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  • 1. Chapter 14 Deferred Compensation and Education Savings Plans©2012 CCH. All Rights Reserved.4025 W. Peterson Ave.Chicago, IL 60646-60851 800 248 3248www.CCHGroup.com
  • 2. Chapter 14 Exhibits 1. Investing for the Future: The Grocery Store Analogy 2. Employer-Sponsored Plans: Qualified v. Nonqualified 3. Distributions from Qualified Plans (QPs): Basic Concepts 4. Comparison of Defined Contribution and Defined Benefit Plans 5. Calculating RMDs Using the Uniform Lifetime Table 6. Portability Chart 7. Common Retirement Plans for Large Employers—Eligible Employers 8. Common Retirement Plans for Large Employers—Basic Features 9. Common Retirement Plans for Large Employers— Contribution Limits 10. 401(k) Plans—Lecture Problem on Tax Consequences 11. Common Retirement Plans for Small Businesses—Basic FeaturesChapter 14, Exhibit Contents A CCH Federal Taxation Basic Principles 2 of 61
  • 3. Chapter 14 Exhibits 12. Common Retirement Plans for Small Businesses—Contribution and Deduction Limits 13. Personal Retirement Plans for Working Individuals 14. Applying the Two Qualifying Tests to Roth Distributions 15. Employee Stock Purchase Plans—Qualifying Distributions 16. Employee Stock Purchase Plans—Disqualifying Distributions 17. Incentive Stock Options—Qualifying Distributions 18. Incentive Stock Options—Disqualifying Distributions 19. Nonqualified Stock Options (NSOs)—Value Known at Grant Date 20. Nonqualified Stock Options (NSOs)—Value Unknown at Grant Date 21. Restricted Stock Plans—With and Without Section 83(b) Election 22. Savings Plans for EducationChapter 14, Exhibit Contents B CCH Federal Taxation Basic Principles 3 of 61
  • 4. Investing for the Future: The Grocery Store Analogy  Fruit: Vegetables: Cereal: Coffee: Soup: Bread: Identify the • Apples • Carrots • Fiber • Freeze-dried • Vegetable • Rye food to buy • Oranges, etc. • Celery, etc. • Frosted, etc. • Instant, etc. • Tomato, etc. • Wheat, etc.  Highly Liquid Treasury Corporate Identify the Stocks: Real Estate: Commodities: Cash Securities: Bonds: investments to Equivalents: buy (this is a mere glimpse • S&P 500 • T-Bills • Risk Specific • Equity REITS • Foreign • Interest-Bearing • Russell 3000 • T-Notes • Term Specific • Mortgage Currencies Time Deposits into the thousands of • Industry-specific • T-Bonds • etc. REITS • Natural • Interest-Bearing (e.g., consumer • Hybrid REITS Resources Demand Deposits possibilities) • I-Bonds staples, utilities) • Industrial • etc. • EE- Bonds • Geographic-specific Metals • TIPS (e.g., Pacific rim, • Precious Latin America) • etc. Metals • Risk specific (e.g., • Grains aggressive growth • etc. stocks, “blue chips”) • Dividend specific (e.g., high yield stocks) • Market-size specific (e.g., emerging markets), etc. Select the grocery store  Kroger Whole Foods Costco Farmers Market Walmart 7-Eleven Select the financial institution  Fidelity Bank of America Vanguard 1st Federal S&L E-Trade PrudentialChapter 14, Exhibit 1a CCH Federal Taxation Basic Principles 4 of 61
  • 5. Investing for the Future: The Grocery Store Analogy Choose the type of food packaging  Cans Plastic Cartons Jugs Jars Rubber wrappers bands Choose the type of investment “packaging”  Mutual Exchange- Money market Bank certificates Savings Annuity funds traded funds funds of deposit accounts contracts  Choose the best Paper Plastic Box food carrier  Tax-free Tax Deferred Accounts Accounts Taxable Accounts Choose the best investment • Roth IRA Any account maintained “carrier” Employer-Sponsored Educational at a financial institution • Roth 401(k) plan Plans: Savings Plans: that generates: • Interest • 401(k) plan • 529 plans • Traditional IRA • Dividend income • 403(b) plan • Coverdell and/or • Employee stock ownership savings account • Capital gains plan (ESOP) • Solo 401(k) plan (for self- employed taxpayers or that is CURRENTLY single-employee entities) TAXABLE • Keogh plan • Simplified employee pension (SEP) IRA • Savings incentive match plan (SIMPLE) • DB/K plan • Nonqualified employer- sponsored plansChapter 14, Exhibit 1b CCH Federal Taxation Basic Principles 5 of 61
  • 6. Employer-Sponsored Plans: Qualified v. Nonqualified Examples of Qualified and Nonqualified Plans: Qualified Plans Nonqualified Plans  401(k) plans (corporate-styled profit  Rabbi Trusts, sharing or stock bonus plans),  Employee stock purchase plans,  Roth 401(k) plans (effective January 1, 2006 for amended 401(k) plans),  Incentive stock options,  403(b) plans (i.e., tax-sheltered annuity  Nonqualified stock options, arrangements),  Variable annuity contracts,  Employee stock ownership plans  Restricted stock, (ESOPs),  Solo 401(k) plans (for self-employed  Informal short-term arrangements. taxpayers or single-employee entities)  Keogh plans,  Simplified employee pension plans (SEP IRAs),  Savings incentive match plans for employees (SIMPLE IRAs)Chapter 14, Exhibit 2a CCH Federal Taxation Basic Principles 6 of 61
  • 7. Employer-Sponsored Plans: Qualified v. Nonqualified Tax Advantages (“+”) and Disadvantages (“-”) Qualified Plans Nonqualified Plans + Flexible Rules Governing Tax Deferral of Employer - Restrictive Rules Governing Deferral of Contributions. Contributions by employers and Employer Contributions. Employee tax employees are tax deferred (tax free for deferral on employer contributions can employee contributions to Roth 401(k) plans). be achieved only under either of two Taxation generally occurs when the amounts conditions: (a) the employer’s obligation contributed are eventually distributed to to pay the benefits remains merely an participants. Thus, the rules for tax deferral are unfunded and unsecured promise to pay more flexible for QPs than for NPs. A QP can (i.e., no “economic benefit”); or (b) the achieve tax deferral even if the employer employer’s obligation is funded or contribution has been funded or secured and the secured but the employee must bear a employee’s right to that compensation is not substantial risk of forfeiture (i.e., no subject to a substantial risk of forfeiture. constructive receipt”). + Deduction immediately available to employers. - No immediate employer tax deduction. An Corporate employers, self-employed taxpayers, employer is not entitled to a tax deduction or individuals (for IRAs) may deduct until such time as the benefits are actually contributions even though income tax is paid to the employee. deferred. For all plans except IRA’s, the contribution may create an NOL.Chapter 14, Exhibit 2b CCH Federal Taxation Basic Principles 7 of 61
