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Deferred Compensation. Rely on Concept Summaries, 19-2 through 19-4 in Text. Qualified Plans. Pension, profit-sharing, stock bonus and ESOPs, cash balance plans Pensions are either defined benefit or defined contribution plans

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Deferred Compensation

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Deferred compensation

Deferred Compensation

Rely on Concept Summaries, 19-2 through 19-4 in Text

Qualified plans

Qualified Plans

  • Pension, profit-sharing, stock bonus and ESOPs, cash balance plans

    • Pensions are either defined benefit or defined contribution plans

  • Must not discriminate in favor of high-paid employees, must cover 21 year-olds and up after 1 year of service.

  • Vesting: cliff after 5 years, graded is 20% after 3 years and fully vested in 7 years.

Some important definitions

Some Important Definitions

  • Defined Contribution Plan

    • Limited to lower of employee’s compensation or $46,000 2008 indexed

  • Includes profit sharing plan, money purchase plan, stock bonus plan, but max limits differ

    • Limited to lower of 25% employee’s compensation or $46,000 indexed

  • Defined Benefit Plan

    • Benefit payable is lesser of $195,000 or 100% of avg. of highest paid 3 years, up to $245,000; $10,000 de minimis floor: 2009

    • Special rules where employee has worked <10 years

    • Must retire at 65 or later (staggered retirement ages)

401 k


  • Participant contributes, employer matches portion up to max; 100% vested; tax deferred contributions and earnings

  • Max tax break on $16,500 indexed (2009)

  • Max reduced $-4-$ by tax-sheltered annuities and SEPs

  • If excess exceeded, extra is taxable or may be distributed tax-free before 4/15 of following year.

  • 10% excise tax for excess contributions; possible loss of qualified status

  • Catch-up contributions of extra $5k for those over 50

  • 403(b) similar to 401(k)

Savings incentive match plan for employees

Savings Incentive Match Plan for Employees

  • So named, presumably, because tax legislators get punchy after working long hours during legislative session

  • EZ 401 (k) for Smalls

  • Less than 100 employees, receiving at least $5,000 over 3yr pd including this year may contribute up to $11,500/year, 2009; indexed w/ $2,500 catch-up provision

  • Employee contributes % of compensation; matching of 3% or direct contribution of 2%,

  • Employer deducts up to cost or 25% of compensation paid/accrued

  • Subject to IRA withdrawal rules, except if withdrawn early in first 2 years of employment, subject to 25% penalty instead of 10% penalty

Regular iras

Regular IRAs

  • Established by due date of return; Contributions: due date of return

  • Ltd: $5,000 (2008, indexed) or 100% combined compensation with $1,000 catch-up provision for those over 50.

  • Ltd: reduced by active participation in another plan, but nondeductible contributions can be made which increase (0) basis in IRA. Limitations begin at $85,000 MFJ

  • 10% Penalty for early withdrawal (before 59 ½)

  • Can be rolled over up to once yearly

  • 6% excise penalty on excess contributions



  • Established by end of tax year; Contributions: due date of return

  • Can be defined contribution: ltd. $49,000 ( 2009, indexed) or 100% earned income

  • Profit-sharing: ltd 25% of employee pay (20% if self-employed, after ½ SE)

  • Personal Service business: ltd to earned income

  • Defined benefit: Ltd: smaller of $195,000 indexed or 100% of average highest 3-yrs of compensation

  • Top-heavy: restrictive rules

Roth iras

Roth IRAs

  • Established by due date of return; Contributions: due date of return

  • Same limits and penalties, but no current tax break for contribution; after-tax contribution + earnings are tax-free if withdrawn timely

  • Withdraw after 59 ½, with 5 year holding period

  • High-income phase-out starts at $166,000 2009 MFJ

Coverdell iras

Coverdell IRAs

  • For education, but sometimes lumped with pensions because of the “IRA” title.

  • Max $2,000/year non-deductible contribution for qualified education expenses for minor:

    • Tuition, fees, books, supplies, equipment

    • Room, board if > ½ time

  • If withdrawn for non-qualified expenses, use annuity rule to figure return of capital.

  • Must be withdrawn or rolled over before beneficiary reaches 30

  • AGI Phase-out of $190,000 MFJ, 2008

Simplified employee pension plan

Simplified Employee Pension Plan

  • Useful because of extended set-up deadline (great for small, family-owned procrastinating clients!)

  • Employer contributes up to lesser of $49,000 (2009) indexed or 15% employee’s earned income to individual employee IRAs; For each eligible employee who is 21 or older and been employed 3 of last 5 years

Minimum distribution rules

Minimum Distribution Rules

  • Must begin April 1 in later of year employee is 70 ½ or retirement year, unless Roth (no required distribution date for Roth)

  • Minimum Required Distributions spread over IRS life expectancy

  • 10% penalty on early distribution (before 59 ½, unless due to death, disability, annuity, early retiree who is at least 55, medical expenses or medical insurance premiums, higher ed, first-time home buyers).

