ACIS 3314

Tax Impact on Decisions

Chapter 12
Compensation

Learning Objectives
1. Discuss and explain the tax implications of compensation in the form of salary and wages from the employees and employers perspectives 2. Describe and distinguish the tax implications of various forms of equity-based compensation from the employers and employees perspectives 3. Compare and contrast taxable and nontaxable fringe benefits and explain the employee and employer tax consequences associated with fringe benefits

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Salary and Wages

Employee Considerations for Salary and Wages
Fixed amount of compensation for the current year no matter how many hours worked Salaried employees eligible for bonuses Employees receiving wages generally get paid by the hour Salary, bonus, and wages taxed as ordinary income They report their wages on page 1, line 7 of the 1040 federal tax return
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Salary and Wages

Withholding Taxes
Employees complete a Form W-4 to supply the information the firm needs to withhold the correct amount of tax and also to indicate Whether to withhold at the single rate or at the lower married rate The number of withholding or personal allowances the employee chooses to claim Whether the employee wants an additional amount of tax withheld each period above the amount based on the number of allowances claimed

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Salary and Wages

Form W-2 Summarizes an employees taxable salary and wages Provides annual federal and state withholding information Generated by employer on an annual basis Form W-4 Supplies an employees withholding information to employer Generated by employee Remains constant unless employee makes changes
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Salary and Wages

FICA (Payroll Taxes)
Paid on employees wages Consists of both Social Security and Medicare component Social Security tax paid at 6.2 percent on wage base and Medicare tax at 1.45 percent on wages Wage base limitation Social Security tax is $106,800 in 2009 No wage base for the Medicare component

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FICA Tax Question

Mike was paid a salary of $70,000 for the current year. How much FICA and Medicare tax does he pay?
Social Security: Medicare: Total Taxes:

Assume now that Mike earned $170,000 for the current year. How much FICA and Medicare tax does he pay?
Social Security: Medicare: Total Taxes:
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Timing of Employers Deduction

General Rule for Deductibility
Employers computing taxable income under
Cash method of accounting generally deduct salary and wages when they pay the employee Accrual method generally deduct wages payable to employees as the employees earn the wages (i.e., when employer incurs liability and services are performed).

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Timing of Employers Deduction

Exceptions
2 month rule. If not paid within 2 months of employers year-end, then considered to be part of a non-qualified deferred compensation plan and, therefore, deductible only when actually paid.
Year-end bonus Accrued vacation pay

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Timing of Employers Deduction

Exceptions
Related parties Matching of Accounting Method: Accrued expenses and interest owed to a related party are deductible by the accrual-basis payer only when actually paid to the cash-basis payee [267(a)(2)]
This rule effectively converts the accrual-basis payer to the cash-basis for purposes of these transactions.

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Salary and Wages

After-tax cost of providing this salary is generally much less than the before-tax cost as the employer deducts the salary and associated FICA taxes paid After-Tax Cost of Salary formula

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After-Tax Cost of Salary Question

XYZ, Inc. paid one of its employees $80,000 in 2009. They are in the 35% tax bracket. What is the after-tax cost of the salary to XYZ, Inc.? (Dont forget FICA taxes)

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After-tax Cost of Salary Solution

Total Cost = Salary + FICA taxes paid
FICA taxes =
Total cost =

After-tax cost =
So after-tax cost =
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Limits on Salary Deductibility

162(a)(1) applies reasonableness requirement to compensation. Compensation in excess of a reasonable amount is not deductible. Facts and circumstances test involves considering the duties of the employee complexities of the business, salary amount compared to overall profits, etc.

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Limits on Salary Deductibility

162(m): Effective for years beginning on or after 1/1/1994 Publicly-traded corporations cannot deduct compensation in excess of $1 million per executive per year. Disallowance applies only to CEO and four highest paid officers. Exception: Certain types of performance-based compensation are not treated as executive compensation for purposes of this limitation.
Stock Options are performance based.
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Equity-Based Compensation
Stock Options - Terminology
Incentive stock options - provide favorable tax treatment to employees Nonqualified stock options - options that dont meet the requirements for being classified as incentive stock options Grant date - Date on which employees are initially allocated stock options Exercise date - Date that employees purchase stock using their options Exercise price - Amount paid to acquire shares with stock options
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Equity-Based Compensation
Bargain element - Difference between the fair market value of stock and the exercise price on the exercise date Vesting date - Time when stock options granted can be exercised

