Employee Compensation

1
EmployeeCompensation

• Chapter 4

2
Employee Compensation

• All forms of compensation (including salaries,
  wages, bonuses, tips, and fringe benefits) are
  taxable as ordinary income to employees unless
  specifically excluded by a provision in the Code
• Employers can deduct all compensation expenses

3
Payroll Taxes for Employees

• FICA rate is 7.65
• 6.2 for Social Security 1.45 for Medicare
• Social security portion is only charged on the
  first 90,000 for 2005

4
Payroll Taxes for Employers

• Employer withholds FICA tax from employee
  employer matches employee FICA and forwards total
  to government
• Employer can deduct employers share of tax
• No deduction for employees share of tax

5
Other Payroll Taxes

• Employers are also required to pay other types of
  payroll taxes such as federal and state
  unemployment taxes
• FUTA rate is 6.2 on first 7,000
• State unemployment taxes vary
• These taxes are all deductible by the employer
  paying them

6
Employee vs.Independent Contractor

• Independent contractors (and other self-employed
  individuals) pay their own Social Security and
  Medicare taxes
• This is called the self-employment tax
• Workers considered employees (instead of an
  independent contractor) if the employer has the
  right to control and direct the end result and
  the means by which the result is accomplished
• Rev. Rul. 87-41 provides 20-factor test

7
Timing of Compensation

• Salaries and bonuses are usually deductible by
  the employer when accrued
• Exceptions
• Compensation accrued but not paid within 2½
  months of year-end is not deductible until paid
• Compensation accrued to cash-basis related party
  not deductible until paid

8
Related Parties

• Related parties include
• Family members (brothers, sisters, spouse,
  ancestors, and lineal descendants, but not
  in-laws)
• A taxpayer and a corporation in which the
  taxpayer directly or indirectly owns more than
  50 of the stock (indirect ownership includes
  stock owned by family members)
• Other relationships such as partners/partnerships
  and beneficiaries/trusts

9
Reasonable Compensation

• Reasonable compensation amount similar business
  would pay for the services under similar
  circumstances
• If a shareholder-employees salary is considered
  unreasonable, the excess can be reclassified by
  IRS as a nondeductible dividend
• If unreasonable compensation is paid to a party
  related to a shareholder, the excess can be
  reclassified as a nondeductible dividend to the
  shareholder

10
Excessive Compensation

• Deductible compensation paid to CEO and 4
  highest-paid officers of publicly-held
  corporations is limited to 1 million per year
• This compensation limit does not include amounts
  that represent
• Compensation based on individual performance
  goals (if approved in advance by outside
  directors)
• Compensation paid on a commission basis
• Employer contributions to a qualified retirement
  plan
• Tax-free employee benefits

11
S Corporations Low Salaries

• There is an incentive for an S corporation to pay
  an unreasonably low salary to a controlling
  shareholder-employee to minimize payroll taxes,
  as S corporation profits are not subject to
  payroll taxes
• IRS can reclassify some of S corporations
  distribution as salary, requiring payment of
  additional employment taxes

12
Employing Children

• Compensation paid to children is deductible if
  reasonable for the services actually performed
• Wages paid to an employers child under age 18
  are not subject to employment taxes (if not paid
  by a corporation)
• Standard deduction for a single individual is
  5,000 in 2005 this amount can be paid to a
  child without tax consequences

13
Foreign Earned Income

• Qualifying earned income includes most income
  earned from working in a foreign country
  including salary, bonuses, allowances and noncash
  benefits
• U.S. government employees not eligible
• Exclusion is 80,000 per year
• Taxpayer must work outside the U.S. for entire
  year or 330 days during a period of 12
  consecutive months

14
Foreign Tax Credit

• Employees who do not qualify for the exclusion
  include the income in taxable income and claim a
  tax credit (or a deduction) for taxes paid to the
  foreign government
• The foreign tax credit cannot exceed the amount
  of U.S. tax that would have been paid on the
  foreign income
• The foreign tax credit is generally more
  advantageous than the deduction

15
Fringe Benefits

• Tax-free fringe benefits are not taxable as
  income to the employee but are deductible by the
  employer
• Most tax-free benefits are limited in dollar
  amount
• If an employer pays an amount in excess of the
  limit (or pays for something that is not a
  qualified tax-free benefit), it is treated as
  taxable compensation (income to the employee and
  deductible by the employer)