  • 8. Employer-Sponsored Plans: Qualified v. Nonqualified Tax Advantages (“+”) and Disadvantages (“-”) Qualified Plans Nonqualified Plans + Accumulated income tax deferred. Interest, dividends & - Income is taxable to the employer (unless other income can accumulate tax free until benefits invested in tax-exempt securities). are paid. (With Roth 401(k) plans, accumulated income is intended to be tax-free.) + Future payouts with lower tax rates. Tax benefits are + Same advantage. typically paid out after retirement when the employee’s effective tax rate is often lower. + Payroll tax exemption. Employer contributions (but not - No payroll tax exemption. Employer employee contributions!) are exempt from FICA contributions are generally subject and FUTA taxes when paid into and out of a QP. to Social Security and Medicare taxes when services are performed or, if later, when a person’s right to receive the compensation no longer is subject to a substantial risk of forfeiture. Sec. 3121(v).Chapter 14, Exhibit 2c CCH Federal Taxation Basic Principles 8 of 61
  • 9. Employer-Sponsored Plans: Qualified v. Nonqualified Tax Advantages (“+”) and Disadvantages (“-”) Qualified Plans Nonqualified Plans + Portability. Tax-free transfers between two QPs and - No Portability. from one QP to a traditional IRAs are permitted, thereby extending tax deferral. - Credit to small employers for startup costs. Small - No employer tax credit available. employers may be entitled to receive a credit for some of the costs of establishing new QPs see CCH ¶9045). - Credit to employees for contributions. Employees may - No employee tax credit available. be entitled to receive a saver’s credit for elective contributions to a QP (see CCH ¶9033).Chapter 14, Exhibit 2d CCH Federal Taxation Basic Principles 9 of 61
  • 10. Employer-Sponsored Plans: Qualified v. Nonqualified Nontax Advantages (“+”) and Disadvantages (“-”) Qualified Plans Nonqualified Plans + Bankruptcy protection. Plan assets are protected from the - No bankruptcy protection. employer, employer creditors, and employee creditors. (O.J. Simpson receives $25,000 monthly from his pension plan despite losing a $36 million judgment to the Goldman family.) + Employment incentive. QPs can be used to attract and + Same advantage. retain employees. + Loan option available to employees. Participants may be - No loan option. permitted to borrow up to $50,000 from their QPs.Chapter 14, Exhibit 2e CCH Federal Taxation Basic Principles 10 of 61
  • 11. Employer-Sponsored Plans: Qualified v. Nonqualified Nontax Advantages (“+”) and Disadvantages (“-”) Qualified Plans Nonqualified Plans - Nondiscrimination. The plan cannot discriminate in + More flexibility in choosing who participates. favor of highly compensated employees. Code NPs are not subject to the same Sec. 401(a)(4). minimum coverage and nondiscrimination requirements as QPs. Therefore, an NP can be designed to cover a limited group of employees. - Distribution restrictions. Distributions made too soon + No statutory restrictions on distributions. may be subject to a 10% penalty. If made too late and/or too little in amount, a 50% penalty may be imposed on the recipient. - Limitation on annual employee compensation. For + Unlimited benefits. An NP can provide most employer-sponsored retirement plans, benefits in excess of those permitted compensation subject to employer and employee under QP limits. contribution percentages is limited to $250,000 in 2012.Chapter 14, Exhibit 2f CCH Federal Taxation Basic Principles 11 of 61
  • 12. Employer-Sponsored Plans: Qualified v. Nonqualified Nontax Advantages (“+”) and Disadvantages (“-”) Qualified Plans Nonqualified Plans - Limitation on contributions. Specified limits apply to how + No limitation on contributions. much employees and employers can contribute to a QP. Code Sec. 415. - Independence of trustee. For most employer-sponsored + No independent trustee retirement plans, retirement funds must be held in requirement. trust managed by an independent trustee. Exceptions include Keogh plans for self-employed taxpayers. - Participation and coverage. Employees meeting certain + No participation and coverage minimum age and service requirements must be requirements.. eligible to participate in an employer-sponsored retirement plan. In addition, the plan must generally cover at least 70% of eligible employees on a nondiscriminatory bases. Sec. 410. Exceptions include SIMPLE IRA plans.Chapter 14, Exhibit 2g CCH Federal Taxation Basic Principles 12 of 61
  • 13. Employer-Sponsored Plans: Qualified v. Nonqualified Nontax Advantages (“+”) and Disadvantages (“-”) Qualified Plans Nonqualified Plans - Written and continuous plan. The plan must be in writing and + The NP need not be written and constitute a continuous program. continuous. - Vesting. An employee’s nonforfeitable right to receive future + No vesting rules imposed on benefits must take effect within a prescribed time frame. employer. Sec. 411. - Exclusive benefit of employees. The plan must be created and + No “exclusive benefit of operated for the exclusive benefit of the employees” requirement. employee/participants and isolated from potential misfortunes of the employer.Chapter 14, Exhibit 2h CCH Federal Taxation Basic Principles 13 of 61
  • 14. Distributions from Qualified Plans (QPs): Basic Concepts “Before-Tax” v. “After-Tax Contributions. Grasping the distinction between “before-tax” and “after-tax” contributions is essential to understanding the distribution rules governing qualified deferred compensation plans. Here’s the distinction: If contributions made to qualified plans such as traditional IRAs or 401(k) plans are deductible, the subsequent withdrawal of these contributions is taxable. Conversely, if the contributions are not deductible, the subsequent withdrawal is tax-free. The rules governing the deductibility of contributions are explained later in this chapter. For now, it’s important to understand why deductible contributions are “before-tax” and why nondeductible contributions are “after-tax.” This distinction is illustrated below.Chapter 14, Exhibit 3a CCH Federal Taxation Basic Principles 14 of 61
  • 15. Distributions from Qualified Plans (QPs): Basic Concepts Illustration of Tax Effect from “Before-Tax” and “After-Tax” Contributions. Assume a taxpayer earns a $100,000 salary and contributes $4,000 into a retirement account such as a traditional IRA or a 401(k). Assume the current tax rate to be 25%.  Will the $4,000 contribution be taxable when it is subsequently distributed back to the taxpayer? As illustrated below, the answer depends on whether or not the contribution was deductible.  Will the income accumulating from the $4,000 contribution be taxable when later distributed? Yes, unless the QP is a Roth IRA or a Roth 401(k).Chapter 14, Exhibit 3b CCH Federal Taxation Basic Principles 15 of 61
