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Employee Compensation

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  1. EmployeeCompensation Chapter4

  2. Employee Compensation • All forms of compensation (including salaries, wages, bonuses, tips, and fringe benefits) are taxable as ordinary income to employees unless specifically excluded by a provision in the Code • Employers can deduct all compensation expenses

  3. Payroll Taxes for Employees • FICA rate is 7.65% (6.2% for Social Security + 1.45% for Medicare) • Social security portion is only charged on the first $87,900 for 2004 • Employer withholds the FICA tax from employee; employer matches employee FICA and then forwards total to government • Employer can deduct employer’s share of tax • No deduction for employee’s share of tax

  4. Other Payroll Taxes • Employers are also required to pay other types of payroll taxes such as federal and state unemployment taxes • FUTA rate is 6.2% on first $7,000 • State unemployment taxes vary • These taxes are all deductible by the employer paying them

  5. Employee vs.Independent Contractor • Independent contractors (and other self-employed individuals) pay their own Social Security and Medicare taxes • This is called the self-employment tax • Workers considered employees (instead of an independent contractor) if the employer has the right to control and direct the end result and the means by which the result is accomplished • Rev. Rul. 87-41 provides 20-factor test

  6. Timing of Compensation • Salaries and bonuses are usually deductible by the employer when accrued • Exceptions • Compensation accrued but not paid within 2½ months of year-end is not deductible until paid • Compensation accrued to cash-basis related party not deductible until paid

  7. Related Parties • Related parties include: • Family members (brothers, sisters, spouse, ancestors, and lineal descendants, but not in-laws) • A taxpayer and a corporation in which the taxpayer owns directly or indirectly more than 50% of the stock (indirect ownership includes stock owned by family members), and • Other relationships such as partners/partnerships and beneficiaries/trusts

  8. Reasonable Compensation • If a shareholder-employee’s salary is considered unreasonable, the excess can be reclassified by IRS as a nondeductible dividend • If unreasonable compensation is paid to a party related to a shareholder, the excess can be reclassified as a nondeductible dividend to the shareholder

  9. Excessive Compensation • Deductible compensation paid to CEO and 4 highest-paid officers of publicly-held corporations is limited to $1 million per year • This compensation limit does not include amounts that represent • Compensation based on individual performance goals (if approved in advance by outside directors) • Compensation paid on a commission basis • Employer contributions to a qualified retirement plan • Tax-free employee benefits

  10. S Corporations & Low Salaries • There is an incentive for an S corporation to pay an unreasonably low salary to a controlling shareholder-employee to minimize payroll taxes as S corporation profits are not subject to payroll taxes

  11. Employing Children • Compensation paid to children is deductible if reasonable for the services actually performed • Wages paid to an employer’s child under age 18 are not subject to employment taxes (if not paid by a corporation) • Standard deduction for a single individual is $4,850 in 2004; this amount can be paid to a child without tax consequences

  12. Foreign Earned Income • Exclusion is $80,000 per year • Exclusion calculated separately for each spouse • Qualifying earned income includes most income earned from working in a foreign country including salary, bonuses, allowances and noncash benefits • U.S. government employees not eligible • Taxpayer must work outside the U.S. for entire year or 330 days during a period of 12 consecutive months

  13. Foreign Tax Credit • Employees who do not qualify for the exclusion include the income in taxable income and claim a tax credit (or a deduction) for the foreign taxes paid • The foreign tax credit cannot exceed the amount of U.S. tax that would have been paid on the foreign income • The foreign tax credit is generally more advantageous than the deduction

  14. Fringe Benefits • Tax-free fringe benefits are not taxable as income to the employee but are deductible by the employer • Most tax-free benefits are limited in dollar amount • If an employer pays an amount in excess of the limit (or pays for something that is not a qualified tax-free benefit), it is treated as taxable compensation (income to the employee and deductible by the employer)

  15. Group Term Life Insurance • Premiums on the first $50,000 of employer-paid group term life insurance coverage may be excluded from an employee's gross income • Excess over $50,000 is included in income with amount determined from a table based on employee's age at year end rather than cost

  16. Group Term Life InsuranceTaxable Amount per Month per $1,000

  17. Group Term Life Insurance • If the insurance plan is discriminatory, key employees must report gross income equal to the greaterof • Employer’s actual premiums paid or • Benefit determined from the table (without $50,000 exclusion)

