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Chap012 Chap012 Presentation Transcript

  • McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter 12Compensation
  • 12-2Learning Objectives1. Discuss and explain the tax implications ofcompensation in the form of salary and wagesfrom the employee’s and employer’s perspectives2. Describe and distinguish the tax implications ofvarious forms of equity-based compensation fromthe employer’s and employee’s perspectives3. Compare and contrast taxable and nontaxablefringe benefits and explain the employee andemployer tax consequences associated with fringebenefits
  • 12-3Salary and Wages Employee Considerations for Salary andWages Fixed amount of compensation for the currentyear no matter how many hours worked Salaried employees eligible for bonuses Employees receiving wages generally get paidby the hour Salary, bonus, and wages taxed as ordinaryincome They report their wages on page 1, line 7 of the1040 federal tax return
  • 12-4Salary and Wages Withholding Taxes Employees complete a Form W-4 to supply theinformation the firm needs to withhold the correctamount of tax and also to indicate Whether to withhold at the single rate or at the lowermarried rate The number of withholding or “personal” allowancesthe employee chooses to claim Whether the employee wants an additional amountof tax withheld each period above the amount basedon the number of allowances claimed
  • 12-5Salary and Wages Form W-2 Summarizes an employee’s taxable salary andwages Provides annual federal and state withholdinginformation Generated by employer on an annual basis Form W-4 Supplies an employee’s withholding information toemployer Generated by employee Remains constant unless employee makeschanges
  • 12-6 Employer Considerations for Salary andWages Deductibility of Salary Payments – General Rule Employers computing taxable income under Cash method of accounting generally deduct salary andwages when they pay the employee Accrual method generally deduct wages payable toemployees as the employees earn the wages Compensation expense accrued at end of year isdeductible in year accrued if paid to an unrelated party paid within 2½ months of year-endSalary and Wages
  • 12-7Compensation expense accrued at end of year isdeductible when paid to related party related party (employee) owns > 50 percent of the value ofthe employer corporationAfter-tax cost of providing this salary is generallymuch less than the before-tax cost as the employerdeducts the salary and associated FICA taxes paidAfter-Tax Cost of Salary formulaSalary and Wages
  • 12-8Salary and WagesLimits on salary deductibility Determining whether compensation is reasonable inamount is a “facts and circumstances test” involves considering the duties of the employee complexities of the business, and amount of salary compared with the income of thebusiness among other things $1,000,000 maximum annual compensation deductionper person Limited—applies to CEO and four other highestcompensated officers Does not apply to performance-based compensation
  • 12-9Equity-Based Compensation Stock Options Incentive stock options - provide favorable taxtreatment to employees Nonqualified stock options - options that don’tmeet 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 shareswith stock options
  • 12-10Equity-Based Compensation Bargain element - Difference between the fairmarket value of stock and the exercise price onthe exercise date Vesting date - Time when stock options grantedcan be exercised Employee Considerations for Stock OptionsNonqualified stock options When exercising NQOs, employees report ordinary incomeequal to the total bargain element on the shares of stockacquired (whether they hold the shares or sell themimmediately)
  • 12-11Equity-Based Compensation Taxpayer’s 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 bargain elementIncentive stock options Basis in shares acquired with ISOs is the exercise price Holding period for stock acquired with NQOs and ISOsbegins on the exercise date Here bargain element is added to taxpayers alternativeminimum taxable incomeFor either type of options, employees experience notax consequences on the grant date or vesting date
  • 12-12 Any future appreciation or depreciation of the stockwill be treated as either short-term or long-term capitalgain or loss depending on the holding period (beginson the date of exercise) Employer Considerations for Stock Options Nonqualified options No tax consequences on grant date On exercise date, bargain element is treated as ordinary(compensation) income to employee Employee holds stock with holding period beginning on dateof exercise Employers deduct bargain element as compensationexpense on exercise dateEquity-Based Compensation
  • 12-13Equity-Based Compensation Incentive stock options No tax consequences on grant date and exercise date (ifemployee holds for two years after grant date and one yearafter exercise date) If holding requirements are not met (if there is adisqualifying disposition), option becomes an NQO When employee sells stock, employee recognizes long-term capital gain No deduction for employers unless employee doesn’t meetholding requirements Employers typically don’t view ISOs as favorable as NQOs,because: ISOs don’t provide them with the same tax benefits (notax deduction) IRS regulatory requirements for ISOs can becumbersome