16
Group Term Life Insurance

• Premiums on the first 50,000 of employer-paid
  group term life insurance coverage may be
  excluded from employee's gross income
• Excess over 50,000 is included in income
• Amount determined from IRS table based on
  employee's age at year end, rather than cost

17
Group Term Life InsuranceMonthly amount per
1,000 of taxable coverage
Employees Age Monthly Amount
Under 25 .05
25 to 29 .06
30 to 34 .08
35 to 39 .09
40 to 44 .10
45 to 49 .15
50 to 54 .23
55 to 59 .43
60 to 64 .66
65 to 69 1.27
70 and above 2.06
18
Group Term Life Insurance

• If the insurance plan is discriminatory, key
  employees must report gross income equal to the
  greater of
• Employers actual premiums paid or
• Benefit determined from the table (without
  50,000 exclusion)

19
Health and Accident Insurance

• Value of insurance premiums paid by employers on
  behalf of employees and their families are
  tax-free
• Self-insured discriminatory plans may result in
  taxable income to highly-compensated employees

20
Dependent Care Benefits

• An employer can provide up to 5,000 (2,500 if
  MFS) for the care of an employee's dependents
  during working hours through an on-site or
  off-site facility
• Highly-compensated employees cannot exclude
  benefits if they are discriminatory

21
Cafeteria Plans

• A qualified cafeteria plan allows an employer to
  offer employees the option of choosing cash or
  nontaxable fringe benefits
• Exception to constructive receipt doctrine
• If employee chooses cash, the cash is taxable
• If employee chooses nontaxable fringe benefits,
  they are excludable

22
Cafeteria Plans

• Benefits can be funded with employer
  contributions or by employees voluntarily
  electing to reduce their salaries (allowing
  employees to obtain fringe benefits with
  before-tax dollars)
• These plans are sometimes called flexible
  spending arrangements (FSA)

23
Cafeteria Plans

• Some nontaxable benefits that can be offered
  include coverage for medical and dental care,
  group-term life insurance up to 50,000, and
  dependent care assistance
• Any amounts set aside in a flexible spending plan
  must be used before the end of the year or they
  are lost

24
Meals and Lodging

• Value of meals and lodging provided by an
  employer to an employee are excluded if
• Provided for the employer's convenience and
• Provided on the employer's business premises and
• Employee required to occupy the lodging to
  perform employment duties
• If an employee is given a choice between
  additional compensation or meals and lodging, the
  value of any meals and lodging is taxable

25
No-Additional-Cost Services

• When an employer provides services for its
  employees and incurs no substantial additional
  cost (excess capacity services), employees can
  exclude the value of the services from gross
  income
• Example Free or discounted seats on an airplane
  when the employee does not displace a paying
  customer

26
No-Additional-Cost Services

• This exclusion applies only to services received,
  not property
• Only employees who work in the line of business
  that renders similar services are allowed to
  exclude the benefits (baggage handlers who work
  for an airline can fly free)
• In addition to current employees, the exclusion
  is available to former employees, as well as
  spouse and dependents

27
Employee Discounts

• Property or services provided to employee at
  below FMV treated as taxable income to employee,
  unless within the qualified employee discount
  limits
• Only property and services offered to customers
  in the ordinary course of the employer's business
  qualifies
• Full discount excluded if discount does not
  exceed gross profit percentage times price
  charged to customers
• For services, discount cant exceed 20

28
Employee Awards

• Employee awards generally are treated as taxable
  compensation
• Exceptions for length of service or safety awards
• Qualifying employee awards must be made with
  tangible property (no cash)
• Average cost of qualified plan awards limited to
  400, but individual awards can be as much as
  1,600

29
De Minimis Fringe Benefits

• Employees who receive de minimis (very small in
  value) property or services from their employers
  can exclude the value from gross income
• An amount is considered de minimis when the value
  is so small that accounting for it is
  unreasonable or impractical
• Examples coffee doughnuts, company picnics,
  limited use of copy machine, etc.