  18. Heath and Accident Insurance • Employees are not taxed on value of insurance premiums paid for by their employers for health and accident plans for employees and their families • Self-insured discriminatory plans may result in taxable income to highly-compensated employees

  19. Dependent Care Benefits • An employer can provide up to $5,000 ($2,500 if MFS) for the care of an employee's dependents during working hours through an on-site or off-site facility • Highly-compensated employees cannot exclude benefits if they are discriminatory

  20. Cafeteria Plans • Are an exception to the doctrine of constructive receipt • A qualified cafeteria plan allows an employer to offer employees the option of choosing cash or nontaxable fringe benefits • If the employee chooses cash, the cash is taxable • If nontaxable fringe benefits are chosen, they are excludable

  21. Cafeteria Plans • Benefits can be funded with employer contributions or by employees voluntarily electing to reduce their salaries (allowing employees to obtain fringe benefits with before-tax dollars) • These plans are sometimes called flexible spending arrangements (FSA)

  22. Cafeteria Plans • Some of the nontaxable benefits that can be offered include coverage for medical and dental care, group-term life insurance up to $50,000, and dependent care assistance • Any amounts set aside in a flexible spending plan must be used before the end of the year or they are lost

  23. Meals and Lodging • Value of meals and lodging provided by an employer to an employee are excluded if • Provided for the employer's convenience and • Provided on the employer's business premises and • Employee required to occupy the lodging to perform employment duties • If an employee is given a choice between additional compensation or meals and lodging, the value of any meals and lodging selected is taxable

  24. No-Additional-Cost Services • When an employer provides services for its employees and incurs no substantial additional cost (excess capacity services), employees can exclude the value of the services from gross income • Example: Free or discounted seats on an airplane when the employee does not displace a paying customer

  25. No-Additional-Cost Services • This exclusion applies only to services received, not property • Only employees who work in the line of business that renders similar services are allowed to exclude the benefits (baggage handlers who work for an airline can fly free) • In addition to current employees, the exclusion is available to former employees, as well as spouse and dependents

  26. Employee Discounts • Property or services provided employee at below FMV results in income to employee unless within the qualified employee discount limits • Only property and services offered to customers in the ordinary course of the employer's business qualifies • Full discount excluded if discount does not exceed gross profit percentage times price charged to customers • For services, discount can’t exceed 20%

  27. Employee Awards • Employee awards generally are treated as taxable compensation • Exceptions for length of service or safety awards • Qualifying employee awards must be made with tangible property (no cash) • Average cost of qualified plan awards limited to $400, but individual awards can be as much as $1,600

  28. De Minimis Fringe Benefits • Employees who receive “de minimis” (very small in value) property or services from their employers can exclude the value from gross income • An amount is considered de minimis when the value is so small that accounting for it is unreasonable or impractical

  29. Transportation & Parking • Transit passes and special carpool commuting expenses (combined value of up to $100 per month) • Free or discounted parking (up to $195 per month in 2004)

  30. Athletic Facilities • Employees (and their families) who use employer-provided athletic facilities that are located on the employer’s business premises can exclude the value of the benefit from gross income • Facilities include tennis courts, gymnasiums, and swimming pools

  31. Working ConditionFringe Benefits • Working condition fringe benefits can be excluded from the employee’s gross income if the employee would have been entitled to a tax deduction if he had actually paid the expense • Discriminatory benefits can still be excluded

  32. Employee Use ofCompany-Owned Cars • The value of an employee’s personal use of a company car is a taxable fringe benefit • In determining the amount of income to be taxed to the employee for personal use, there are 3 methods: • Lease value (from table) • Cents per mile rate (37.5¢ in 2004) • Commuting method (valued at $1.50 per one-way trip)

  33. Relocation Expenses • Qualified direct moving expenses include the reasonable cost of moving household belongings and family members from the old home to the new home by the shortest and most direct route • No dollar limit • Indirect expenses such as house-hunting or temporary living expenses do not qualify

  34. Relocation Expenses • Moving expenses are deductible if they are related to assuming duties at a new place of business and both the distance and time requirements are met • Distance test - distance from old residence to new job must be at least 50 miles greater than the distance from old residence to old job • Even though a taxpayer is required to relocate, no deduction is allowed if the distance test is not met

