1. McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Principles of Taxation Chapter 14 Compensation and Retirement

2. Slide 14-2 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Objectives  Employees versus self-employed  Family compensation planning  Nontaxable employee fringe benefits  Stock options  Employee-related expenses  Qualified versus nonqualified retirement plans  Deferred compensation

3. Slide 14-3 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Employee versus Contractor  Who cares?  Why would an employer rather treat the worker as a contractor?  Why would the IRS rather treat the worker as an employee?  What will the worker prefer?  How to decide?  Regulations, rulings and court cases  See www.irs.ustreas.gov/prod/bus_info/emp_tax/ind ex.html for information about employment tax.  What are some characteristics of employees?

4. Slide 14-4 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Salaries  Employers may deduct wages if they are ordinary business expenses.  Exception: cash compensation > $________________ to a top-5 officer is not deductible unless it is performance based.  Wages are taxable to employees at ordinary rates.  Family salary issues are a review of Chapter 9 and 10. Why does the IRS care if a family corporate pays too much salary to its owners?  What are the factors in deciding reasonable compensation?

5. Slide 14-5 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Foreign Earned Income Exclusion  What are Expatriates?  Exclude $__________ (2001 limit) from taxation in the U.S.  Can an employee claim a foreign tax credit (see Chapter 12) on excluded income?

6. Slide 14-6 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Employee Fringe Benefits  General rule: Fringe benefits are taxable.  Exclusions of fringe benefits are usually:  A social welfare benefit (health, life ins, child care),  Hard to enforce anyway (de minimis rules, cisounts),  Non-discriminatory, or  Necessary for job (moving expenses, supplies at work).

7. Slide 14-7 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Employee Fringe Benefits  Why are these advantageous to employees?  Cafeteria plans allow broader employee choices among same-cost options for employer.

8. Slide 14-8 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Specific Fringe Benefit Examples  When is health insurance or coverage nontaxable?  Only cost to provide group term life insurance benefits > $___________ is taxable.  Dependent care assistance up to $______________ is excluded.  See http://www.irs.ustreas.gov/prod/forms_pu bs/pubs/p5350404.htm for an IRS summary of other nontaxable fringe benefits.

9. Slide 14-9 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Employee Stock Options -BIG $$$’s  Stock option defined: The right to buy stock in the future for a set price (called the exercise price).  General attributes: When the stock option is granted, the option price is the FMV at the date of the grant.

10. Slide 14-10 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Stock Options - Grant Date  GAAP rules: Must disclose compensation element due 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).

11. Slide 14-11 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Employee Stock Options - Nonqualified Stock Option (NSO)  Employee has salary income equal to difference in _________________ and__________________.  Employee’s new basis in stock is_____________________.  Employer gets tax deduction equal to______________________.  When employee sells stock in future, he generates a capital gain (loss) = _______________- basis (= $FMV date of____________).

12. Slide 14-12 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 NSO Example  The CFO is granted 100 options (NSOs) in 1990 at a price of $10 per share, when the stock is trading at $10 per share. In 1994, he exercises these shares when the FMV of the stock is $25 per share. In 1996, 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?  1990 - no tax effect to either party  1994 - CFO salary income $1,500, salary deduction $1500  1996 - capital gain $500, no company deduction.

13. Slide 14-13 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 NSO Example (You Do It)  The Treasurer is granted 100 options (NSOs) in 1990 at a price of $10 per share, when the stock is trading at $10 per share. In 1995, she exercises these shares when the FMV of the stock is $30 per share. In 1998, she sells these shares at $36 per share.  What is the amount, character, and timing of the Treasurer’s income and the corporation’s deduction?

14. Slide 14-14 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Employee Stock Options - Incentive Stock Option (ISO)  Employee has no salary income on exercise. AMT adjustment = untaxed bargain element.  Does the employer get a wage deduction?  Employee has basis in stock equal to_______________________.  When employee sells stock in future, he generates at capital gain (loss) = _________-___________.