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Qualification Requirements for ISOs

ISO plan approved by shareholders Not exercisable > 10 years after grant date Grantee owns 10% of employers voting stock X Pg Sale > 2 years after grant and > 1 year after exercise FMV of stock (measured at grant date) limited to $100,000 per year per individual

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Equity-Based Compensation
Employee Considerations for Stock Options
Nonqualified stock options When exercising NQOs, employees report ordinary income equal to the total bargain element on the shares of stock acquired (whether they hold the shares or sell them immediately) Taxpayers basis in NQOs acquired is the fair market value on the date of exercise Basis includes the exercise price plus the ordinary income the taxpayer recognizes on the bargain element

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Equity-Based Compensation
Incentive stock options Basis in shares acquired with ISOs is the exercise price Holding period for stock acquired with NQOs and ISOs begins on the exercise date Here bargain element is added to taxpayers alternative minimum taxable income For either type of options, employees experience no tax consequences on the grant date or vesting date Any future appreciation or depreciation of the stock will be treated as either short-term or long-term capital gain or loss depending on the holding period (begins on the date of exercise)

Equity-Based Compensation
Employer Considerations for Stock Options

Nonqualified options
No tax consequences on grant date On exercise date, bargain element is treated as ordinary (compensation) income to employee Employee holds stock with holding period beginning on date of exercise Employers deduct bargain element as compensation expense on exercise date

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Equity-Based Compensation
Incentive stock options
No tax consequences on grant date and exercise date (if employee holds for two years after grant date and one year after exercise date) If holding requirements are not met (if there is a disqualifying disposition), option becomes an NQO When employee sells stock, employee recognizes long-term capital gain No deduction for employers unless employee doesnt meet holding requirements Employers typically dont view ISOs as favorable as NQOs, because: ISOs dont provide them with the same tax benefits (no tax deduction) IRS regulatory requirements for ISOs can be cumbersome
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Equity-Based Compensation
Firms with high marginal tax rates may lose significant tax benefits by issuing ISOs rather than NQOs On the other hand, start-up companies or firms with net operating losses may actually benefit by issuing ISOs instead of NQOs Accounting Issues For tax purposes, employer deducts bargain element on exercise date For GAAP purposes, employer expenses the estimated value of the option pro rata over the vesting period

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Pg X

Tax Treatment of Stock Options

Pe
Option Exercised

Ps
Stock Sold

Option Granted

ISO
Employee
Grant Exercise Sale No Income No Income LTCG = Ps X No Deduction Ever

NQO
No Income Ordinary = Pe X CG = Ps Pe Deduction at Exercise = Pe X

Employer

Same Amount, Same Time

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Stock Options Questions

Mary is offered 7,000 options on Jan. 1st, 2009. They vest on Jan. 1st 2012. The exercise price is $10 per share. On Jan. 1st 2012 she exercises all 7,000 options when the price is $17 per share. She holds the stock for two years and sells all 7,000 shares for $20 per share. She is in the 30% tax bracket. What is her tax liability on the grant date, exercise date, and date of sale?
If the options are ISOs? If the options are NQOs?

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Stock Options Solution

If the options are ISOs:
Grant date: Exercise Date: Sale Date: Because she held the stock for 1 year after exercise date she will be taxed on the full appreciation from the exercise price at preferential rates.
Tax liability =
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Stock Options Solution

If options are NQOs:
Grant date:
Exercise date:

Sale date:

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Restricted Stock Awards

Employee is given stock, generally at zero cost However, stock is restricted (i.e. cannot be sold or otherwise treated as owned until the vesting date). IRC 83(a): General rules for Employee Timing of income recognition = tax year in which property becomes transferable (i.e. fully vested) or not subject to a substantial risk of forfeiture. Amount of income recognition = Excess of propertys FMV (determined when property becomes transferable) over amount paid (if any) 83(h): Amount & timing of employers deduction tied to employees income recognition.

Restricted Stock Awards

Pg Stock Grant Pv Ps Stock Sold

Vesting

IRC 83(b): Employees election to recognize income in year of grant. Non-revocable election by employee

Must be made within 30 days of grant date.

