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8/2/2019 ACIS+3314+Ch+12 1+Compensation
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Chapter 12
Compensation
ACIS 3314Tax Impact on Decisions
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Learning Objectives
1. Discuss and explain the tax implications ofcompensation in the form of salary and wages from theemployees and employers perspectives
2. Describe and distinguish the tax implications of variousforms of equity-based compensation from theemployers and employees perspectives
3. Compare and contrast taxable and nontaxable fringebenefits and explain the employee and employer taxconsequences associated with fringe benefits
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Salary and Wages
Employee Considerations for Salary andWages
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 bythe hour
Salary, bonus, and wages taxed as ordinaryincome
They report their wages on page 1, line 7 of the1040 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 makeschanges
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FICA (Payroll Taxes) Paid on employees wages
Consists of both Social Security and Medicarecomponent
Social Security tax paid at 6.2 percent on wage baseand 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
Salary and Wages
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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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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).
Timing of Employers Deduction
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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
Timing of Employers Deduction
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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.
Timing of Employers Deduction
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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 tocompensation.
Compensation in excess ofa 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 after1/1/1994
Publicly-traded corporations cannot deductcompensation in excess of $1 million per executive
per year.
Disallowance applies only to CEO and four highestpaid officers.
Exception: Certain types ofperformance-basedcompensation are not treated as executivecompensation 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 asincentive stock options
Grant date - Date on which employees are initiallyallocated stock options
Exercise date - Date that employees purchasestock using their options
Exercise price - Amount paid to acquire shares withstock 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 grantedcan 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) limitedto $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 theshares of stock acquired (whether they hold theshares or sell them immediately)
Taxpayers basis in NQOs acquired is the fair marketvalue on the date of exercise
Basis includes the exercise price plus the ordinaryincome the taxpayer recognizes on the bargainelement
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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 beginson the exercise date
Here bargain element is added to taxpayers alternativeminimum taxable income
For either type of options, employees experience no taxconsequences on the grant date or vesting date
Any future appreciation or depreciation of the stock will betreated as either short-term or long-term capital gain or lossdepending on the holding period (begins on the date ofexercise)
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Employer Considerations for Stock Options
Nonqualified options
No tax consequences on grant date
On exercise date, bargain element is treated asordinary (compensation) income to employee
Employee holds stock with holding period beginning
on date of exercise
Employers deduct bargain element ascompensation expense on exercise date
Equity-Based Compensation
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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 exercisedate)
If holding requirements are not met (if there is a disqualifyingdisposition), option becomes an NQO
When employee sells stock, employee recognizes long-term capitalgain
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 taxdeduction)
IRS regulatory requirements for ISOs can be cumbersome
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Firms with high marginal tax rates may lose significant taxbenefits by issuing ISOs rather than NQOs
On the other hand, start-up companies or firms with netoperating losses may actually benefit by issuing ISOs instead
of NQOs Accounting Issues
For tax purposes, employer deducts bargain element onexercise date
For GAAP purposes, employer expenses the estimated valueof the option pro rata over the vesting period
Equity-Based Compensation
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Tax Treatment of Stock Options
ISO NQO
Employee Grant
Exercise
Sale
No Income
No Income
LTCG = PsX
No Income
Ordinary = PeX
CG = PsPe
Employer No Deduction Ever Deduction at Exercise =
PeX
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Same Amount, Same Time
Option Granted Option Exercised Stock Sold
Pg X Pe Ps
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Stock Options Questions
Mary is offered 7,000 options on Jan. 1st, 2009. They veston Jan. 1st 2012. The exercise price is $10 per share. OnJan. 1st 2012 she exercises all 7,000 options when the
price is $17 per share. She holds the stock for two yearsand sells all 7,000 shares for $20 per share. She is in the30% tax bracket. What is her tax liability on the grantdate, 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 atpreferential rates.
Tax liability =
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Stock Options Solution
If options are NQOs:
Grant date:
Exercise date:
Sale date:
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Employee is given stock, generally at zero cost
However, stock is restricted (i.e. cannot be sold orotherwise treated as owned until the vesting date).
IRC 83(a): General rules for Employee
Timing of income recognition = tax year in which propertybecomes transferable (i.e. fully vested) or not subject to asubstantial risk of forfeiture.
Amountof income recognition = Excess of propertys FMV
(determined when property becomes transferable) overamount paid (if any)
83(h): Amount & timing ofemployers deduction tied toemployees income recognition.
Restricted Stock Awards
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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
Restricted Stock Awards
Stock Grant Vesting Stock Sold
Pg Pv Ps
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Restricted Stock Awards
Without 83(b) Election No tax consequences on grant
date
On vesting date
Employee recognizesordinary income = FMV
Holding period for stock
begins
Employer deductscompensation expense =FMV
Stock Grant Vesting Stock Sold
Pg P
v P
s
With83(b) Election On grant date
Employee recognizes ordinary
income = FMV
Holding period for stock begins
Employer deducts compensation
expense = FMV
No tax consequences on vestingdate
If employee never vests, no taxdeduction for basis in stock.
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Employer Considerations for Restricted Stock
Timing of the deduction is determined by theemployees decisions regarding the 83(b) election
Other non tax issues
For tax purposes, employers deduct the marketvalue of stock when the employee recognizesincome
For GAAP purposes, employers deduct the grantdate value over the vesting period
Equity-Based Compensation
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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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Employers often provide noncash benefits toemployees 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
Fringe Benefits
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Employees recognize gross income when employers pay lifeinsurance premiums for policies with death benefits >
$50,000
To compute the annual taxable benefit
Step 1: Subtract $50,000 from the policys death benefitStep 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 ageStep 4: Multiply the outcome of Step 3 by 12 (months)
Example: Group Term Life Insurance
E l T t t f T bl F i
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Pay the employers share of FICA taxes on thetaxable portion of benefits provided to
employees
Deduct employers cost of the benefit (not valueof benefit to employee)
Report taxable fringe benefit on employees W-2
Employer Treatment of Taxable Fringe
Benefits
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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)
Nontaxable Fringe Benefits
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Certain Fringe Benefits132
No-Additional-Cost Services
Qualified Employee Discounts
Working Condition Fringe Benefits
De Minimis Fringe Benefits
Qualified Transportation Fringe
Qualified Moving Expense Reimbursement
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Cafeteria Plans125
Employer determines the total dollar amountit wishes to provide each employee
Employee then chooses how to spend those
dollars among a menu of nontaxable fringebenefits
If employee doesnt spend the entire
amount, employee receives the difference astaxable cash compensation
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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 wouldbe 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 FringeBenefits (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