Principles of Taxation

1
Principles of Taxation

• Chapter 14
• Compensation and Retirement

2
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
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/inde
  x.html for information about employment tax.
• What are some characteristics of employees?

4
Salaries

• Employers may deduct wages if they are ordinary
  business expenses.
• Exception cash compensation gt ________________
  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
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
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
Employee Fringe Benefits

• Why are these advantageous to employees?
• Cafeteria plans allow broader employee choices
  among same-cost options for employer.

8
Specific Fringe Benefit Examples

• When is health insurance or coverage nontaxable?
• Only cost to provide group term life insurance
  benefits gt ___________ is taxable.
• Dependent care assistance up to ______________
  is excluded.
• See http//www.irs.ustreas.gov/prod/forms_pubs/pub
  s/p5350404.htm for an IRS summary of other
  nontaxable fringe benefits.

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
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
Employee Stock Options - Nonqualified Stock
Option (NSO)

• Employee has salary income equal to difference in
  _________________ and__________________.
• Employees 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
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
  CFOs income and the corporations 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
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
  Treasurers income and the corporations
  deduction?

14
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
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
  CFOs income and the corporations deduction?
• 1990 - no effect
• 1994 - no effect (except AMT)
• 1996 - 2000 capital gain, no corporate deduction

16
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
  Treasurers income and the corporations
  deduction?

17
Employee Stock Options - Thinking

• Which would employee prefer?
• Which would employer prefer?
• Do you expect preference has changed over time?

18
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 cant use.

19
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
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
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
Tax Advantages of Typical Qualified Plan

• Formula1 / (1-tp0) x (1R)n x (1-tpn)
• 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
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
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
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
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
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
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
Roth IRA

• Roth works differently from general rule.
• NO deduction when contribute, but NO tax when
  distribute.
• Formula 1 x (1R)n
• Roth is better than regular if you expect tax
  rates to increase.
• Roth not available for rich - e.g. MFJ
  AGIgt____________.