Starts employees holding period at grant date. Amount of income = FMV at grant

Pg

Restricted Stock Awards

Pv Vesting
With 83(b) Election

Ps

Stock Grant
Without 83(b) Election

Stock Sold

No tax consequences on grant date On vesting date Employee recognizes ordinary income = FMV Holding period for stock begins Employer deducts compensation expense = FMV

On grant date Employee recognizes ordinary income = FMV Holding period for stock begins Employer deducts compensation expense = FMV No tax consequences on vesting date If employee never vests, no tax deduction for basis in stock.

Equity-Based Compensation

Employer Considerations for Restricted Stock Timing of the deduction is determined by the employees decisions regarding the 83(b) election Other non tax issues For tax purposes, employers deduct the market value of stock when the employee recognizes income For GAAP purposes, employers deduct the grant date value over the vesting period

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Restricted Stock Question

James received 4,000 shares of restricted stock on June 1st, 2009 when the stock was valued at $3 per share. The shares vest on June 1st 2010 when the shares are valued at $8 per share. He sells the shares on the vesting date. He is in the 30% tax bracket. What is his tax liability on the grant date and vesting date?
If he doesnt make an 83(b) election? If he makes an 83(b) election?

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Restricted Stock Solution

If 83(b) election not made:
Grant date:
Vesting date:

If 83(b) election is made:

Grant date:

Vesting date/sales date:

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Fringe Benefits
Employers often provide noncash benefits to employees in addition to their cash compensation Ranges from common (health insurance) to the exotic (use of a corporate aircraft) In general, gross income includes all income from whatever source derived, includingcompensation for services, fees, commissions, fringe benefits, and similar items Exceptions to this rule are non-taxable or qualified fringe benefits Exclusions

Taxable Fringe Benefits

Not covered by an exclusion provision Value of benefit is taxed like cash compensation Employer deducts cost and pays employees share of FICA taxes on benefit Employees may prefer a taxable benefit to an equivalent amount of cash when they benefit from employer-provided quantity or group discounts associated with the benefit (e.g. group-term life insurance with death benefit > $50,000).

Example: Group Term Life Insurance

Employees recognize gross income when employers pay life insurance premiums for policies with death benefits > $50,000
To compute the annual taxable benefit

Step 1: Subtract $50,000 from the policys death benefit Step 2: Divide the Step 1 result by $1,000 Step 3: Multiply the result from Step 2 by the cost per $1,000 of protection for one month from the table provided in the Treasury Regulations based on the taxpayers age Step 4: Multiply the outcome of Step 3 by 12 (months)

Employer Treatment of Taxable Fringe Benefits

Pay the employers share of FICA taxes on the taxable portion of benefits provided to employees Deduct employers cost of the benefit (not value of benefit to employee) Report taxable fringe benefit on employees W-2

Nontaxable Fringe Benefits

Specifically identified in the Code Employee excludes benefit from taxable income Employer deducts cost when benefit is paid Examples:
Group-Term Life Insurance up to $50,000 (79) Health and Accident Insurance and Benefits (106) Meals & Lodging for the Convenience of the Employer (119) Employee Educational Assistance (127) Dependent Care Benefits (129) Other (132)

Certain Fringe Benefits 132

No-Additional-Cost Services Qualified Employee Discounts Working Condition Fringe Benefits De Minimis Fringe Benefits Qualified Transportation Fringe Qualified Moving Expense Reimbursement

Cafeteria Plans 125

Employer determines the total dollar amount it wishes to provide each employee Employee then chooses how to spend those dollars among a menu of nontaxable fringe benefits If employee doesnt spend the entire amount, employee receives the difference as taxable cash compensation

Fringe Benefits
Tax Planning with Fringe Benefits Example Employer proposed to reimburse employee $200 a month for his parking costs. What amount of this reimbursement would be a nontaxable qualified transportation fringe to employee? Answer: All $2,400. Employee can exclude up to $230 per month ($2,760 per year) as a qualified transportation fringe IRS publication 15-B Employers Tax Guide to Fringe Benefits (available at www.IRS.gov) provides tax guidance for employers providing fringe benefits

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Fringe Benefits
Fringe Benefits Summary
Both taxable and nontaxable, can make up a significant portion of an employees compensation Are taxable unless the tax laws specifically exclude them from gross income Taxable fringe benefits usually represent a luxury perk, while nontaxable fringe benefits are generally excluded for public policy reasons At this point, you should be able to distinguish between taxable and nontaxable fringe benefits

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