30
Transportation Parking

• Exclusions limited
• Transit passes and special carpool commuting
  expenses (combined value of up to 105 per month)
• Free or discounted parking (up to 200 per month
  in 2005)

31
Athletic Facilities

• Employees (and their families) who use
  employer-provided athletic facilities that are
  located on the employers business premises can
  exclude the value of the benefit from gross
  income
• Facilities include tennis courts, gymnasiums, and
  swimming pools

32
Working ConditionFringe Benefits

• Working condition fringe benefits can be excluded
  from the employees gross income if the employee
  would have been entitled to a tax deduction if he
  had actually paid the expense
• Examples job-related education, professional
  membership dues
• Discriminatory benefits can still be excluded

33
Employee Use ofCompany-Owned Cars

• The value of an employees personal use of a
  company car is a taxable fringe benefit
• In determining the amount of income to be taxed
  to the employee for personal use, there are 3
  methods
• Lease value (from table)
• Cents per mile rate (40.5 in 2005)
• Commuting method (valued at 1.50 per one-way
  trip)

34
Relocation Expenses

• Qualified direct moving expenses include the
  reasonable cost of moving household belongings
  and family members from the old home to the new
  home by the shortest and most direct route
• No dollar limit
• Indirect expenses such as house-hunting or
  temporary living expenses do not qualify

35
Relocation Expenses

• Moving expenses are deductible if they are
  related to assuming duties at a new place of
  business and both the distance and time
  requirements are met
• Distance test - distance from old residence to
  new job must be at least 50 miles greater than
  the distance from old residence to old job
• Even though a taxpayer is required to relocate,
  no deduction is allowed if the distance test is
  not met

36
Relocation Expenses

• Time Test - taxpayer must work as an employee at
  the new location for 39 weeks during the 12
  months following arrival
• Self-employed person must work for 78 weeks
  during the 24 months following arrival
• Exceptions allowed in event of death, disability,
  involuntary separation, or transfers for the
  employers benefit
• Qualified moving expenses that are not reimbursed
  are deductible for AGI by employee

37
Education Assistance Plans

• Up to 5,250 a year of employer-provided
  educational assistance benefits can be excluded
• Courses do not need to be job-related.
• Excludable benefits are payments for tuition,
  fees, books, supplies, and equipment

38
Job-Related Education

• No dollar limit if education expenses are related
  to the current job of the employee
• Qualified educational expenses include tuition,
  fees, books, and transportation from job to class
  
• Expenses that meet the minimum education
  requirements for the taxpayers job or qualify
  taxpayer for a new profession do not qualify for
  exclusion

39
Substantiating Expenses

• Accountable Plan - an employee provides adequate
  accounting to the employer and refunds to the
  employer any excess payments
• Adequate Accounting - provides details concerning
  the time, date, place, business purposes, and the
  amount of the expense
• If an employee makes an adequate accounting, and
  the reimbursement exceeds the deductible
  expenses, the employee must include the excess in
  income

40
Substantiating Expenses

• Nonaccountable plan does not require the employee
  to substantiate expenses or refund excess
  advanced funds
• Employer must report all of the reimbursed
  expenses on employees W-2
• Employees who receive advances in a
  nonaccountable plan must report details of both
  the reimbursement and the expenses
• Employees deductions are subject to 2 AGI floor
  for miscellaneous itemized deductions

41
Restricted Stock

• Value not taxed until stock vests
• Employee recognizes ordinary income FMV of
  stock when vested
• Dividends taxed as ordinary income prior to
  vesting
• Election to accelerate income made by recognizing
  income FMV in year of receipt
• No deduction for loss if forfeited

42
Stock Options

• Option right to purchase stock at guaranteed
  strike price for a specific time
• Grant date date option offered to individual
• Exercise date date option used to purchase
  stock
• Bargain element difference between strike price
  and FMV of stock

43
Nonqualified Stock Options

• Employee recognizes ordinary income equal to the
  bargain element on the date the NQSO is exercised
  
• Employer gets matching compensation deduction for
  bargain element
• Employees basis for stock is cash paid income
  recognized

44
Incentive Stock Options

• ISOs provide more favorable treatment for
  employee
• ISOs do not trigger any income recognition at the
  date of grant or exercise
• Income is recognized only upon the sale of the
  stock, usually as long-term capital gain
• But bargain element is an individual AMT
  adjustment
• Employer receives no compensation deduction

45
Phantom Stock and SARs

• Phantom stock plan - deferred compensation is
  hypothetically invested in shares of companys
  stock
• At the end of deferral period (such as at
  retirement), the employer pays the employee the
  FMV of the phantom shares
• Stock appreciation right (SAR) plan - employees
  are given the right to receive a cash payment
  equal to the appreciation in value of employers
  stock for a certain period of time
• Employees recognize income only when they exercise

46
Qualified Deferred Compensation Plans

• Funded plans that receive favorable tax
  treatment
• Employer contributions are deducted as they are
  paid into the trust
• Earnings on these contributions accumulate
  tax-free until withdrawn
• Benefits are taxable to the employee only when
  actually received

