as spouse and dependents

27. Employee Discounts
Property or services provided to employee at below FMV treated as taxable income to employee, unless within the qualified employee discount limits
Only property and services offered to customers in the ordinary course of the employer's business qualifies
Full discount excluded if discount does not exceed gross profit percentage times price charged to customers
For services, discount can’t exceed 20%

28. Employee Awards
Employee awards generally are treated as taxable compensation
Exceptions for length of service or safety awards
Qualifying employee awards must be made with tangible property (no cash)
Average cost of qualified plan awards limited to $400, but individual awards can be as much as $1,600

29. De Minimis Fringe Benefits
Employees who receive “de minimis” (very small in value) property or services from their employers can exclude the value from gross income
An amount is considered de minimis when the value is so small that accounting for it is unreasonable or impractical
Examples: coffee & doughnuts, company picnics, limited use of copy machine, etc.

30. Transportation & Parking
Exclusions limited:
Transit passes and special carpool commuting expenses (combined value of up to $105 per month)
Free or discounted parking (up to $200 per month in 2005)

31. Athletic Facilities
Employees (and their families) who use employer-provided athletic facilities that are located on the employer’s business premises can exclude the value of the benefit from gross income
Facilities include tennis courts, gymnasiums, and swimming pools

32. Working Condition Fringe Benefits
Working condition fringe benefits can be excluded from the employee’s gross income if the employee would have been entitled to a tax deduction if he had actually paid the expense
Examples: job-related education, professional membership dues
Discriminatory benefits can still be excluded

33. Employee Use of Company-Owned Cars
The value of an employee’s personal use of a company car is a taxable fringe benefit
In determining the amount of income to be taxed to the employee for personal use, there are 3 methods:
Lease value (from table)
Cents per mile rate (40.5¢ in 2005)
Commuting method (valued at $1.50 per one-way trip)

34. Relocation Expenses
Qualified direct moving expenses include the reasonable cost of moving household belongings and family members from the old home to the new home by the shortest and most direct route
No dollar limit
Indirect expenses such as house-hunting or temporary living expenses do not qualify

35. Relocation Expenses
Moving expenses are deductible if they are related to assuming duties at a new place of business and both the distance and time requirements are met
Distance test - distance from old residence to new job must be at least 50 miles greater than the distance from old residence to old job
Even though a taxpayer is required to relocate, no deduction is allowed if the distance test is not met

36. Relocation Expenses
Time Test - taxpayer must work as an employee at the new location for 39 weeks during the 12 months following arrival
Self-employed person must work for 78 weeks during the 24 months following arrival
Exceptions allowed in event of death, disability, involuntary separation, or transfers for the employer’s benefit
Qualified moving expenses that are not reimbursed are deductible for AGI by employee

37. Education Assistance Plans
Up to $5,250 a year of employer-provided educational assistance benefits can be excluded
Courses do not need to be job-related.
Excludable benefits are payments for tuition, fees, books, supplies, and equipment

38. Job-Related Education
No dollar limit if education expenses are related to the current job of the employee
Qualified educational expenses include tuition, fees, books, and transportation from job to class
Expenses that meet the minimum education requirements for the taxpayer’s job or qualify taxpayer for a new profession do not qualify for exclusion

39. Substantiating Expenses
Accountable Plan - an employee provides adequate accounting to the employer and refunds to the employer any excess payments
Adequate Accounting - provides details concerning the time, date, place, business purposes, and the amount of the expense
If an employee makes an adequate accounting, and the reimbursement exceeds the deductible expenses, the employee must include the excess in income

40. Substantiating Expenses
Nonaccountable plan does not require the employee to substantiate expenses or refund excess advanced funds
Employer must report all of the reimbursed expenses on employee’s W-2
Employees who receive advances in a nonaccountable plan must report details of both the reimbursement and the expenses
Employee’s deductions are subject to 2% AGI floor for miscellaneous itemized deductions

41. Restricted Stock Value not taxed until stock vests
Employee recognizes ordinary income = FMV of stock when vested
Dividends taxed as ordinary income prior to vesting
Election to accelerate income made by recognizing income = FMV in year of receipt
No deduction for loss if forfeited

42. Stock Options
Option – right to purchase stock at guaranteed strike price for a specific time
Grant date – date option offered to individual
Exercise date – date option used to purchase stock
Bargain element – difference between strike price and FMV of stock

43. Nonqualified Stock Options
Employee recognizes ordinary income equal to the bargain element on the date the NQSO is exercised
Employer gets matching compensation deduction for bargain element
Employee’s basis for stock is cash paid + income recognized

44. Incentive Stock Options
ISOs provide more favorable treatment for employee
ISOs do not trigger any income recognition at the date of grant or exercise
Income is recognized only upon the sale of the stock, usually as long-term capital gain
But bargain element is an individual AMT adjustment
Employer receives no compensation deduction