  • 12-14 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 ISOsinstead of NQOsAccounting Issues For tax purposes, employer deducts bargain element onexercise date For GAAP purposes, employer expenses the estimatedvalue of the option pro rata over the vesting periodEquity-Based Compensation
  • 12-15 Restricted Stock Can’t be sold or otherwise treated as owned byemployees until employees legally have theright to sell the shares on the vesting date Employees receive restricted stock on thevesting date without having to pay for it, afterwhich they can either sell it immediately orretain it Employee Considerations for Restricted Stock Restricted Stock are taxed on the full fair marketvalue of the shares on the date the restricted stockvestsEquity-Based Compensation
  • 12-16Equity-Based Compensation Without §83(b) Election No tax consequences on grant date Employee recognizes ordinary income on value of stock onvesting date Holding period for stock begins on vesting date Employer deducts value of stock on vesting date With Section §83(b) Election On grant date, employee recognizes market value of stockas ordinary income Employee takes fair market value basis in stock Holding period for stock begins on grant date If employee never vests, no deduction for basis in stock Employer deducts value of stock on grant date
  • 12-17 Employer Considerations for Restricted Stock Timing of the deduction is determined by the employee’sdecisions regarding the §83(b) election Other non tax issues For tax purposes, employers deduct the market value ofstock when the employee recognizes income For GAAP purposes, employers deduct the grant date valueover the vesting periodEquity-Based Compensation
  • 12-18 Employers often provide noncash benefits toemployees in addition to their cash compensation Ranges from common (health insurance) to theexotic (use of a corporate aircraft) Taxable to the employee on receipt IRC §61(a) indicates that, “gross income meansall income from whatever source derived,including Compensation for services, including fees,commissions, fringe benefits, and similar items(emphasis added)”Fringe Benefits
  • 12-19 Taxable Fringe Benefits Employees recognize compensation income on all benefitsreceived unless specifically excluded by tax laws Treats benefits received like taxable cash compensation Employer deducts cost and pays employee’s share of FICAtaxes on benefit Employee Considerations for Taxable Fringe Benefits Employees may prefer a taxable benefit to an equivalentamount of cash when they benefit from employer-providedquantity or group discounts associated with the benefitFringe Benefits
  • 12-20 Employees must recognize a certain amount of grossincome when employers pay life insurance premiums forthe employee for policies with a death benefit in excess of$50,000 To compute the annual taxable benefit, taxpayers use thefollowing steps Step 1: Subtract $50,000 from the death benefit of theiremployer-provided group-term life insurance policy Step 2: Divide the Step 1 result by $1,000 Step 3: Multiply the result from Step 2 by the cost per$1,000 of protection for one month from the table providedin the Treasury Regulations based on the taxpayer’s age Step 4: Multiply the outcome of Step 3 by 12 (months)Fringe Benefits
  • 12-21 Employer Considerations for Taxable FringeBenefits Treat taxable fringe benefits just like cashcompensations Has an outlay for the cost of the benefit and must paythe employer’s share of FICA taxes on the taxableportion of benefits it provides to employees Deducts its cost of the benefit (plus FICA taxes), not thevalue of the benefit to the employee Are often able to purchase fringe benefits at a lower costthan can individual employeesFringe Benefits
  • 12-22 Nontaxable Fringe Benefits Specifically identified in the Code Employee excludes benefit from taxable income Employer deducts cost when benefit is paid Group-Term Life Insurance Health and Accident Insurance and Benefits Meals and Lodging for the Convenience of theEmployer Employee Educational Assistance Dependent Care BenefitsFringe Benefits
  • 12-23Fringe Benefits No-Additional-Cost Services Qualified Employee Discounts Working Condition Fringe Benefits De Minimis Fringe Benefits Qualified Transportation Fringe Qualified Moving Expense Reimbursement Cafeteria Plans and Flexible Spending Accounts(FSAs) Employee and Employer Considerations forNontaxable Fringe Benefits
  • 12-24Fringe Benefits Tax Planning with Fringe Benefits Example Employer proposed to reimburse employee $200 amonth for his parking costs. What amount of thisreimbursement would be a nontaxable qualifiedtransportation fringe to employee? Answer: All $2,400. Employee can exclude up to $230per month ($2,760 per year) as a qualifiedtransportation fringe IRS publication 15-B “Employer’s Tax Guide toFringe Benefits” (available at http://www.IRS.gov)provides tax guidance for employers providing fringebenefits
  • 12-25Fringe Benefits Fringe Benefits Summary Both taxable and nontaxable, can make up asignificant portion of an employee’s compensation Are taxable unless the tax laws specifically excludethem from gross income Taxable fringe benefits usually represent a luxuryperk, while nontaxable fringe benefits are generallyexcluded for public policy reasons At this point, you should be able to distinguishbetween taxable and nontaxable fringe benefits