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Employee Compensation. Chapter 4. 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.

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employee compensation1
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
payroll taxes for employees
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 $106,800 for 2010
payroll taxes for employers
Payroll Taxes for Employers
  • Employer withholds FICA tax from employee; employer matches employee FICA and forwards total to government
  • Employer can deduct employer’s share of tax
    • No deduction for employee’s share of tax
other payroll taxes
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
2010 payroll tax forgiveness
2010 Payroll Tax Forgiveness
  • 2010 Hiring Incentives to Restore Employment Act allows employers who hire qualified new employees after 2/3/10 and before 1/1/11 to elect to be exempt from Social Security tax for these employees
    • Employee must not have been employed for more than 40 hours in the last 60 days prior to beginning the new job
    • Employer must still pay the Medicare tax
employee vs independent contractor
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
timing of compensation
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
related parties
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 directly or indirectly owns more than 50% of the stock (indirect ownership includes stock owned by family members)
    • Other relationships such as partners/partnerships and beneficiaries/trusts
reasonable compensation
Reasonable Compensation
  • Reasonable compensation – amount similar business would pay for the services under similar circumstances
  • 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
excessive compensation
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
s corporations low salaries
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
  • IRS can reclassify some of S corporation’s distribution as salary, requiring payment of additional employment taxes
employing children
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 $5,700 in 2010; this amount can be paid to a child without tax consequences
fringe benefits
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)
group term life insurance
Group Term Life Insurance
  • Premiums on the first $50,000 of employer-paid group term life insurance coverage may be excluded from employee's gross income
  • Excess over $50,000 is included in income
    • Amount determined from IRS table based on employee's age at year end, rather than cost
group term life insurance1
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)
health and accident insurance
Health and Accident Insurance
  • Value of insurance premiums paid by employers on behalf of employees and their families are tax-free
    • Self-insured discriminatory plans may result in taxable income to highly-compensated employees
dependent care benefits
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
cafeteria plans
Cafeteria Plans
  • A qualified cafeteria plan allows an employer to offer employees the option of choosing cash or nontaxable fringe benefits
    • Exception to constructive receipt doctrine
  • If employee chooses cash, the cash is taxable
  • If employee chooses nontaxable fringe benefits, they are excludable
cafeteria plans1
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)
cafeteria plans2
Cafeteria Plans
  • Some 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
meals and lodging
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 is taxable
no additional cost services
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
no additional cost services1
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
employee discounts
Employee Discounts
  • Property or services provided to employee at below FMV treated as taxable 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 qualify
    • Full discount excluded if discount does not exceed gross profit percentage times price charged to customers
    • For services, discount can’t exceed 20%
employee awards
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
de minimis fringe benefits
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
    • Examples: coffee & doughnuts, company picnics, limited use of copy machine, etc.
transportation parking
Transportation & Parking
  • Exclusions limited:
    • Free or discounted parking (up to $230 per month in 2010)
    • Transit passes and special carpool commuting expenses (combined value of up to $230 per month)
    • Reimbursement of up to $20 per month for costs of commuting by bicycle
athletic facilities
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
working condition fringe benefits
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
    • Examples: job-related education, professional membership dues
  • Discriminatory benefits can still be excluded
employee use of company owned cars
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 (50¢ in 2010)
    • Commuting method (valued at $1.50 per one-way trip)
relocation expenses
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 (but mileage rate if driving limited to 16.5¢ per mile)
    • Indirect expenses such as house-hunting or temporary living expenses do not qualify
relocation expenses1
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
relocation expenses2
Relocation Expenses
  • Time Test - taxpayer must work as an employee at the new location for 39 weeks during the 12 months following arrival
    • Self-employed person must work 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
education assistance plans
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
job related education
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
    • If employee pays for expenses and is not reimbursed, employee can deduct qualified expenses as miscellaneous itemized deductions
other education provisions
Other Education Provisions
  • Qualified Tuition Reduction
    • Schools can provide a tuition waiver for employees and their immediate family members
    • Only undergraduate tuition can be waived as a tax-free benefit; graduate tuition waivers are taxable
  • Other education provisions discussed in Ch. 11
    • American opportunity credit ($2,500 maximum)
    • Lifetime learning credit ($2,000 maximum)
    • Deduction for up to $4,000 of tuition (if extended)
substantiating expenses
Substantiating Expenses
  • Accountable Plan - an employee provides 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
substantiating expenses1
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
restricted stock
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
stock options
Stock Options
