Chapter 15Chapter 15

Compensation and

Retirement Planning

McGraw-Hill Education Copyright © 2015 by McGraw-Hill Education. All rights reserved.

15-2

ObjectivesObjectives

• Distinguish between employees and independent contractors

• List the factors determining reasonable compensation for a shareholder-employee

• Identify the most common nontaxable employee fringe benefits

• Describe the tax consequences of stock options• Compare the after-tax wealth accumulated in a

qualified and a nonqualified retirement plan

15-3

Objectives (continued)Objectives (continued)

• Distinguish between defined-benefit and defined-contribution plans

• Explain why employers use nonqualified deferred-compensation plans

• Describe the tax benefit of a Keogh plan to a self-employed individual

• Describe the tax benefits of traditional and Roth IRAs

15-4

Employee versus ContractorEmployee versus Contractor

• Employee is an individual

• Whose duties are controlled (as to how, when, and where) by an employer

• Who works according to a regular schedule in return for a wage or salary

15-5

Employee versus ContractorEmployee versus Contractor

• Independent contractor is a self-employed individual

• Who performs services for a fee

• Who controls the way the services are performed

• Whose work relationship with client is temporary

• Who can have many clients at the same time

15-6

Employee versus ContractorEmployee versus Contractor

• Employees• Employer withholds income and payroll taxes

from salary or wage payments• Employer issues Form W-2 to employees

• Independent contractors • Clients don’t withhold tax from fee payments

• Contractor reports fees as Schedule C business income

• Contractor pays income and self-employment tax directly

• Client issues Form 1099-MISC to independent contractors

15-7

Employee versus ContractorEmployee versus Contractor

• Self-employed individuals have relatively low level of compliance because they fail to file or they understate income• IRS takes an aggressive stance regarding

worker classification

• How is worker classification decided?• Based on facts and circumstances including:

• Degree of supervision

• Materials provided

• Person versus job

15-8

Compensation payments Compensation payments

• Employers treat compensation payments as either:• Deductible ordinary and necessary business expenses• Capitalized costs

• Compensation is ordinary income to recipient

15-9

Foreign Earned Income ExclusionForeign Earned Income Exclusion

• Expatriates are U.S. citizens who reside and work overseas on an extended basis

• Can exclude $99,200 (2014) foreign salary or wages from gross income for U.S. tax purposes

• Can’t claim foreign tax credit (see Chapter 13) on excluded income

15-10

Employee Fringe BenefitsEmployee Fringe Benefits

• General rule: fringe benefits are taxable

• Nontaxable fringe benefits include:• Health and accident insurance• $50,000 group-term life insurance• Dependent care assistance

15-11

Employee Stock OptionsEmployee Stock Options

• Stock option is the right to buy stock in the future for a set price (option price or strike price) for limited period of time• Option price usually is less than or equal to market price

of the stock on date the option is granted

• Stock options are a form of compensation that requires no cash outlay by corporate employer

15-12

Stock Options - Grant DateStock Options - Grant Date

• Under GAAP, firms must record compensation expense equal to FMV of option at grant date

• Tax rules:• No deduction to employer when option is granted• No income to employee on receipt of option• Tax consequences when employee exercises an

option depends on whether the option is a:• Nonqualified stock option (NSO)

• Incentive stock option (ISO)

15-13

Nonqualified Stock Option (NSO)Nonqualified Stock Option (NSO)

• Employee has taxable compensation equal to excess of FMV of stock over exercise price• Taxable excess is referred to as the bargain element• Employee’s basis in stock is FMV at exercise date

• Employer is allowed a deduction in the year of exercise equal to employee’s taxable compensation

15-14

Incentive Stock Option (ISO)Incentive Stock Option (ISO)

• No compensation income to employee on exercise of ISO• Employee’s basis in stock is cost• Untaxed bargain element is AMT preference item

• No employer deduction for bargain element

15-15

Employee ExpensesEmployee Expenses

• When employers reimburse employees for employment-related expenses, employees don’t report the reimbursement as income or deduct the expense

15-16

Employee Expenses Employee Expenses

• Employees may deduct unreimbursed business expenses as miscellaneous itemized deductions• Miscellaneous itemized deductions are deductible

only to extent they exceed 2% of AGI• Consequently, employees may derive no tax benefit

from unreimbursed business expenses

15-17

Moving ExpensesMoving Expenses

• Employee unreimbursed moving expenses are an above-the-line deduction• Costs to transport household goods

and personal belongings• Certain travel costs for family members

• Household move must be required by commencement of employment in a new place of work

15-18

Retirement PlanningRetirement Planning

• Key concepts• Qualified plans provide deferral of tax on earned income.