  • 16. Distributions from Qualified Plans (QPs): Basic Concepts Formula: Description: Before Tax Cont’n After-Tax Cont’n (a) = Given Contribution $4,000 $4,000 (b) = Given Deductible? (The rules for Assume Yes Assume No qualifying for a deduction are explained later in this chapter.) (c) = Given Gross income $100,000 $100,000 (d) = (a) only if Deduction (4,000) 0 (b)=“yes” (e) = (c)–(d) Taxable income 96,000 100,000 (ignoring other deductions) (f) = Given Tax rate 25% 25% (g) = (e) x (f) Tax 24,000 25,000 (h) = (d) x (f) Immediate tax savings from the 1,000 0 $4m deductionChapter 14, Exhibit 3c CCH Federal Taxation Basic Principles 16 of 61
  • 17. Distributions from Qualified Plans (QPs): Basic Concepts Formula: Description: Before Tax Cont’n After-Tax Cont’n (i) = (d) x tax Estimated future taxes $1.000 $0 rate in payable when the (assuming a 25% future tax rate; if effect in $4,000 is the future tax rate is lower (or the year of subsequently higher) due to, say, lower dist’n distributed (higher) retirement income, the tax burden will be less (more) than $1m) If (b) =“yes:” Amount of income $4,000 $5,333 (j) = (a) needed to afford the (Same as the contribution amount. (To afford a $4,000 If (b) =“no:” $4,000 contribution This is why the contribution is contribution, the (j) = (a) ÷ [1– “before-tax”.) taxpayer needs to earn (f)] at least $5,333, which, taxed at 25%, would result in $4,000 cash after-tax. This explains why the nondeductible contribution is considered to be “after- tax.” Proof: 25% x $5,333 = $4,000)Chapter 14, Exhibit 3d CCH Federal Taxation Basic Principles 17 of 61
  • 18. Comparison of Defined Contribution and Defined Benefit Plans Defined Contribution Plans (DCPs) Defined Benefit Plans (DBPs) Contributions (a) Fixed percentages; or Determined actuarially based on (b) Flat dollar amounts. defined benefits. Contribution Limit Lesser of: N/A (1) $50,000 in 2012, or (2) 100% employee’s gross compensation (25% for profit sharing, money purchase, or stock bonus plans). (Note: This limit applies to the aggregate of employer and employee contributions, as well as forfeitures allocated to the employee’s account.) Benefits The final benefits depend upon investment The final benefit is a fixed and pre- performance of the trust account. Upon determinable lump-sum or retirement, an employee is entitled to the annuity. account balance, either as a lump-sum or an annuity.Chapter 14, Exhibit 4a CCH Federal Taxation Basic Principles 18 of 61
  • 19. Comparison of Defined Contribution and Defined Benefit Plans Defined Contribution Plans (DCPs) Defined Benefit Plans (DBPs) Benefit Limit N/A Lesser of: (1) $200,000 in 2012 (2) Average salary for highest 3 years of employment (Adjustments based on age, years’ participation or years’ employment may be required.) Forfeitures Increase employee benefits, or Must reduce future contributions by Reduce future contributions by employer. (Forfeitures cannot increase employer. employee benefits.) Ideal Employee More favorable for younger employees More favorable for older employees at the Targets since, over a longer period of time the plan is adopted since it is time, higher benefits may result. possible to fund higher benefits over a shorter period. Complexity Less than DBPs Require greater reporting requirements and more actuarial and administrative costs. (This explains why (a) it is impractical for many small businesses and (b) there has been a massive shift away from DBPs over the past decade.)Chapter 14, Exhibit 4b CCH Federal Taxation Basic Principles 19 of 61
  • 20. Calculating RMDs Using the Uniform Lifetime Table Minimum amount of first distribution = (a) ÷ (b), where: (a) = Accrued benefit or account balance as of December 31 of the year preceding the year in which the taxpayer attains the age of 70 1/2, or retires, if applicable. (b) = Hypothetical joint life expectancy provided in the Uniform Lifetime table below, that is based on: (i) the taxpayer’s age on December 31 of the year in which the taxpayer attains the age of 70 1/2, (or retires, if applicable,) and (ii) a hypothetical beneficiary whose age is exactly ten years younger than the taxpayer’s.Chapter 14, Exhibit 5a CCH Federal Taxation Basic Principles 20 of 61
  • 21. Calculating RMDs Using the Uniform Lifetime Table Minimum amount of subsequent distributions = (c) ÷ (d), where: (c) = Accrued benefit or account balance as of December 31 of the year preceding the year in which a distribution must be made (e.g., use the balance as of December 31, Year 1 if a second distribution is due by December 31, Year 2). (d) = Redetermined joint life expectancy provided in the Uniform Lifetime table below.]Chapter 14, Exhibit 5b CCH Federal Taxation Basic Principles 21 of 61
  • 22. Calculating RMDs Using the Uniform Lifetime Table Table 2: Uniform Lifetime Table Age of IRA Owner Distribution Period Age Life Age Life Age Life Age Life Age Life Exp. Exp. Exp. Exp. Exp. 70 27.4 80 18.7 90 11.4 100 6.3 110 3.1 71 26.5 81 17.9 91 10.8 101 5.9 111 2.9 72 25.6 82 17.1 92 10.2 102 5.5 112 2.6 73 24.7 83 16.3 93 9.6 103 5.2 113 2.4 74 23.8 84 15.5 94 9.1 104 4.9 114 2.1 75 22.9 85 14.8 95 8.6 105 4.5 115 1.9 76 22.0 86 14.1 96 8.1 106 4.2 (or older) 77 21.2 87 13.4 97 7.6 107 3.9 78 20.3 88 12.7 98 7.1 108 3.7 79 19.5 89 12.0 99 6.7 109 3.4Chapter 14, Exhibit 5c CCH Federal Taxation Basic Principles 22 of 61
  • 23. Calculating RMDs Using the Uniform Lifetime Table Eve’s traditional IRA account balances for five years are shown below: Date Account Balance December 31, Year 1 $274,000 December 31, Year 2 $296,200 December 31, Year 3 $320,000 December 31, Year 4 $345,800 December 31, Year 5 $340,500Chapter 14, Exhibit 5d CCH Federal Taxation Basic Principles 23 of 61
  • 24. Calculating RMDs Using the Uniform Lifetime Table Eve becomes age 70 on June 1, Year 2, and retires at the end of Year 3. Since Eve’s plan is not employer-sponsored, the retirement date is irrelevant in determining her RMD. The initial RMD (deadline and amount) is based on the year in which she becomes 70 ½ (Year 2). The deadlines and amounts associated with the first four RMDs are shown below. Distribution: Relevant Relevant Computation of RMD Amt. No. RMD Acct. Bal. Age on (refer to the Uniform RMD Date Date (12/31) Dec. 31 of: Lifetime Table above) Amount 1st 4/1 Yr 3 Yr 1 Yr 2: 70 $274,000 ÷ 27.4 $10,000 2nd 12/31, Yr 3 Yr 2 Yr 3: 71 [$296,200 - $10,000] ÷ 26.5 $10,800 3rd 12/31, Yr 4 Yr 3 Yr 4: 72 $320,000 ÷ 25.6 $12,500 4th 12/31, Yr 5 Yr 4 Yr 5: 73 $345,800 ÷ 24.7 $14,000Chapter 14, Exhibit 5e CCH Federal Taxation Basic Principles 24 of 61