Tax on distribution

Tax on Distribution

  • Employee’s basis in annuity returned tax-free

  • Distributions can be rolled over within 60 days tax-free, but with 20% withholding

  • If taxpayer has basis (contributed after-tax $), use annuity calculation to determine amount of distribution excludable from tax

  • Special rules fro pre-1987 lump-sum distributions

Deferred compensation

55. Louise terminated her employment and received a cash distribution from her qualified retirement plan in the amount of $120,000. She made a qualified rollover contribution of $100,000. If her marginal tax rate is 30%, and she is 45 years old, what is the total amount of taxes she must pay on the distribution?

A) $ 6,000

B) $36,000

C) $ 8,000

D) $18,000

Annuity example

Annuity Example

  • Assume an employee invested $10,000 in an annuity that will begin paying $100/mo for the next 30 years. If the annuity begins paying April 1st of this year, how much is taxable?

  • [10,000/($100*30*12)]*(100*9) = Excludable amount

  • $250 of $900 received is excludable; the remaining $650 is includable

Annuity payments unknown

Annuity, # Payments Unknown

  • Assume an employee invested $10,000 in an annuity that will begin paying $100/mo for life. If the annuity begins paying April 1st of this year when the recipient turns 56, how much is taxable?

  • Look up the table, Sec. 72 (d)(3)

  • [10,000/($100*310)]*(100*9) = Excludable amount

  • $290.32 of $900 received is excludable; the remaining $609.68 is includable

Deferred compensation

14. The taxpayer purchased a 10-year annuity for $96,000 late in 2005. The annuity will pay him $4,000 per month for ten years starting on September 1, 2005. How much of the $16,000 received this year will be taxable?

A) $12,800

B) $16,000

C) $ 0

D) $3,200

Corporate deductions for defined benefit pensions

Corporate Deductions for Defined Benefit Pensions

  • Aggregate Cost, + up to 10% past service costs,

  • w/ carryover

  • 10% excise tax on nondeductible contributions

Nonqualified deferred compensation plans

Nonqualified Deferred Compensation Plans

  • …When your executives just don’t make enough…

  • As dependable as the company that is promising to pay you later

  • Employee taxed when payment is made, which is either: separation, disability, death, fixed schedule, change in employer control, unforeseeable emergency

  • May be in the form of “phantom stock options”

Golden parachutes

Golden Parachutes

  • Excess severance pay

  • Deductible to employer unless payment is contingent on change of ownership of corp AND amt of comp > 3x employee’s annual comp.

  • Disallowed amount subject to 20% excise tax

Excess compensation limit

Excess Compensation Limit

  • Only first $1million deductible by publicly-traded corp. unless based on performance

Restricted property plans

Restricted Property Plans

  • Employer transfers property (e.g. stock) at bargain price contingent upon services performed.

  • Employee includes as gross income when substantial risk of forfeiture is removed, or if elected, earlier when restricted property is received

Stock options

Stock Options

  • Right to purchase shares at stated price within stated time period.

  • Generally Incentive Stock options

  • Not included in $1million cap on top 5 executives *if* the options are disclosed, shareholder-approved, and not issued in money.

  • May also be employee stock purchase plan or nonqualified options or restricted property

Incentive stock options

Incentive Stock Options

  • At time of grant: no tax consequences to employee or grantor, because exercise price > FMV, however this difference is a tax preference item for AMT.

  • If option exercised, employee taxed later, when stock is sold, as ltcg. (Employee must hold option for >2 years; stock >1)

    • No deduction for employer

    • Ltd. To $100,000 ISO exercise per year per employee

  • If option lapses, capital loss to employee for amt pd, if any.

Deferred compensation

3. In the current year, employee F is given an incentive stock option (ISO) entitling him to purchase 100 shares of his employer Sigma Corporation’s stock for $50 per share. He exercises the option in the following year when the shares are selling for $80 per share. If F sells these 100 shares four years later for $200 per share, he will recognize

a.a long‑term capital gain of $120 per share.

b.a long‑term capital gain of $150 per share.

c.ordinary income of $30 per share and a long‑term capital gain of $120 per share. income upon sale.

Non qualified stock options

Non-Qualified Stock Options

  • FMV included in employees income at date of grant

  • That amount plus exercise price is basis against capital gain or loss at sale

  • Employer gets tax deduction equal to *ordinary* amount included in employee’s income.

Stock appreciation rights

Stock Appreciation Rights

  • Rights granted to an employee for appreciation in the value of share price, not actually stock itself.

  • Rights may be paid in cash and/or stock

  • No tax on grant date, but FMV of stock/cash taxes as ordinary income on exercise date

  • Employer takes equal amount as deduction

Rabbi trusts etc

Rabbi Trusts, etc.

  • Rabbi trust: Irrevocable, unsecured, often unfunded, employer-established trust for nonqualified deferred compensation to highly-compensated employees

  • Corporate Owned Life Insurance (COLI): policies that grow tax-deferred and pay at death.

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