Compounding effect of deferral can be significant!• Individuals must include withdrawals from qualified plans

in ordinary gross income • Withdrawals before age 59½ subject to 10% penalty• Withdrawals must begin when individual reaches age 70½

• Types of qualified plans• Employer-provided• Self-employed (Keogh)• IRAs

15-19

Employer-provided PlansEmployer-provided Plans

• Two policy objectives• Employer-provided plans should carry minimum risk

for participating employees• Employer-provided plans should provide benefits in

an equitable manner to all participating employees• Plans can’t discriminate in favor of highly

compensated employees

15-20

Defined Benefit PlansDefined Benefit Plans

• Employer assumes risk and promises a certain retirement income stream (pension) to participating employees

• Annual pension limited to the lesser of:• Average compensation for employee’s three

highest compensation years• $210,000 (2014)

15-21

Defined Contribution PlansDefined Contribution Plans

• Employer contributes a defined amount each year to each participating employee’s retirement account• Employee may choose how the balance

in the account is invested• Employee bears investment risk

• Annual contribution limited to the lesser of:• 100% of annual compensation or• $52,000 (2014)

15-22

Types of Defined Contribution PlansTypes of Defined Contribution Plans

• Types of defined contribution plans

• Profit-sharing plans – Employer contributes percentage of current earnings to employees’ retirement accounts

• Employee Stock Ownership plans (ESOPs) – employer contributions are invested in employer’s stock

• 401(k) plans – Participating employees elect to contribute current compensation to their retirement accounts• Contributions are excluded from current income• Contribution limit = $17,500 (2014)

15-23

Nonqualified PlansNonqualified Plans

• Nonqualified deferred compensation• Employee doesn’t recognize deferred compensation as

income until payment is received• Employer can’t deduct deferred compensation expense

until payment is made • Employer accrues a liability for unfunded

deferred compensation

• Used to compensate top executives on a discriminatory basis

15-24

Self-Employed Plans - KeoghSelf-Employed Plans - Keogh

• Self-employed individuals can contribute and deduct the lesser of:• 20% of earned income from self-employment• $52,000 (2014)

• If individual’s business hasemployees, the Keogh planmust provide them with retirement benefits on a nondiscriminatory basis

15-25

Individual Retirement AccountsIndividual Retirement Accounts

• Any individual who earns compensation or self-employment income can save for retirement through an individual retirement account (IRA)

• IRAs are tax-exempt so that earnings on the account grow at a before-tax rate• With a traditional IRA, earnings on the account are

taxed when the owner withdraws them

• With a Roth IRA, withdrawals are tax-exempt so the earnings on the account are never taxed

15-26

IRA ContributionsIRA Contributions

• Individuals can contribute up to $5,500 to an IRA in 2014• Contribution limited to 100% of

compensation/self-employment income• Additional $1,000 catch-up contribution for

individuals who reach age 50 by year-end

• Special rules:• Traditional IRAs – no contribution after age 70½• Roth IRAs – amount of contribution phased down

to zero for higher-income individuals

15-27

Deduction of IRA ContributionsDeduction of IRA Contributions

• Traditional IRAs – contributions can be fully deductible, partially deductible, or nondeductible based on two factors:

• Participation or nonparticipation by the individual in another qualified retirement plan

• AGI level (deduction phased down to zero for higher-income taxpayers)

• Roth IRAs – contributions are nondeductible

15-28

IRA WithdrawalsIRA Withdrawals

• Traditional IRAs

• Withdrawals must begin when owner reaches age 70½

• Tax consequences of withdrawals:

• Amount attributable to deductible contributions and accumulated earnings is taxed as ordinary income

• Amount attributable to nondeductible contributions is excluded from income

15-29

IRA Withdrawals (con’t)IRA Withdrawals (con’t)

• Roth IRAs

• Qualified withdrawals are tax-exempt

• Contributions are qualified if they occur after:

• Owner has reached age 59½

• Five-year period beginning with year of initial contribution

15-30

Rollover IRAsRollover IRAs

• Individuals can avoid tax (and premature withdrawal penalty) on distributions from qualified plans by rolling the distribution over into a traditional IRA• Rollover continues tax deferral on retirement income until

owner makes a withdrawal from the IRA

• Individuals can roll over distributions into a Roth IRA, regardless of their income level• Rollover from a tax-deferred retirement account

to a tax-exempt Roth IRA is a taxable event

15-31