  • 25. Portability Chart ELIGIBLE ROLLOVER TO RECIPIENT PLAN? (Yes v. No) Roth Keogh SEP Trad’l 403(b) Govt. Plan IRA SIMPLE IRA Roth TO: 401(k) 401(k)/ Plan 457(b) IRA IRA 403(b) FROM: 401(k) - Other Than Yd N Yc Yc Yd Y N Y Y Roth 401(k) 403(b) - Other Than Y N Y Y Y Y N Y Y Roth 403(b) Roth 401(k)/ 403(b) by N Y N N N N N N Y Direct Rollover Governmental 457(b) Y N Y Y Y Y N Y Y Keogh Yd N Yc Yc Yd Y N Y Y SEP IRA Ya N Ya Ya Ya Y N Y Y SIMPLE IRAb Y N Y Y Y Y Y Y Y Traditional IRA Ya N Ya Ya Ya Y N Y Y Roth IRA N N N N N N N N Y Superscript Notes: a Only pretax amounts from a traditional IRA or SEP IRA may be rolled to these plans. bChapter 14, Exhibit 6 CCH Federal Taxation Basic Principles 25 of 61
  • 26. Common Retirement Plans for Large Employers—Eligible Employers Characteristics: 401(k) 403(b) 457(b) 457(b) (“Tax Sheltered (Governmental) (Nongovernmental) Annuity” Plan) Description of Taxable • Tax-exempt • State and local • Tax-exempt Eligible entities organizations governments organizations Employers: • Public school systems Examples of eligible employers: For-profit employer Yes No No No formed as a C or S corporation, partnership, LLC, or proprietorshipChapter 14, Exhibit 7a CCH Federal Taxation Basic Principles 26 of 61
  • 27. Common Retirement Plans for Large Employers—Eligible Employers Characteristics: 401(k) 403(b) 457(b) 457(b) (“Tax Sheltered (Governmental) (Nongovernmental) Annuity” Plan) Examples of eligible employers (contd.): Federal government No No No No State and local No No Yes No governments (unless it’s an educational institution) Schools (K to No Yes for both Yes for Yes for 501(c)(3) university level) (unless it’s a governmental governmenta organizations for-profit (state & local) l (state & business) or 501(c)(3) tax local) exempt employers organizationsChapter 14, Exhibit 7b CCH Federal Taxation Basic Principles 27 of 61
  • 28. Common Retirement Plans for Large Employers—Eligible Employers Characteristics: 401(k) 403(b) 457(b) 457(b) (“Tax Sheltered (Governmental) (Nongovernmental) Annuity” Plan) Examples of eligible employers (contd.): Hospitals No Yes for 501(c)(3) Yes for Yes for 501(c)(3) (unless it’s a organizations governmental organizations for-profit (state & local) business) employers Museums that are tax- No Yes for 501(c)(3) Yes for Yes for 501(c)(3) exempt organizations governmental organizations (state & local) employers Libraries that are tax- No Yes for 501(c)(3) Yes for Yes for 501(c)(3) exempt organizations governmental organizations (state & local) employers Private research No Yes No Yes foundations Labor unions No Yes No Yes Private clubs No Yes No YesChapter 14, Exhibit 7c CCH Federal Taxation Basic Principles 28 of 61
  • 29. Common Retirement Plans for Large Employers—Basic Features Features: 401(k) 403(b) 457(b) 457(b) (“Tax Sheltered (Governmental) (Nongovernmental) Annuity” Plan) Plan type Qualified Qualified Nonqualified Nonqualified Able to discriminate? No No Yes Yes Loans up to $50,000 OK? Yes Yes Yes No Subject to 10% penalty on Yes Yes No (unless the No premature withdrawals? distribution consists of an amount previously rolled over from another type of plan) Subject to 50% penalty on Yes Yes Yes No late RMDs? Subject to $5,000 mandatory Yes Yes Yes No cash-out rules?Chapter 14, Exhibit 8a CCH Federal Taxation Basic Principles 29 of 61
  • 30. Common Retirement Plans for Large Employers—Basic Features Features: 401(k) 403(b) 457(b) 457(b) (“Tax Sheltered (Governmental) (Nongovernmental) Annuity” Plan) Portable with other employer- Yes Yes Yes No sponsored plans and IRAs? Subject to statutory vesting Yes Yes No No rules for employer contributions? Must be for exclusive benefit of Yes Yes for Yes No employees? retirement income accounts; No, for annuity contracts and custodial accounts. Protection from creditors of Yes Yes Yes No employer?Chapter 14, Exhibit 8b CCH Federal Taxation Basic Principles 30 of 61
  • 31. Common Retirement Plans for Large Employers—Contribution Limits Limits: 401(k) 403(b) 457(b) 457(b) (“Tax Sheltered (Governmental) (Nongovernmental) Annuity” Plan) Are employee Yes, limited to the Yes, limited to the Yes, limited to the Yes, limited to the elective lesser of: lesser of: lesser of: lesser of: deferral (1) = 17,000; (1) = 17,000; (1) = 17,000; (1) = 17,000; contributions (2) = 100% GC (2) = 100% GC (2) = 100% GC (2) = 100% GC allowed? * + $5,500 if age * + $5,500 if age 50+ * + $5,500 if age + $15,000 (max.) if (“GC” is defined 50+ + $3,000 (max.) if 50+ within 3 years below) completed 15 years OR of retirement of service + $15,000 (max.) if (The 50 + catch-up within 3 years contribution is of retirement not permitted.) Aggregate Limit Lesser of: Lesser of: Same as employee Same as employee on Employer (1) = $50,000 or (1) = $50,000 or elective elective and (2) = 100% GC (2) = 100% GC deferral deferral Employee plus catch-up plus catch-Up contribution contribution Contributions contributions contributions limit above. limit above. “GC:” Gross compensation is equal to the employee’s salary plus any qualified benefits such as medical insurance premiums under a cafeteria plan.Chapter 14, Exhibit 9a CCH Federal Taxation Basic Principles 31 of 61
  • 32. Common Retirement Plans for Large Employers—Contribution Limits Limits: 401(k) 403(b) 457(b) 457(b) (“Tax Sheltered (Governmental) (Nongovernmental Annuity” Plan) ) Are No for employer Same as 401(k) Same as 401(k) Yes contribution contributions; s subject to Yes for employee FICA or contributions. FUTA? Are employee Yes if written into Same as 401(k) No No supplement the plan al after-tax contribution s allowed? “GC:” Gross compensation is equal to the employee’s salary plus any qualified benefits such as medical insurance premiums under a cafeteria plan.Chapter 14, Exhibit 9b CCH Federal Taxation Basic Principles 32 of 61
  • 33. 401(k) Plans—Lecture Problem on Tax Consequences Facts: • ABC Corp’s 401(k) plan provides that employees may elect to contribute 100% of their “gross” compensation, up to $17,000, the elective deferral limit. • ABC will match employee contributions up to 6% of “net” compensation. • Cy elects to contribute 10% of his $25,000 salary in 2012. Explain the tax consequences. Tax consequences: Employee elective deferral contribution: $2,500 (= 10% x $25,000) Employer contribution: $1,350 (= 6% x [$25,000 - $2,500]) Amt. of salary subject to employee $25,000 (i.e., elective employee contributions, but not FICA: employer contributions, are subject to FICA tax.) Amt. of salary currently subject to $22,500 (= $25,000 - [10% x $25,000]) federal income tax: Amt. of salary currently escaping $3,850 (= $2,500 + $1,350) federal income tax: Note: If ABC’s plan had been a 403(b) or 457, the tax consequences would have been the same.Chapter 14, Exhibit 10 CCH Federal Taxation Basic Principles 33 of 61
