4 - 1 ©2005 Prentice Hall, Inc. Employee Compensation Chapter 4.

4 - 1©2005 Prentice Hall, Inc.

EmployeeCompensation

Chapter 4


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


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 $87,900 for 2004 Employer withholds the FICA tax from

employee; employer matches employee FICA and then forwards total to government

Employer can deduct employer’s share of tax No deduction for employee’s share of tax


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


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


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


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 owns directly or indirectly more than 50% of the stock (indirect ownership includes stock owned by family members), and

Other relationships such as partners/partnerships and beneficiaries/trusts


Reasonable Compensation

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


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


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


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 $4,850 in 2004; this amount can be paid to a child without tax consequences


Foreign Earned Income

Exclusion is $80,000 per year Exclusion calculated separately for each spouse

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

Taxpayer must work outside the U.S. for entire year or 330 days during a period of 12 consecutive months


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 the foreign taxes paid

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


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)


Group Term Life Insurance

Premiums on the first $50,000 of employer-paid group term life insurance coverage may be excluded from an employee's gross income

Excess over $50,000 is included in income with amount determined from a table based on employee's age at year end rather than cost


Group Term Life InsuranceTaxable Amount per Month per $1,000

Employee’s 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


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)


Heath and Accident Insurance

Employees are not taxed on value of insurance premiums paid for by their employers for health and accident plans for employees and their families Self-insured discriminatory plans may result

in taxable income to highly-compensated employees


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


Cafeteria Plans

Are an exception to the doctrine of constructive receipt

A qualified cafeteria plan allows an employer to offer employees the option of choosing cash or nontaxable fringe benefits

If the employee chooses cash, the cash is taxable

If nontaxable fringe benefits are chosen, they are excludable


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)


Cafeteria Plans

Some of the 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


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 selected is taxable


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


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


Employee Discounts

Property or services provided employee at below FMV results in 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%


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


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


Transportation & Parking

Transit passes and special carpool commuting expenses (combined value of up to $100 per month)

Free or discounted parking (up to $195 per month in 2004)


Athletic Facilities

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


Working ConditionFringe 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

Discriminatory benefits can still be excluded


Employee Use ofCompany-Owned Cars

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 (37.5¢ in 2004) Commuting method (valued at $1.50 per

one-way trip)


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


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


Relocation Expenses

Time Test - taxpayer must work as an employee at the new location for 39 weeks during the 12 months following arrival or as a self-employed person 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

Qualified moving expenses that are not reimbursed are deductible for AGI by employee


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


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 taxpayer’s job or qualify taxpayer for a new profession do not qualify for exclusion


Substantiating Expenses

Accountable Plan - an employee provides an 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


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


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


Stock Options

Option – right to purchase stock at 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


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


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


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

their SARs


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


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


Distributions

Taxpayers may not take distributions before age 59½ without paying a 10 percent penalty for premature distributions (in addition to the regular tax)

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


Types of Plans

Defined Benefit - 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


401(k) Plans

Employees can elect to have employer contribute part of their salary to plan on pretax basis In 2004, up to $13,000 plus extra $3,000 if age 50

or older Flexibility - employee can elect each year to have

a different amount contributed Employer may match some of the contributions


Other Plans

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

(SIMPLE) SIMPLE 401k plans


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


Nonqualified Deferred Compensation

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


Individual Retirement Accounts (IRA)

Individuals can contribute up to $3,000 ($3,500 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


IRA Phaseout Limits

Deductible contribution phased out for AGI over a range Single $45,000 - $55,000 Married filing jointly $65,000 - $75,000

Zero if married filing separately

If spouse an active participant, phaseout over AGI of $150,000 - $160,000


Roth IRA

Taxpayers may make nondeductible contributions to a Roth IRA

Contributions phase out if AGI $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 $3,000 ($3,500 if age 50 or older)


Roth IRA

Primary advantage of the Roth IRA is that distributions are totally 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


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 $87,900 in 2004 2.9% (1.45% x 2) for Medicare – no income limit

Deduction for employer portion simulated by multiplying net income from self-employment by 92.35% (100% - 7.65%) before calculating SE tax


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

There is no deduction for the employee’s half of the taxes


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


Retirement Plans for Self-Employed

Keogh (HR 10) plan is designed for self-employed persons and 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


The End

4 - 1 ©2005 Prentice Hall, Inc. Employee Compensation Chapter 4.

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Transcript of 4 - 1 ©2005 Prentice Hall, Inc. Employee Compensation Chapter 4.