1. Chapter 15 Compensation and Retirement Planning McGraw-Hill Education
Copyright © 2015 by McGraw-Hill Education. All rights reserved.

2. Objectives Distinguish between employees and independent contractors
List the factors determining reasonable compensation for a shareholder-employee
Identify the most common nontaxable employee fringe benefits
Describe the tax consequences of stock options
Compare the after-tax wealth accumulated in a qualified and a nonqualified retirement plan

3. Objectives (continued)
Distinguish between defined-benefit and defined-contribution plans
Explain why employers use nonqualified deferred-compensation plans
Describe the tax benefit of a Keogh plan to a self-employed individual
Describe the tax benefits of traditional and Roth IRAs

4. 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 a wage or salary

5. Employee versus Contractor
Independent contractor is a self-employed individual
Who performs services for a fee
Who controls the way the services are performed
Whose work relationship with client is temporary
Who can have many clients at the same time

6. Employee versus Contractor
Employees
Employer withholds income and payroll taxes from salary or wage payments
Employer issues Form W-2 to employees
Independent contractors
Clients don’t withhold tax from fee payments
Contractor reports fees as Schedule C business income
Contractor pays income and self-employment tax directly
Client issues Form 1099-MISC to independent contractors

7. Employee versus Contractor
Self-employed individuals have relatively low level of compliance because they fail to file or they understate income
IRS takes an aggressive stance regarding worker classification
How is worker classification decided?
Based on facts and circumstances including:
Degree of supervision
Materials provided
Person versus job

8. Compensation payments
Employers treat compensation payments as either:
Deductible ordinary and necessary business expenses
Capitalized costs
Compensation is ordinary income to recipient

9. Foreign Earned Income Exclusion
Expatriates are U.S. citizens who reside and work overseas on an extended basis
Can exclude $99,200 (2014) foreign salary or wages from gross income for U.S. tax purposes
Can’t claim foreign tax credit (see Chapter 13) on excluded income

10. Employee Fringe Benefits
General rule: fringe benefits are taxable
Nontaxable fringe benefits include:
Health and accident insurance
$50,000 group-term life insurance
Dependent care assistance

11. Employee Stock Options
Stock option is the right to buy stock in the future for a set price (option price or strike price) for limited period of time
Option price usually is less than or equal to market price of the stock on date the option is granted
Stock options are a form of compensation that requires no cash outlay by corporate employer

12. Stock Options - Grant Date
Under GAAP, firms must record compensation expense equal to FMV of option at grant date
Tax rules:
No deduction to employer when option is granted
No income to employee on receipt of option
Tax consequences when employee exercises an option depends on whether the option is a:
Nonqualified stock option (NSO)
Incentive stock option (ISO)

13. Nonqualified Stock Option (NSO)
Employee has taxable compensation equal to excess of FMV of stock over exercise price
Taxable excess is referred to as the bargain element
Employee’s basis in stock is FMV at exercise date
Employer is allowed a deduction in the year of exercise equal to employee’s taxable compensation

14. Incentive Stock Option (ISO)
No compensation income to employee on exercise of ISO
Employee’s basis in stock is cost
Untaxed bargain element is AMT preference item
No employer deduction for bargain element

15. Employee Expenses
When employers reimburse employees for employment-related expenses, employees don’t report the reimbursement as income or deduct the expense

16. Employee Expenses
Employees may deduct unreimbursed business expenses as miscellaneous itemized deductions
Miscellaneous itemized deductions are deductible only to extent they exceed 2% of AGI
Consequently, employees may derive no tax benefit from unreimbursed business expenses

17. Moving Expenses
Employee unreimbursed moving expenses are an above-the-line deduction
Costs to transport household goods and personal belongings
Certain travel costs for family members
Household move must be required by commencement of employment in a new place of work

18. Retirement Planning Key concepts
Qualified plans provide deferral of tax on earned income. Compounding effect of deferral can be significant!
Individuals must include withdrawals from qualified plans in ordinary gross income
Withdrawals before age 59½ subject to 10% penalty
Withdrawals must begin when individual reaches age 70½
Types of qualified plans
Employer-provided
Self-employed (Keogh)
IRAs

19. Employer-provided 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
Plans can’t discriminate in favor of highly compensated employees

20. Defined Benefit Plans
Employer assumes risk and promises a certain retirement income stream (pension) to participating employees
Annual pension limited to the lesser of:
Average compensation for employee’s three highest compensation years
$210,000 (2014)

21. Defined Contribution Plans
Employer contributes a defined amount each year to each participating employee’s retirement account
Employee may choose how the balance in the account is invested
Employee bears investment risk
Annual contribution limited to the lesser of:
100% of annual compensation or
$52,000 (2014)

22. Types of Defined Contribution Plans
Profit-sharing plans – Employer contributes percentage of current earnings to employees’ retirement accounts
Employee Stock Ownership plans (ESOPs) – employer contributions are invested in employer’s stock
401(k) plans – Participating employees elect to contribute current compensation to their retirement accounts
Contributions are excluded from current income
Contribution limit = $17,500 (2014)

23. Nonqualified Plans Nonqualified deferred compensation
Employee doesn’t recognize deferred compensation as income until payment is received
Employer can’t deduct deferred compensation expense until payment is made
Employer accrues a liability for unfunded deferred compensation
Used to compensate top executives on a discriminatory basis

24. Self-Employed Plans - Keogh
Self-employed individuals can contribute and deduct the lesser of:
20% of earned income from self-employment
$52,000 (2014)
If individual’s business has employees, the Keogh plan must provide them with retirement benefits on a nondiscriminatory basis

25. Individual Retirement Accounts
Any individual who earns compensation or self-employment income can save for retirement through an individual retirement account (IRA)
IRAs are tax-exempt so that earnings on the account grow at a before-tax rate
With a traditional IRA, earnings on the account are taxed when the owner withdraws them
With a Roth IRA, withdrawals are tax-exempt so the earnings on the account are never taxed

26. IRA Contributions
Individuals can contribute up to $5,500 to an IRA in 2014
Contribution limited to 100% of compensation/self-employment income
Additional $1,000 catch-up contribution for individuals who reach age 50 by year-end
Special rules:
Traditional IRAs – no contribution after age 70½
Roth IRAs – amount of contribution phased down to zero for higher-income individuals

27. Deduction of IRA Contributions
Traditional IRAs – contributions can be fully deductible, partially deductible, or nondeductible based on two factors:
Participation or nonparticipation by the individual in another qualified retirement plan
AGI level (deduction phased down to zero for higher- income taxpayers)
Roth IRAs – contributions are nondeductible

28. IRA Withdrawals Traditional IRAs
Withdrawals must begin when owner reaches age 70½
Tax consequences of withdrawals:
Amount attributable to deductible contributions and accumulated earnings is taxed as ordinary income
Amount attributable to nondeductible contributions is excluded from income

29. IRA Withdrawals (con’t)
Roth IRAs
Qualified withdrawals are tax-exempt
Contributions are qualified if they occur after:
Owner has reached age 59½
Five-year period beginning with year of initial contribution

30. Rollover IRAs
Individuals can avoid tax (and premature withdrawal penalty) on distributions from qualified plans by rolling the distribution over into a traditional IRA
Rollover continues tax deferral on retirement income until owner makes a withdrawal from the IRA
Individuals can roll over distributions into a Roth IRA, regardless of their income level
Rollover from a tax-deferred retirement account to a tax-exempt Roth IRA is a taxable event