  • 34. Common Retirement Plans for Small Businesses—Basic Features Features Solo 401(k) Keogh SEP SIMPLE Form of plan: 401(k) Pension, profit- IRA IRA or 401(k) sharing, or both Self as trustee Yes Yes No No OK? Permitted legal • LLCs, • LLCs, • LLCs, • LLCs, entity type: • Partnerships • Partnerships • Partnerships • Partnerships • Sole props. • Sole props. • Sole props. • Sole props. • C or S • C or S corps., corporations Limit on number Must not exceed 1 No limit No limit Must not exceed of owner-employee 100 employees employees: (except for spouse)Chapter 14, Exhibit 11a CCH Federal Taxation Basic Principles 34 of 61
  • 35. Common Retirement Plans for Small Businesses—Basic Features Features Solo 401(k) Keogh SEP SIMPLE Annual filing Annual IRS Form Annual IRS Form None. None. requirements: 5500-EZ or 5500-EZ or (although certain (although certain W- Form 5500 once Form 5500 once W-2 reporting 2 reporting is balance exceeds balance exceeds is required.) required.) $250,000 (by last $100,000, or day of 7th month $250,000 for a after year-end) one-participant plan (by last day of 7th month after year-end) Statutory By December 31 of By December 31 of By extension due By October 1 of establishment the current year. the current date of current year. deadline year. employer (financial return. institutions may set earlier deadlines):Chapter 14, Exhibit 11b CCH Federal Taxation Basic Principles 35 of 61
  • 36. Common Retirement Plans for Small Businesses—Basic Features Features Solo 401(k) Keogh SEP SIMPLE Statutory Employee: By Dec. By extension due By extension due By extension due date contribution 31 of current date of date of of employer deadline: year; employer employer return. Employer: By return. return. extension due date. Vesting None Regular vesting None None requirements: (since no employee rules (e.g., 3- (Employer (Employer other than yr. cliff or 6- contributions contributions spouse may be yr. graded) are always are always employed) apply nonforfeitable) nonforfeitable) Plan loans ok? Yes, up to $50,000 Yes, up to $50,000 No NoChapter 14, Exhibit 11c CCH Federal Taxation Basic Principles 36 of 61
  • 37. Common Retirement Plans for Small Businesses—Basic Features Features Solo 401(k) Keogh SEP SIMPLE Participation Only owner- Each employee: Each employee: SIMPLE IRA: requirements: employee (and • age 21 or • age 21 or over; Each employee: spouse) may over; & • who performed • Any age limit; participate • with 1 year of services in • Earn at least $5K service (2 current year for any past 2 years with 2- and in 3 out of years and be year vesting). past 5 years; expected to do so • who earned at in current year. least $550 for SIMPLE 401(k): current year. (same as Keogh) Rollovers Yes Yes Yes Yes, but rules are very permitted? restrictive for SIMPLE IRAsChapter 14, Exhibit 11d CCH Federal Taxation Basic Principles 37 of 61
  • 38. Common Retirement Plans for Small Businesses— Contribution and Deduction Limits Features Solo 401(k) Keogh SEP SIMPLE Contribution limits for Lesser of: N/A N/A Lesser of: employees (or (1) = 17,000; (1) = 100% GC (or gross SEI), or “deemed (2) = 100% GC or (2) = $11,500 employees”) (see gross SEI “Terms” below): Contribution limits for (See aggregate (See aggregate (See aggregate Elective contributions: employers (or contribution contribution contribution Lesser of (a) or (b): “deemed limit on the limit on the limit on the (a) = Employee (or “deemed” employers”) next slide.) next slide.) next slide.) employee) contributions (from above), or (b) = 3% GC (or gross SEI) for each participating employee Nonelective contributions: 2% GC for each eligible employee Terms: • “GC” mean gross compensation, i.e., salary paid or accrued to employees. • “Gross SEI” refers to (a) – (b) – (c) where (a) = self-employed taxpayer’s gross income from the business; (b) = business deductions; (c) = 1/2 x self-employment tax actually paid (for Keoghs and SEP IRAs); or [(a) – (b)] x .9235 (for solo 401(k)s & SIMPLE IRAs). • “Net SEI” is equal to gross SEI – the actual retirement plan deduction.Chapter 14, Exhibit 12a CCH Federal Taxation Basic Principles 38 of 61
  • 39. Common Retirement Plans for Small Businesses— Contribution and Deduction Limits Features Solo 401(k) Keogh SEP SIMPLE Aggregate Lesser of: Lesser of: Lesser of: (Separate employee and contribution limit (1) = $50,000 or (1) = $50,000 or (1) = $50,000 or employer limits apply for employers (2) = 25% GC (or (2) = 100% GC (2) = 25% GC (or —see and employees 20% gross or net SEI 20% gross preceding slide) SEI) (25% for SEI) single- profit sharing plans) $50,000 (of GC or net Yes Yes Yes For SIMPLE 401(k)s: Yes SEI) limit in For SIMPLE IRAs: No, contribution except for nonelective formula? contributions Terms: • “GC” mean gross compensation, i.e., salary paid or accrued to employees. • “Gross SEI” refers to (a) – (b) – (c) where (a) = self-employed taxpayer’s gross income from the business; (b) = business deductions; (c) = 1/2 x self-employment tax actually paid (for Keoghs and SEP IRAs); or [(a) – (b)] x .9235 (for solo 401(k)s & SIMPLE IRAs). • “Net SEI” is equal to gross SEI – the actual retirement plan deduction.Chapter 14, Exhibit 12b CCH Federal Taxation Basic Principles 39 of 61
  • 40. Common Retirement Plans for Small Businesses— Contribution and Deduction Limits Features Solo 401(k) Keogh SEP SIMPLE Age 50+ catch-up Yes, $5,500 for 2012. Yes, $5,500 for 2012. Yes, $2,500 for 2012 contributions: (This is in (This is in addition to the addition to the $50,000 $50,000 aggregate limit.) maximum limit.) Minimum None 1% to 3%, None The 3% employer contribution depending contribution percentage limits on the form shown above may be of Keogh reduced to 1% in any 2 out of 5 years. Terms: • “GC” mean gross compensation, i.e., salary paid or accrued to employees. • “Gross SEI” refers to (a) – (b) – (c) where (a) = self-employed taxpayer’s gross income from the business; (b) = business deductions; (c) = 1/2 x self-employment tax actually paid (for Keoghs and SEP IRAs); or [(a) – (b)] x .9235 (for solo 401(k)s & SIMPLE IRAs). • “Net SEI” is equal to gross SEI – the actual retirement plan deduction.Chapter 14, Exhibit 12c CCH Federal Taxation Basic Principles 40 of 61