  35. Relocation Expenses • Time Test - taxpayer must work as an employee at the new location for 39 weeks during the 12 months following arrival or as a self-employed person for 78 weeks during the 24 months following arrival • Exceptions allowed in event of death, disability, involuntary separation, or transfers for the employer’s benefit • Qualified moving expenses that are not reimbursed are deductible for AGI by employee

  36. Education Assistance Plans • Up to $5,250 a year of employer-provided educational assistance benefits can be excluded • Courses do not need to be job-related. • Excludable benefits are payments for tuition, fees, books, supplies, and equipment

  37. Job-Related Education • No dollar limit if education expenses are related to the current job of the employee • Qualified educational expenses include tuition, fees, books, and transportation from job to class • Expenses that meet the minimum education requirements for the taxpayer’s job or qualify taxpayer for a new profession do not qualify for exclusion

  38. Substantiating Expenses • Accountable Plan - an employee provides an adequate accounting to the employer and refunds to the employer any excess payments • Adequate Accounting - provides details concerning the time, date, place, business purposes, and the amount of the expense • If an employee makes an adequate accounting, and the reimbursement exceeds the deductible expenses, the employee must include the excess in income

  39. Substantiating Expenses • Nonaccountable plan does not require the employee to substantiate expenses or refund excess advanced funds • Employer must report all of the reimbursed expenses on employee’s W-2 • Employees who receive advances in a nonaccountable plan must report details of both the reimbursement and the expenses • Employee’s deductions are subject to 2% AGI floor for miscellaneous itemized deductions

  40. Restricted Stock • Value not taxed until stock vests • Employee recognizes ordinary income = FMV of stock when vested • Dividends taxed as ordinary income prior to vesting • Election to accelerate income made by recognizing income = FMV in year of receipt • No deduction for loss if forfeited

  41. Stock Options • Option – right to purchase stock at strike price for a specific time • Grant date – date option offered to individual • Exercise date – date option used to purchase stock • Bargain element – difference between strike price and FMV of stock

  42. Nonqualified Stock Options • Employee recognizes ordinary income equal to the bargain element on the date the NQSO is exercised • Employer gets matching compensation deduction for bargain element • Employee’s basis for stock is cash paid + income recognized

  43. Incentive Stock Options • ISOs provide more favorable treatment for employee • ISOs do not trigger any income recognition at the date of grant or exercise • Income is recognized only upon the sale of the stock, usually as long-term capital gain • But bargain element is an individual AMT adjustment • Employer receives no compensation deduction

  44. Phantom Stock and SARs • Phantom stock plan - deferred compensation is hypothetically invested in shares of company’s stock • At the end of deferral period (such as at retirement), the employer pays the employee the FMV of the phantom shares • Stock appreciation right (SAR) plan - employees are given the right to receive a cash payment equal to the appreciation in value of employer’s stock for a certain period of time • Employees recognize income only when they exercise their SARs

  45. Qualified Deferred Compensation Plans • Funded plans that receive favorable tax treatment • Employer contributions are deducted as they are paid into the trust • Earnings on these contributions accumulate tax-free until withdrawn • Benefits are taxable to the employee only when actually received

  46. Distributions • When funds are withdrawn, taxes must be paid by employee on • All earnings • All employer contributions • All pre-tax (deductible) employee contributions • Employee must begin distributions by age 70½

  47. Distributions • Taxpayers may not take distributions before age 59½ without paying a 10 percent penalty for premature distributions (in addition to the regular tax) • A taxpayer may roll over all or part of a distribution within 60 days without paying any tax or penalty on the distribution • Lump sum distributions are subject to 20% withholding unless there is a direct trustee to trustee transfer

  48. Types of Plans • Defined Benefit - employer assumes the risk that the plan assets will be sufficient to pay benefits • Defined Contribution - amounts contributed are determined according to a formula • Employee’s benefit is dependent upon employer’s contributions and the actual earnings in the individual account

  49. 401(k) Plans • Employees can elect to have employer contribute part of their salary to plan on pretax basis • In 2004, up to $13,000 plus extra $3,000 if age 50 or older • Flexibility - employee can elect each year to have a different amount contributed • Employer may match some of the contributions

  50. Other Plans • Employee stock ownership plans (ESOPs) • Simplified employee pension plans (SEPs) • Savings incentive match plans for employees (SIMPLE) • SIMPLE 401k plans