1. Module 12 Compensation and Fringe Benefits

2. Module Topics n Employer-Employee Motivations n Forms of Compensation n Property Transfers n Fringe Benefits n Flow-Through Entities n IRS Challenges n Equity-Based Compensation

3. Employer-Employee Motivations Key Learning Objective Distinguish the preferences that employers and employees may have for certain types of compensation

4. Parties to Consider n Employer n Employee n Government

5. Why Pay Compensation? n To attract, motivate, and retain employees n To distribute closely-held corporate earnings at lowest tax cost n To compensate family members

6. Motivations n Different employees are attracted to different types of compensation packages n Employers often use performance-based bonuses as motivation

7. Forms of Compensation Key Learning Objective n Distinguish between current and deferred forms of compensation

8. Current Compensation and Short-Term Bonuses n Paid in year services are performed and generally subject to payroll taxes u Salary and wages u Prizes and awards u Vacation and sick pay u Property transfers u Fringe benefits (many excluded from payroll tax) u Commissions u Bonuses (often short-term performance based)

9. Deferred Compensation n Paid in future for services performed currently u e.g., retirement plan n Employer and/or employee may prefer this timing arrangement u e.g., lower marginal rate after retirement n Often used to reward long-term performance

10. Forms of Deferred Compensation n Qualified plan u Meets certain tax law requirements *Coverage*Nondiscrimination*Vesting*Funding n Nonqualified plan u Does not meet the requirements

11. Qualified Plans-- Potential Benefits n Immediate deduction for employee n Nontaxable to employee until payments are received n Deferral of tax on earnings until funds are distributed n Reduced or deferred tax on lump-sum distributions

12. Deferred Compensation-- Nonqualified Plans n No deduction by employer until employee reports income n Often limited to a select group of employees n Generally not currently funded

13. Nonqualified Plans-- Funded vs Unfunded n Funded u Generally income to employee when funded u Not income if creditors can reach funds u Key factor: Are funds subject to a substantial risk of forfeiture? n Unfunded u No tax consequences to employer or employee until payment is made

14. Property Transfers Key Learning Objective n Determine the tax treatment of compensation paid in property

15. Property Transfers n Use FMV of property to measure compensation n Employer gets deduction when employee reports income n Property is generally income when received unless it is: u Not freely transferable, and u Subject to a substantial risk of forfeiture

16. Research Query n An employee receives property from an employer subject to a requirement that it be returned if the total earnings of the employer do not increase. n Does the employee have income when the property is received?

17. Solution--Research Query n No. The property is subject to a substantial risk of forfeiture. u Reg. § 1.83-3(c)(2) n Note that conditioning a property’s return upon not accepting a job with another firm or being discharged for cause are generally not treated as resulting in a substantial risk of forfeiture.

18. Fringe Benefits Key Learning Objective n Identify the most common forms of fringe benefits offered to employees

19. Some Common Fringe Benefits n Group-term life insurance n Accident and health care coverage n Dependent care assistance n Employee discounts n Employer provided meals and lodging n Moving expense reimbursement n Employee death benefits n Qualified transportation benefits

20. Non-Cash Fringe Benefits Key Learning Objective n Determine the tax treatment of compensation paid in the form of non-cash fringe benefits

21. Fringe Benefits-- Potential Advantages n Cost of benefits deductible by employer n Value of benefits tax-free to employee n Not subject to payroll taxes

22. Fringe Benefits-- Some Disadvantages n Can be costly to comply with statutory rules n Most benefits must be offered on a nondiscriminatory basis to obtain favorable tax treatment

23. Some Specific Fringe Benefits n Accident and health plans u Includes self-insured plans n Group-term life insurance u First $50,000 of coverage tax-free n Dependent care assistance u $5,000 annual exclusion

24. Generic Fringe Benefits n No additional cost benefits n Qualified employee discounts u Goods--gross profit percentage u Services--20% n Working condition benefits* n De minimis benefits* *generally can discriminate

25. Compliance Query n T, an employee of QRS Corporation, buys a TV from QRS for $400. The regular price is $600, and the gross profit percentage is 25%. n How much income should T recognize?

26. Solution--Compliance Query n T’s income is $50 Discount taken ($600 - $400)$200 Allowable discount ($600 x 25%) 150 Income $50 Income $50

27. Fringe Benefits-- Cafeteria Plans n Allows employee to choose between cash and one or more excludable fringe benefits n Choosing excludable fringe benefit does not trigger constructive receipt of cash

28. Fringe Benefits-- Flexible Spending Accounts n Benefit offered within a cafeteria plan n Available for medical or dependent care n Employee pays expenses with “pre-tax dollars” n Saves income and payroll taxes n Use-it-or-lose-it risk

29. Flow-Through Entities Key Learning Objective n Determine the tax treatment of fringe benefits offered to owners of flow-through entities

30. Partners and > 2% S Corporation Shareholders n NOT entitled to tax benefits available for: u Cafeteria plans u Employee death benefits u Accident and health plans u Group-term life insurance u Employer provided meals and lodging u Cafeteria plan benefits u Employer provided parking

31. IRS Challenges Key Learning Objective n Evaluate when the IRS is most likely to question the deductibility of compensation payments

32. Reasonable Compensation n Employee-shareholders of C corporation overcompensated? u Attempt to turn nondeductible dividend payments into deductible compensation n Employee-shareholders of S corporation undercompensated? u Attempt to avoid payroll taxes or shift income

33. Research Query: n Which factors have been employed by the courts to determine the reasonableness of compensation?

34. Solution--Research Query: n Employee's qualifications and role in the company n Character and condition of the company n Compensation paid by similar companies for comparable services n Salary policy of the company for all its employees

35. Solution--Research Query: n Likelihood that a hypothetical, independent investor would be willing to compensate the employee at a similar level u Automotive Investment Development Inc., (1993) TC Memo 1993-298, 1993 RIA TC Memo ¶93298

36. Equity-Based Compensation Key Learning Objective n Identify different types of equity-based compensation and evaluate the tax and economic aspects of such arrangements

37. Compensation Paid in Stock n Taxable when received unless: u Not freely transferable, and u Subject to a substantial restriction n Lapse restriction u Employee recognizes income when restriction lapses u Section 83(b) election to recognize income before restriction lapses

38. Compliance Query: n ABC Corporation gives 100 shares of its stock to T, an employee u the stock is worth $200/share. u T cannot transfer the stock for the next 3 years u she must return the stock to ABC if she quits within that 3-year period. n The stock is worth $300/share 3 years later. n How much income should T report, and when?

39. Solution--Compliance Query: n Stock is nontransferable and subject to a substantial restriction n T should recognize $30,000 of income in 3 years when restriction lapses