  • 41. Common Retirement Plans for Small Businesses— Contribution and Deduction Limits Features Solo 401(k) Keogh SEP SIMPLE Deduction limit Same as aggregate Lesser of: Same as aggregate For corporate employers: for owner- contribution (1) = $50,000 contribution Same as employer employees limit (see or limit (see limit above. preceding slide) (2) = 25% GC preceding slide) For owner-employees: or net SEI Sum of the separate contribution limits for deemed employees and deemed employers Terms: • “GC” mean gross compensation, i.e., salary paid or accrued to employees. • “Gross SEI” refers to (a) – (b) – (c) where (a) = self-employed taxpayer’s gross income from the business; (b) = business deductions; (c) = 1/2 x self-employment tax actually paid (for Keoghs and SEP IRAs); or [(a) – (b)] x .9235 (for solo 401(k)s & SIMPLE IRAs). • “Net SEI” is equal to gross SEI – the actual retirement plan deduction.Chapter 14, Exhibit 12d CCH Federal Taxation Basic Principles 41 of 61
  • 42. Personal Retirement Plans for Working Individuals Features: Traditional IRA Roth IRA Ideal Investor Shorter time horizon Longer time horizon Time Frame Age of Must be age 18 but not 70 ½ or older No age restrictions. Contributor Minimum Yes Yes Compensation Requirement? Establishment By filing due date (April 15 of following year). Same deadline Deadline Contribution By filing due date (April 15 of following year). Same deadline Deadline Maximum $5,000 ($6,000 if age 50+) aggregate limit for Same limit Contribution traditional IRAs, deemed IRAs (SEP or SIMPLE), Amount and Roth IRAsChapter 14, Exhibit 13a CCH Federal Taxation Basic Principles 42 of 61
  • 43. Personal Retirement Plans for Working Individuals Features: Traditional IRA Roth IRA Contribution None MFJ: $173,000 – 183,000 Phase-Out Single: $110,000 - $125,000 (MAGI Limits) Deduction Phase- • For active participants: Never deductible Out (MAGI MFJ: $92,000 – $112,000 Limits) Single: $58,000 – $68,000 • For nonparticipant spouses of active participants: $173,000- $183,000) • For nonparticipants (including married taxpayers who are both nonparticipants): Contributions are fully deductible IRA Earnings Taxed when withdrawn Tax exempt if conditions are met Penalty for Early 10% 10% Withdrawals Penalty for Late None Withdrawals (no minimum distribution rules apply while participant is living) (Chapter 14, Exhibit 13b CCH Federal Taxation Basic Principles 43 of 61
  • 44. Applying the Two Qualifying Tests to Roth Distributions Ordering of Roth IRA Sources 1st 2nd 3rd 4th Direct Taxable Nontaxable Earnings Tests: Contributions Portion of Portion of Rollover Rollover Contributions Contributions (1) Has the five-year holding period requirement been met? If yes: ⇒⇒⇒⇒⇒⇒⇒⇒⇒ Penalty-free Penalty-free Penalty-free Penalty-free only if (2) below is also met If no: ⇒⇒⇒⇒⇒⇒⇒⇒⇒ Penalty-free 10% Penalty Penalty-free 10% penalty (2) Has the age 59 ½, death, disability, or 1st time home buying requirement been satisfied? If yes: ⇒⇒⇒⇒⇒⇒⇒⇒⇒ Tax-free Tax-free Tax-free Tax-free If No: ⇒⇒⇒⇒⇒⇒⇒⇒⇒ Tax-free Tax-free Tax-free TaxableChapter 14, Exhibit 14 CCH Federal Taxation Basic Principles 44 of 61
  • 45. Employee Stock Purchase Plans— Qualifying Distributions Consider an ESPP with a 10% discount, a look-back provision, and a 6-month offering period. Assume Avery Cobb is paid $90,000 annually and (on an after-tax basis) contributes 5% of gross pay to purchase stock, or $4,500. Let the share price be $50 on the first day of the offering period and $200 on the last day of the offering period. With the discount and look-back, Avery gets to purchase stock at a per share price of $45, which is equal to 85 percent of the lesser of (a) the offering price ($50) or (b) the purchase price ($200). The total number of shares purchased with the $4,500 contributed is thus 100 ($4,500 ÷ $45). Assume first that Avery holds the shares 18 months for a qualified disposition. If the price per share at disposition is $250, the total gain per share is $250 - $45 = $155. The discount at the start of offering period was $5 per share ($50 × 10% ). This is less than the $155 per share total gain on sale, so $5 per share is taxed as ordinary income and is subject to FICA and FUTA taxes; the remainder, $150 per share, is taxed as a long-term capital gain. Furthermore, because the shares were held for a qualified disposition, the employer gets no corporate tax deduction. See per share computations below.Chapter 14, Exhibit 15a CCH Federal Taxation Basic Principles 45 of 61
  • 46. Employee Stock Purchase Plans— Qualifying Distributions Formula Description Per Share Amt. (a) = Given Grant price (FMV at beginning of offering $50 period) (b) = Given Purchase price (FMV at end of offering period) $200 (c) = Given Sale price (upon disposition of stock) $250 (d) = Given Employee purchase discount % 10% (e) = (d) x [the lesser of ( a) or (b)] Employee purchase discount amount: $5 10% x $50 = $5 (f) = [the lesser of ( a) or (b)] – (e) Actual cost to employee: $45 $50 – $5 = $45 (g) = the lesser of: Ordinary income = the lesser of: $5 • (c) - (f); • $250 - $45 = $205 • (a) x (d) • $50 x 10% = $5 (h) = (f) + (g) Tax basis for computing capital gain: $50 $45 + $5 = $50 (i) = (c) – (h) Capital gain: $250 - $50 = $200 $200Chapter 14, Exhibit 15b CCH Federal Taxation Basic Principles 46 of 61
  • 47. Employee Stock Purchase Plans— Disqualifying Distributions Referring to the preceding example, assume that the shares were disposed of immediately after purchase in a same-day sale. The sale would be a disqualifying disposition for either of two reasons: Avery would have sold the stock (1) within one year or less from the exercise (purchase) date and (2) less than two years after the offering (grant) date. In this case, the disposition is $200 per share and the gain per share is $200 - $45 = $155, all of which is taxed as ordinary income and is subject to FICA and FUTA taxes. Because the shares were sold in a disqualifying disposition, the employer gets a corporate tax deduction for the compensation amount of $155 per share. The employer’s statutory FICA and FUTA taxes on the $155 per share ordinary income are deductible as well. The formula for disqualifying dispositions is provided in the computations in the next slide.Chapter 14, Exhibit 16a CCH Federal Taxation Basic Principles 47 of 61