45. Phantom Stock and SARs
Phantom stock plan - deferred compensation is hypothetically invested in shares of company’s stock
At the end of deferral period (such as at retirement), the employer pays the employee the FMV of the phantom shares
Stock appreciation right (SAR) plan - employees are given the right to receive a cash payment equal to the appreciation in value of employer’s stock for a certain period of time
Employees recognize income only when they exercise

46. Qualified Deferred Compensation Plans
Funded plans that receive favorable tax treatment:
Employer contributions are deducted as they are paid into the trust
Earnings on these contributions accumulate tax-free until withdrawn
Benefits are taxable to the employee only when actually received

47. Distributions
When funds are withdrawn, taxes must be paid by employee on
All earnings
All employer contributions
All pre-tax (deductible) employee contributions
Employee must begin distributions by age 70½

48. Distributions
Premature withdrawals - 10% penalty (in addition to income tax) for taking distributions before age 59 ½
A taxpayer may roll over all or part of a distribution within 60 days without paying any tax or penalty on the distribution
Lump sum distributions are subject to 20% withholding unless there is a direct trustee to trustee transfer

49. Types of Plans Defined Benefit – provides fixed benefit at retirement
Employer assumes the risk that the plan assets will be sufficient to pay benefits
Defined Contribution - amounts contributed are determined according to a formula
Employee’s benefit is dependent upon employer’s contributions and the actual earnings in the individual account

50. 401(k) Plans
Employees can elect to have employer contribute part of their salary to plan on pretax basis
In 2005, up to $14,000 plus extra $4,000 if age 50 or older
Flexibility - employee can elect each year to have a different amount contributed
Employer may match some of the contributions

51. Other Plans Employee stock ownership plans (ESOPs)
Simplified employee pension plans (SEPs)
Savings incentive match plans for employees (SIMPLE)
SIMPLE 401k plans

52. Nonqualified Deferred Compensation
Advantages - no dollar limits and can be offered on a discriminatory basis
Employer receives a deduction only upon the actual payment of benefits to the employee
Employee recognizes income upon the actual receipt of these benefits

53. Nonqualified Deferred Compensation
Employer accrues liability on financial statements, but no cash is set aside
If the employer’s business fails, the employee is merely an unsecured creditor

54. Individual Retirement Accounts (IRA)
Individuals can contribute up to $4,000 ($4,500 if age 50 or older) or earned income if less
A married taxpayer can contribute for a nonworking spouse
Qualified contributions are deductible for AGI
Deductions not allowed if the individual is a participant in an employer-sponsored retirement plans, unless AGI is below certain limits

55. IRA Phaseout Limits
Deductible contribution phased out in 2005 for AGI over a range
Single $50,000 - $60,000
Married filing jointly $70,000 - $80,000
Zero if married filing separately
If spouse an active participant, phaseout over AGI of $150,000 - $160,000

56. Roth IRA Taxpayers may make nondeductible contributions to a Roth IRA
Contributions phase out if AGI between
$95,000 - $110,000 if single
$150,000 -$160,000 if married filing joint return
Contributions to Roth and the regular IRA cannot exceed a total of $4,000 ($4,500 if age 50 or older)

57. Roth IRA
Primary advantage of Roth IRA – able to withdraw earnings & contributions tax-free
Distributions from Roth IRAs are not subject to minimum distribution rules
Do not have to begin by age 70½
But cannot be made for first 5 years and taxpayer must usually be at least age 59½

58. Self-Employment Taxes
Self-employed individuals must pay both the employer’s and the employee’s share of FICA taxes for a combined rate of 15.3%
12.4 % (6.2% x 2) for Social Security on income up to $90,000 in 2005
2.9% (1.45% x 2) for Medicare – no income limit

59. Self-Employment Taxes
Tax computed on Schedule SE
Self-employed individuals are also allowed a deduction for AGI for the employer’s half of self-employment taxes
Calculated by multiplying net income from self- employment by 92.35% (100% %) before calculating SE tax
There is no deduction for the employee’s half of the taxes

60. Fringe Benefits for Self-Employed
Self-employed individuals (including sole proprietors, partners, and greater than 2% shareholders of S corporations) do not qualify for most fringe benefits on a tax-free basis
Special deduction for AGI applies to health insurance for self-employed individuals

61. Retirement Plans for Self-Employed
Keogh (HR 10) plan has limits on contributions similar to corporate retirement plans
Contributions are deductible for AGI
Extending return due date also extends deadline for making contributions to plan
Earnings and deductible contributions fully taxed when withdrawn
May also contribute to an IRA unless limitations apply

62. The End