1. #14-1 McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Compensation and Retirement Planning Chapter 14

2. #14-2Objectives  employees versus self-employed  family compensation planning  nontaxable employee fringe benefits  stock options  employee-related expenses  qualified versus nonqualified retirement plans  deferred compensation

3. #14-3 Employee versus Contractor  Who cares?  Employer avoids FICA on contractor, w/h taxes, employee benefit. Easier to dismiss.  IRS more likely to collect tax because employees report income.  Contractor MAY have additional deductible expenses, but often SE tax is higher.  How decide?  Regulations, rulings and court cases involve:  Degree of supervision, materials, person versus job.

4. #14-4Salaries  Employers may deduct wages if they are ordinary business expenses.  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.  Family salary issues are a review of Chapter 9 and 10. Compensation must be reasonable - remember risk of constructive dividend treatment.

5. #14-5 Foreign Earned Income Exclusion  Expatriates are U.S. citizens (or permanent residents) who reside and work overseas.  Exclude $80,000 (2002 limit) from taxation in the U.S.  Cannot claim foreign tax credit (see chapter 12) on excluded income.

6. #14-6 Employee Fringe Benefits  General rule: fringe benefits are taxable.  Exclusions of fringe benefits are usually:  Providing a social welfare benefit (health, life ins, child care),  Hard to enforce  Non-discriminatory, or  Necessary for job (moving expenses, supplies at work)

7. #14-7 Employee Fringe Benefits  Why are these advantageous  Often lower cost than employee can obtain  Nontaxable  Cafeteria plans allow broader employee choices among same-cost options for employer.

8. #14-8 Specific Fringe Benefit Examples  Health insurance or coverage is not taxable if nondiscriminatory.  Only cost to provide group term life insurance benefits > $50,000 is taxable.  Dependent care assistance up to $5000 is excluded.  Self-employed persons can deduct 70% of medical insurance costs.

9. #14-9 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. #14-10 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. #14-11 Employee Stock Options - Nonqualified Stock Option (NSO)  Employee has salary income equal to difference in FMV of stock and exercise price.  Employee’s new basis in stock is FMV at exercise date.  Employer gets tax deduction equal to employee income.  When employee sells stock in future, he generates a capital gain (loss) = selling price - basis ($FMV date of exercise).

12. #14-12 NSO Example  The CFO is granted 100 options (NSOs) in 1998 at a price of $10 per share, when the stock is trading at $10 per share. In 2001, he exercises these shares when the FMV of the stock is $25 per share. In 2004, 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?  1998 - no tax effect to either party  2001 - CFO salary income $1,500, salary deduction $1500  2004 - capital gain $500, no company deduction.

13. #14-13 NSO Example (you do it)  The Treasurer is granted 100 options (NSOs) in 1998 at a price of $10 per share, when the stock is trading at $10 per share. In 2001, she exercises these shares when the FMV of the stock is $30 per share. In 2004, she sells these shares at $28 per share.  What is the amount, character, and timing of the Treasurer’s income and the corporation’s deduction?

14. #14-14 Employee Stock Options - Incentive Stock Option (ISO)  Employee has no salary income on exercise. 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 at capital gain (loss) = selling price - exercise price.

15. #14-15 ISO Example  The CFO is granted 100 options (ISOs) in 1998 at a price of $10 per share, when the stock is trading at $10 per share. In 2001, he exercises these shares when the FMV of the stock is $25 per share. In 2004, 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?  1998 - no effect.  2001 - no effect (except AMT)  2004 - $2000 capital gain, no corporate deduction.

16. #14-16 ISO Example (you do it)  The Treasurer is granted 100 options (ISOs) in 1998 at a price of $10 per share, when the stock is trading at $10 per share. In 2001, she exercises these shares when the FMV of the stock is $30 per share. In 2004, she sells these shares at $28 per share.  What is the amount, character, and timing of the Treasurer’s income and the corporation’s deduction?

17. #14-17 Employee Stock Options - Thinking  Which would employee prefer?  ISO - delay taxation, all capital gain, net gain/loss(if any)  Which would employer prefer?  NSO - claim salary deduction  Do you expect preference has changed over time?

18. #14-18 Employee Expenses  Unreimbursed expenses are deductible to the extent they exceed 2% of AGI.  These are ITEMIZED deductions.  2% limit, combined with Itemized requirement, means most employees can’t use.

19. #14-19 Moving Expenses  Unreimbursed moving expenses are deducted in computing AGI (not an itemized deduction).  transport household goods  travel costs except meals  Requirements for moving expenses:  new job meeting certain mileage and time of work requirements  deduct cost of moving furniture and cars, moving family (but not meals).

20. #14-20 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 is BIG.  Withdrawal cannot begin before age 59 1/2 (without 10% penalty) but must begin after 70 1/2.  Basic types of qualified plans: a) employer, b) self- employed (Keogh), c) IRAs

21. #14-21 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 deduction for funding plan.  The plan itself is tax exempt, so earnings are not taxed as they accumulate.  Retiree is taxed on withdrawals of all amounts.  Premature withdrawals 10% excise tax

22. #14-22 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 the 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. #14-23 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  100% of average three highest years’ wages  $160,000 (in 2004).

24. #14-24 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  100% of annual compensation or  $40,000 (in 2003).  401K plan - the employer and employee both contribute. Employee contribution limit = $13,000 in 2004. MY ADVICE - Start right away!

25. #14-25 Employer Plans - Nonqualified  Nonqualified deferred compensation -  Employee delays paying tax until receive money.  Corporation delays deducting salary expense until pay money.  Often used by top executives.  Since nonqualified, these plans CAN discriminate!

26. #14-26 Self-Employed Plans - Keogh  Contribute up to the lesser of  20% of earned income from self-employment  $40,000 in 2004.  Must not discriminate. If owner has employees then he/she must provide retirement benefits to them.

27. #14-27 Individual Retirement Accounts  Individuals contribute the lesser of  $3,000 (in 2003) or  100% of compensation (but each spouse may contribute $3000 if combined earned income = $6,000).  Deduction for contribution is limited  if taxpayer participates in a qualified plan (phase-out range for MFJ starts at $65,000 in 2004)  if spouse participates in a qualified plan (phase-out range for MFJ starts at $150,000).

28. #14-28 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

29. #14-29 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>160,000.