  • 48. Employee Stock Purchase Plans— Disqualifying Distributions Formula Description Per Share Amt. (a) = Given Grant price (FMV at beginning of offering period) $50 (b) = Given Purchase price (FMV at end of offering period) $200 (c) = Given Sale price (upon disposition of stock) $200 (d) = Given Employee purchase discount % 10% (e) = (d) x [the lesser of ( a) or (b)] Employee purchase discount amount: 10% x $50 = $5 $5 (f) = [the lesser of ( a) or (b)] – (e) Actual cost to employee: $45 $50 – $5 = $45 (g) = (b) - (f) Ord. income: $200 - $45 = $155 $155 (h) = (f) + (g) Tax basis for computing capital gain: $45 + $155 = $200 $200 (i) = (c) – (h) Capital gain: $200 - $200 = $0 $0Chapter 14, Exhibit 16b CCH Federal Taxation Basic Principles 48 of 61
  • 49. Incentive Stock Options—Qualifying Distributions ABC Corp. grants George Willingham 1,000 ISOs on January 1, Year 1 (the “grant” date). On this date, the stock’s fair market value is $10 per share and each ISO entitles the holder to buy one share of ABC stock for $10 (the exercise price). George can exercise the ISO after one year of employment but not more than 10 years after the grant date and not more than three months after the effective severance date in the event his employment is terminated. George exercises the ISOs on December 31, Year 2 (the “exercise” date) when the stock is worth $200 per share. He sells the stock on January 1, Year 4 (the “sale” date) for $250 per share. Neither the granting nor exercising of the stock will have regular tax consequences to George in a qualifying disposition (but see discussion on AMT below). In the year of sale, George will report a $240 per share long-term capital gain. ABC is not allowed any deduction in connection with the ISOs, since no ordinary income was recognized by George. See per share computations in the next slide.Chapter 14, Exhibit 17a CCH Federal Taxation Basic Principles 49 of 61
  • 50. Incentive Stock Options—Qualifying Distributions Key Dates Qualifying Disposition No ordinary income (OI); ISO’s tax basis = $0 per ISO • ISO tax basis = $0 cost + $0 ordinary incomeChapter 14, Exhibit 17b CCH Federal Taxation Basic Principles 50 of 61
  • 51. Incentive Stock Options— Disqualifying Distributions Referring to the foregoing example, suppose that George Willingham sold his shares on June 30, Year 3. Because the stock was not held for one year from the exercise date, December 31, Year 3, George made a disqualifying disposition of the stock. As before, George will recognize no income on the grant date or on the exercise date. On June 30, Year 3 (the sale date) however, George will recognize $190 per share in ordinary income ($200 - $10) and $50 per share short-term capital gain ($250 - $200). The holding period of a disqualified ISO begins on the day after the exercise date; thus, George’s holding period is short-term (from January 1, Year 3, the day after the exercise date, to June 30, Year 3, the sale date). ABC is allowed a corresponding deduction of $190 per share for its tax year which includes December 31, Year 3, George’s year-end.Chapter 14, Exhibit 18a CCH Federal Taxation Basic Principles 51 of 61
  • 52. Incentive Stock Options— Disqualifying Distributions Key Dates Disqualifying Disposition Jan. 1, Year 1 No ordinary income (OI); ISO’s tax basis = $0 per ISO (ISO is granted.) • ISO tax basis = $0 cost + $0 ordinary income December 31, Year 2 No tax effect; stock basis = $10 per share (ISO is exercised.) • Stock basis = $10 cost + $0 ordinary income June 30, Year 3 (a) $190 per share ordinary income (OI) (Stock is sold.) • $190 OI = $200 exercise price - $10 stock basis (b) $50 per share short-term capital gain (STCG) • $50 STCG = $250 sale price - $200 FMV at exercise date • The holding period begins on January 1, Year 3, the day after the exercise date; therefore, the holding period is short-term.Chapter 14, Exhibit 18b CCH Federal Taxation Basic Principles 52 of 61
  • 53. Nonqualified Stock Options (NSOs)— Value Known at Grant Date XYZ Corp. grants Wesley Bloeme 1,000 NSOs on January 1, Year 1 (the “grant” date). Each NSO grants the holder the right to buy 1 share of XYZ stock for $10. Wesley can exercise the NSO after one year of employment. The stock’s readily ascertainable fair market value on the grant date is $50 per share. (Note that with NSOs, the exercise price may be below the market value of the stock since the Code Sec. 422(b)(4) pricing rules do not apply as they do for incentive stock options.) Wesley exercises the NSO on December 31, Year 2 (the “exercise” date) when the stock is worth $200 per share. He sells the stock on January 1, Year 4 (the “sale” date) for $250 per share. Wesley must recognize $50 per share ordinary income on the grant date and XYZ is allowed a corresponding deduction of $50 per share for its tax year which includes December 31, Year 1, Wesley’s year-end. Wesley must also report a $190 per share long-term capital gain in the year of sale. See per share computations in the next slide.Chapter 14, Exhibit 19a CCH Federal Taxation Basic Principles 53 of 61
  • 54. Nonqualified Stock Options (NSOs)— Value Known at Grant Date Key Dates Readily Ascertainable Value at Grant Date Jan. 1, Year 1 Ordinary income (OI) = $50 per share (NSO is granted.) • $50 OI = $50 NSO market value - $0 cost NSO tax basis = $50 per NSO • $50 NSO tax basis = $0 cost + $50 OI Dec. 31, Year 2 No ordinary income (OI); stock basis = $60 (NSO is exercised.) • $60 stock basis = $10 cost + $0 OI + $50 NSO basis Jan. 1, Year 4 $190 per share long-term capital gain (LTCG) (Stock is sold.) • $190 LTCG = $250 selling price - $60 stock basis • The holding period begins on January 2, Year 1, the day after grant date; therefore, the holding period is long-term.Chapter 14, Exhibit 19b CCH Federal Taxation Basic Principles 54 of 61
  • 55. Nonqualified Stock Options (NSOs)— Value Unknown at Grant Date Referring to the foregoing example, suppose that the XYZ stock had no readily ascertainable value on the grant date. Wesley recognizes no taxable income on the grant date. He recognizes $190 per share of ordinary compensation income on December 31, Year 2, when he exercises the NSO. XYZ will be allowed a deduction of the same $190 per share for its taxable year which contains December 31, Year 2, Wesley’s year-end. Wesley will also recognize a $50 per share long- term gain upon the sale of the stock on January 1, Year 4, since his holding period was more than twelve months (January 1, Year 3 – January 1, Year 4.Chapter 14, Exhibit 20a CCH Federal Taxation Basic Principles 55 of 61