15. Slide 14-15 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 ISO Example  The CFO is granted 100 options (ISOs) in 1990 at a price of $10 per share, when the stock is trading at $10 per share. In 1994, he exercises these shares when the FMV of the stock is $25 per share. In 1996, 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?  1990 - no effect  1994 - no effect (except AMT)  1996 - $2000 capital gain, no corporate deduction

16. Slide 14-16 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 ISO Example (You Do It)  The Treasurer is granted 100 options (ISOs) in 1990 at a price of $10 per share, when the stock is trading at $10 per share. In 1995, she exercises these shares when the FMV of the stock is $30 per share. In 1998, she sells these shares at $35 per share.  What is the amount, character, and timing of the Treasurer’s income and the corporation’s deduction?

17. Slide 14-17 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Employee Stock Options - Thinking  Which would employee prefer?  Which would employer prefer?  Do you expect preference has changed over time?

18. Slide 14-18 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Employee Expenses  Unreimbursed expenses are deductible to the extent they exceed _____% of AGI.  These are ITEMIZED deductions.  2% limit, combined with itemized requirement, means most employees can’t use.

19. Slide 14-19 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Moving Expenses  Unreimbursed moving expenses are deducted in computing AGI. Form 3903 flows to Line 25 of 1040.  This is more advantageous because you can take the deduction even if you are using the standard deduction.  Requirements for moving expenses:

20. Slide 14-20 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Retirement Planning  This is COMPLICATED - we are only covering highlights.  Main concepts to learn in this course:  Qualified plans provide DEFERRAL (sometimes exemption) of tax on earnings. The compounding effect of this is BIG.  Withdrawal cannot begin before age ________without penalty, but must begin after age___________  Basic types of qualified plans: a) employer, b) self-employed (Keogh), c) IRA

21. Slide 14-21 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Attributes - Qualified Plans  Plan cannot be discriminatory; $ limits in law.  Are current earnings of the plan taxable? (IRA, 401K, Defined contribution plans)  When does the employer usually get a deduction?  Are contributions taxable to the employee?  Retired person is taxed on withdrawals of all amounts.  Premature withdrawals _______ % excise tax.

22. Slide 14-22 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Tax Advantages of Typical Qualified Plan  Formula: {$1 / (1-tp 0 )} x (1+R) n x (1-tp n )  This means that the dollar after the benefit of the tax deduction in period 0, accumulates for n periods at tbe before tax rate, then the total is taxed at the rate in period n.  Having a higher rate in the year you contribute (tp0), and a lower rate in the year you withdraw (tpn) makes this worth more.

23. Slide 14-23 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Employer Plans - Qualified  Qualified plans cannot discriminate - have $ limits.  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  ______% of average _______ highest years’ wages  $___________ (in 2001).

24. Slide 14-24 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Employer Plans - Qualified  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  ______% of annual compensation or  $__________ (in 2000).  401K plan - the employer and employee both contribute. Employee contribution limit = $__________. MY ADVICE - Start right away!

25. Slide 14-25 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Employer Plans - Nonqualified  Nonqualified deferred compensation:  Employee delays paying tax until when?  Corporation delays deducting salary expense until when?  Often used by top executives.  Since nonqualified, these plans CAN discriminate!

26. Slide 14-26 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Self-Employed Plans - Keogh  Contribute up to the lesser of  ____% of earned income from self- employment  $___________ in 2001.  Must not discriminate. If owner has employees then he/she must provide retirement benefits to them.

27. Slide 14-27 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Individual Retirement Accounts  Individuals contribute the lesser of  $________ or  ______ % of compensation (but each spouse may contribute $2000 if combined earned income = $4000).  Deduction for contribution is limited  if taxpayer participates in a qualified plan (phase-out range for MFJ starts at $53,000 in 2001).  if spouse participates in a qualified plan (phase-out range for MFJ starts at $150,000).

28. Slide 14-28 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 IRA Withdrawals  Withdrawal is ordinary income if all contributions were deductible.  If some contributions were nondeductible:  nontaxable withdrawal % = _______________/___________________.  Early withdrawals subject to 10% penalty, except:  $__________________ withdrawal for “first-time homebuyer.”  Funds to pay higher education expenses.

29. Slide 14-29 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Roth IRA  Roth works differently from general rule.  NO deduction when contribute, but NO tax when distribute.  Formula = $1 x (1+R) n  Roth is better than regular if you expect tax rates to increase.  Roth not available for rich - e.g. MFJ AGI>____________.