Transcript Chapter 4: Employee Compensation

Chapter 4
Employee
Compensation
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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
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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
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Payroll Taxes for Employers


Employer withholds FICA tax from
employee; employer matches employee
FICA and forwards total to government
Employer can deduct employer’s share of
tax
No deduction for employee’s share of
tax
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Other Payroll Taxes

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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
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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
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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
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Related Parties

Related parties include:
Family members (brothers, sisters, spouse,
ancestors, and lineal descendants, but not inlaws)
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
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Reasonable Compensation
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Reasonable compensation – amount similar
business would pay for the services under
similar circumstances
If a shareholder-employee’s 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
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Excessive Compensation

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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
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S Corporations & Low Salaries
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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 corporation’s
distribution as salary, requiring payment of
additional employment taxes
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Employing Children

Compensation paid to children is deductible if
reasonable for the services actually
performed
 Wages paid to an employer’s 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
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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
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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
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Foreign Tax Credit
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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
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Fringe Benefits
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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)
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Group Term Life Insurance
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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
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Group Term Life Insurance
Monthly amount per $1,000 of taxable coverage
Employee’s Age
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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
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Group Term Life Insurance

If the insurance plan is discriminatory,
key employees must report gross
income equal to the greater of
Employer’s actual premiums paid or
Benefit determined from the table
(without $50,000 exclusion)
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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
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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
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Cafeteria Plans
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A qualified cafeteria plan allows an employer
to offer employees the option of choosing
cash or nontaxable fringe benefits
 Exception to constructive receipt doctrine
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If employee chooses cash, the cash is
taxable
If employee chooses nontaxable fringe
benefits, they are excludable
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Cafeteria Plans
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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)
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Cafeteria Plans
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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
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Meals and Lodging

Value of meals and lodging provided by an
employer to an employee are excluded if:
1) Provided for the employer's convenience and
2) Provided on the employer's business premises
and
3) 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
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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
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No-Additional-Cost Services
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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
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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 can’t exceed 20%
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Employee Awards
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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
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De Minimis Fringe Benefits
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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.
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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)
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Athletic Facilities
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Employees (and their families) who use
employer-provided athletic facilities that are
located on the employer’s business premises
can exclude the value of the benefit from
gross income
Facilities include tennis courts, gymnasiums,
and swimming pools
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Working Condition
Fringe Benefits

Working condition fringe benefits can be
excluded from the employee’s 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
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Employee Use of
Company-Owned Cars

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The value of an employee’s 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 oneway trip)
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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
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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
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Relocation Expenses
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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 employer’s benefit
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Qualified moving expenses that are not
reimbursed are deductible for AGI by
employee
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Education Assistance Plans
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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
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Job-Related Education
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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 taxpayer’s job or qualify
taxpayer for a new profession do not qualify
for exclusion
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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
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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 employee’s W-2
Employees who receive advances in a
nonaccountable plan must report details of
both the reimbursement and the expenses
Employee’s deductions are subject to 2% AGI
floor for miscellaneous itemized deductions
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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
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Stock Options
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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
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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
Employee’s basis for stock is cash paid +
income recognized
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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
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Phantom Stock and SARs

Phantom stock plan - deferred compensation is
hypothetically invested in shares of company’s
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 employer’s
stock for a certain period of time
 Employees recognize income only when they exercise
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Qualified Deferred
Compensation Plans

Funded plans that receive favorable tax
treatment:

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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
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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
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Distributions
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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
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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
 Employee’s benefit is dependent upon
employer’s contributions and the actual
earnings in the individual account
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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
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Other Plans
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Employee stock ownership plans (ESOPs)
Simplified employee pension plans (SEPs)
Savings incentive match plans for employees
(SIMPLE)
SIMPLE 401k plans
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Nonqualified Deferred
Compensation

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
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
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Nonqualified Deferred
Compensation
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Employer accrues liability on financial
statements, but no cash is set aside
If the employer’s business fails, the
employee is merely an unsecured creditor
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Individual Retirement
Accounts (IRA)
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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
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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
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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)
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Roth IRA

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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
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Self-Employment Taxes

Self-employed individuals must pay both
the employer’s and the employee’s 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
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Self-Employment Taxes


Tax computed on Schedule SE
Self-employed individuals are also allowed
a deduction for AGI for the employer’s half
of self-employment taxes
 Calculated by multiplying net income from selfemployment by 92.35% (100% - 7.65%) before
calculating SE tax

There is no deduction for the employee’s
half of the taxes
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Fringe Benefits for
Self-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
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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
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The End
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