  • 56. Nonqualified Stock Options (NSOs)— Value Unknown at Grant Date Key Dates No Readily Ascertainable Value at Grant Date Jan. 1, Year 1 No ordinary income (OI); NSO tax basis = $0 per NSO (NSO is granted.) • NSO tax basis = $0 cost + $0 ordinary income Dec. 31, Year 2 Ordinary income (OI) = $190 per share (NSO is exercised.) • $190 OI = $200 stock value - $10 cost] Stock basis = $200 per share • $200 stock basis = $10 cost + $190 OI Jan. 1, Year 4 $50 per share long-term capital gain (LTCG) (Stock is sold.) • $50 LTCG = $250 selling price - $200 stock basis • The holding period begins on January 1, Year 3, the day after exercise date; therefore, the holding period is long- term.Chapter 14, Exhibit 20b CCH Federal Taxation Basic Principles 56 of 61
  • 57. Restricted Stock Plans—With and Without Section 83(b) Election CTK Corp. transfers one hundred shares of its common stock to Matt Andres, an executive of CTK on January 1, Year 1. On the date of the transfer, the stock has a market value of $50 per share. Matt’s cost of the shares is discounted to $10 per share. The stock is intended as a bonus for Matt’s work for the year, but is issued with the restriction that if Matt leaves CKS’s employment within the next two years, he must return the shares to the corporation. On December 31, Year 2, when the restrictions expire, the stock is trading publicly at $200 per share. On January 1, Year 4, Matt sells the stock for $250 per share. Matt will recognize $40 per share ordinary income in Year 1 under the special Code Sec. 83(b) election, or he may postpone recognizing any ordinary income until the expiration of the restriction in Year 2. However, his recognized ordinary income would be $150 per share more. One of the principal advantages of the Code Sec. 83(b) election is the conversion of what would be ordinary income into a more favorable capital gain. For example, if Matt had sold the stock at its market value on the date of the lapse of the restrictions, December 31, Year 2, the entire gain of $190 would have been taxed as ordinary income without the election. With the election, he would have converted $150 per share of ordinary income into long-term capital gain. Since the ordinary tax rate can be substantially higher than the long-term capital gain rate, the Code Sec. 83(b) may be advantageous, despite accelerating the recognition of a portion of the income. See per share computations in the next slide.Chapter 14, Exhibit 21a CCH Federal Taxation Basic Principles 57 of 61
  • 58. Restricted Stock Plans—With and Without Section 83(b) Election Dates: Without Sec. 83(b) Election With Sec. 83(b) Election Jan. 1, Yr. 1 No ordinary income (OI) Ordinary income (OI) = $40 per share (Stock is Stock basis = $10 per share • $40 OI = $50 stock value - $10 issued.) • Stock basis = $10 cost + $0 OI stock cost] Stock basis = $50 per share • $50 stock basis = $10 cost + $40 OI Dec. 31, Yr. 2 Ordinary income (OI) = $190 per share No ordinary income (OI) (Restriction is • $190 OI = $200 stock value - $10 stock Stock basis = $50 per share (Unchanged lifted.) cost] from above) Stock basis = $200 per share • $200 stock basis = $10 cost + $190 OI Jan. 1, Yr. 4 $50 per share long-term capital gain $200 per share long-term capital gain (Stock is (LTCG) (LTCG) sold.) • $50 LTCG = $250 selling price - $200 • $200 LTCG = $250 selling price - stock basis $50 stock basis • The holding period begins on January 1, • The holding period begins on Year 3, the day after the restriction is January 2, Year 1, the day after the lifted; therefore, the holding period is stock is issued; therefore, the long-term. holding period is long-term.Chapter 14, Exhibit 21b CCH Federal Taxation Basic Principles 58 of 61
  • 59. Savings Plans for Education Item: Coverdell ESA 529 Prepaid Tuition Plan 529 Savings Plan Purpose: Tax-exempt accumulation of Tax-exempt accumulation Tax-exempt accumulation of income to pay for the of income to pay for income to pay for the qualified kindergarten the qualified qualified postsecondary through postsecondary postsecondary education expenses of a education expenses of a education expenses of beneficiary. beneficiary under age 30. a beneficiary. Age Restrictions: • For qualified None None contributions: the beneficiary must not be over age 18 at the end of the contribution year. • For qualified distributions: the beneficiary must not be more than age 30 at the end of the distribution year. Establishment By December 31 of current Depends on the plan Depends on the plan Deadline: year.Chapter 14, Exhibit 22a CCH Federal Taxation Basic Principles 59 of 61
  • 60. Savings Plans for Education Item: Coverdell ESA 529 Prepaid Tuition Plan 529 Savings Plan Contribution By filing due date (April 15 of Depends on the plan Depends on the plan Deadline following year). Maximum $2,000 per beneficiary (not per Determined by each state Determined by each state Contribution contributor) per year Amount Contribution MFJ: $190,000- $220,000 None None Phase-Out Other: $95,000 - $110,000 (MAGI Limits) Control of the In most states, account assets In most states, control of In most states, control of the Account: become property of the the account will account will always remain beneficiary at age 18. always remain with with the contributor. the contributor. Assignability to Immediate family of Same as CESA Same as CESA Other beneficiary, including Relatives: cousins, step-relatives, and in-lawsChapter 14, Exhibit 22b CCH Federal Taxation Basic Principles 60 of 61
  • 61. Savings Plans for Education Item: Coverdell ESA 529 Prepaid Tuition Plan 529 Savings Plan Earnings: Tax exempt if conditions are Same as CESA Same as CESA met. Penalty for Non- Earnings are taxed as ordinary Same as CESA Same as CESA Qualified income to contributor, plus Withdrawals: a 10% penalty. Effect on Considered to be an asset of the Considered to be the Assets are considered to be Financial Aid beneficiary, which means a student’s resource and property of the account Calculation: large portion of the assets thus reduces financial owner, which—unless the will be considered in the aid dollar-for-dollar. owner is also the financial aid calculation. beneficiary—means only a small portion of the assets will be considered in the financial aid calculation. Coordination Credits can be claimed in the Credits can be claimed in the Credits can be claimed in the with Hope same year as tax-free same year as tax-free same year as tax-free and Lifetime withdrawals provided that withdrawals provided withdrawals provided that Learning the distribution is not used that the distribution is the distribution is not used Credits for the same expenses for not used for the same for the same expenses for which a credit is claimed. expenses for which a which a credit is claimed. credit is claimed.Chapter 14, Exhibit 22c CCH Federal Taxation Basic Principles 61 of 61