47
Distributions

• When funds are withdrawn, taxes must be paid by
  employee on
• All earnings
• All employer contributions
• All pre-tax (deductible) employee contributions
• Employee must begin distributions by age 70½

48
Distributions

• Premature withdrawals - 10 penalty (in addition
  to income tax) for taking distributions before
  age 59 ½
• A taxpayer may roll over all or part of a
  distribution within 60 days without paying any
  tax or penalty on the distribution
• Lump sum distributions are subject to 20
  withholding unless there is a direct trustee to
  trustee transfer

49
Types of Plans

• Defined Benefit provides fixed benefit at
  retirement
• Employer assumes the risk that the plan assets
  will be sufficient to pay benefits
• Defined Contribution - amounts contributed are
  determined according to a formula
• Employees benefit is dependent upon employers
  contributions and the actual earnings in the
  individual account

50
401(k) Plans

• Employees can elect to have employer contribute
  part of their salary to plan on pretax basis
• In 2005, up to 14,000 plus extra 4,000 if age
  50 or older
• Flexibility - employee can elect each year to
  have a different amount contributed
• Employer may match some of the contributions

51
Other Plans

• Employee stock ownership plans (ESOPs)
• Simplified employee pension plans (SEPs)
• Savings incentive match plans for employees
  (SIMPLE)
• SIMPLE 401k plans

52
Nonqualified Deferred Compensation

• Advantages - no dollar limits and can be offered
  on a discriminatory basis
• Employer receives a deduction only upon the
  actual payment of benefits to the employee
• Employee recognizes income upon the actual
  receipt of these benefits

53
Nonqualified Deferred Compensation

• Employer accrues liability on financial
  statements, but no cash is set aside
• If the employers business fails, the employee is
  merely an unsecured creditor

54
Individual Retirement Accounts (IRA)

• Individuals can contribute up to 4,000 (4,500
  if age 50 or older) or earned income if less
• A married taxpayer can contribute for a
  nonworking spouse
• Qualified contributions are deductible for AGI
• Deductions not allowed if the individual is a
  participant in an employer-sponsored retirement
  plans, unless AGI is below certain limits

55
IRA Phaseout Limits

• Deductible contribution phased out in 2005 for
  AGI over a range
• Single 50,000 - 60,000
• Married filing jointly 70,000 - 80,000
• Zero if married filing separately
• If spouse an active participant, phaseout over
  AGI of 150,000 - 160,000

56
Roth IRA

• Taxpayers may make nondeductible contributions to
  a Roth IRA
• Contributions phase out if AGI between
• 95,000 - 110,000 if single
• 150,000 -160,000 if married filing joint return
• Contributions to Roth and the regular IRA cannot
  exceed a total of 4,000 (4,500 if age 50 or
  older)

57
Roth IRA

• Primary advantage of Roth IRA able to withdraw
  earnings contributions tax-free
• Distributions from Roth IRAs are not subject to
  minimum distribution rules
• Do not have to begin by age 70½
• But cannot be made for first 5 years and taxpayer
  must usually be at least age 59½

58
Self-Employment Taxes

• Self-employed individuals must pay both the
  employers and the employees share of FICA taxes
  for a combined rate of 15.3
• 12.4 (6.2 x 2) for Social Security on income
  up to 90,000 in 2005
• 2.9 (1.45 x 2) for Medicare no income limit

59
Self-Employment Taxes

• Tax computed on Schedule SE
• Self-employed individuals are also allowed a
  deduction for AGI for the employers half of
  self-employment taxes
• Calculated by multiplying net income from
  self-employment by 92.35 (100 - 7.65) before
  calculating SE tax
• There is no deduction for the employees half of
  the taxes

60
Fringe Benefits forSelf-Employed

• Self-employed individuals (including sole
  proprietors, partners, and greater than 2
  shareholders of S corporations) do not qualify
  for most fringe benefits on a tax-free basis
• Special deduction for AGI applies to health
  insurance for self-employed individuals

61
Retirement Plans for Self-Employed

• Keogh (HR 10) plan has limits on contributions
  similar to corporate retirement plans
• Contributions are deductible for AGI
• Extending return due date also extends deadline
  for making contributions to plan
• Earnings and deductible contributions fully taxed
  when withdrawn
• May also contribute to an IRA unless limitations
  apply

62
The End