  • Option – right to purchase stock at guaranteed 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
nonqualified stock options
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
incentive stock options
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
phantom stock and sars
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 rights are exercised
qualified deferred compensation plans
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
  • 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
  • Premature withdrawals - 10% penalty (in addition to income tax) for taking distributions before age 59½
  • 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
types of plans
Types of Plans
  • Defined Benefit – provides fixed benefit at retirement
    • 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
401 k plans
401(k) Plans
  • Employees can elect to have employer contribute part of their salary to plan on pretax basis
    • In 2010, up to $16,500 plus extra $5,500 if age 50 or older
  • Flexibility - employee can elect each year to have a different amount contributed
  • Employer may match some of the contributions
other plans
Other Plans
  • Employee stock ownership plans (ESOPs)
  • Simplified employee pension plans (SEPs)
  • Savings incentive match plans for employees (SIMPLE)
  • SIMPLE 401k plans
nonqualified deferred compensation
Nonqualified Deferred Compensation
  • Advantages - no dollar limits and can be offered on a discriminatory basis
  • Employer receives a deduction only upon the actual payment of benefits to the employee
  • Employee recognizes income upon the actual receipt of these benefits
nonqualified deferred compensation1
Nonqualified Deferred Compensation
  • Employer accrues liability on financial statements, but no cash is set aside
  • If the employer’s business fails, the employee is merely an unsecured creditor
individual retirement accounts ira
Individual Retirement Accounts (IRA)
  • Individuals can contribute up to $5,000 ($6,000 if age 50 or older) or earned income if less
  • A married taxpayer can contribute for a nonworking spouse
  • Qualified contributions are deductible for AGI
  • Deductions not allowed if the individual is a participant in an employer-sponsored retirement plans, unless AGI is below certain limits
ira phaseout limits
IRA Phaseout Limits
  • Deductible contribution phased out in 2010 for AGI over a range
    • Single $56,000 - $66,000
    • Married filing jointly $89,000 - $109,000
      • Zero if married filing separately
    • If spouse an active participant, phaseout over AGI of $167,000 - $177,000
roth ira
Roth IRA
  • Taxpayers may make nondeductible contributions to a Roth IRA
  • Contributions phase out if AGI between
    • $105,000 - $120,000 if single
    • $167,000 -$177,000 if married filing joint return
  • Contributions to Roth and the regular IRA cannot exceed a total of $5,000 ($6,000 if age 50 or older)
roth ira1
Roth IRA
  • Primary advantage of Roth IRA – able to withdraw earnings & contributions tax-free
  • Distributions from Roth IRAs are not subject to minimum distribution rules
    • Do not have to begin by age 70½
    • But cannot be made for first 5 years and taxpayer must usually be at least age 59½
self employment taxes
Self-Employment Taxes
  • Self-employed individuals must pay both the employer’s and the employee’s share of FICA taxes for a combined rate of 15.3%
    • 12.4 % (6.2% x 2) for Social Security on income up to $106,800 in 2010
    • 2.9% (1.45% x 2) for Medicare – no income limit
self employment taxes1
Self-Employment Taxes
  • Tax computed on Schedule SE
  • Self-employed individuals are also allowed a deduction for AGI for the employer’s half of self-employment taxes
    • Calculated by multiplying net income from self-employment by 92.35% (100% - 7.65%) before calculating SE tax
  • There is no deduction for the employee’s half of the taxes
fringe benefits for self employed
Fringe Benefits forSelf-Employed
  • Self-employed individuals (including sole proprietors, partners, and greater than 2% shareholders of S corporations) do not qualify for most fringe benefits on a tax-free basis
  • Special deduction for AGI applies to health insurance for self-employed individuals
retirement plans for self employed
Retirement Plans for Self-Employed
  • Keogh (HR 10) plan has limits on contributions similar to corporate retirement plans
    • Contributions are deductible forAGI
    • Extending return due date also extends deadline for making contributions to plan
    • Earnings and deductible contributions fully taxed when withdrawn
  • May also contribute to an IRA unless limitations apply
foreign earned income
Foreign Earned Income
  • 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
  • Exclusion is $91,500 per year for 2010
  • Taxpayer must be a bona fide resident of a foreign country for entire year or be physically present in a foreign country for 330 full days during a period of 12 consecutive months
foreign housing exclusion
Foreign Housing Exclusion
  • A taxpayer who qualifies for the foreign earned income exclusion may also exclude a portion of excess housing costs provided by the employer
    • House costs in excess of a base amount (16% of the maximum foreign earned income exclusion) are eligible
    • The upper limit is 30% of the foreign earned income exclusion
    • For 2010, up to $12,810 of housing costs can be excluded
foreign tax credit
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 taxes paid to the foreign government
    • 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
tax reimbursement plans
Tax Reimbursement Plans
  • To encourage employees to accept foreign assignments, some employers agree to pay the employee’s taxes as part of their compensation package
  • If the employer pays any of the employee’s taxes, this results in additional compensation income for the employee
tax reimbursement plans1
Tax Reimbursement Plans
  • Typical reimbursement arrangements include
    • Tax Protection Plans – the employee is reimbursed for any U.S. or foreign taxes paid in excess of the tax liability that would have been incurred had the employee remained in the U.S.
      • The employer pays any excess tax but the employee benefits from any tax savings from low-tax countries
    • Tax Equalization Plans – the employee will pay the same net tax liability that would have been paid had the employee stayed in the U.S.
      • The employer pays any excess tax but also keeps any tax savings from low-tax countries
tax treaties
Tax Treaties
  • Treaties generally provide tax exemptions to residents of one treaty country on short-term assignments to the other country
    • A typical treaty allows no more than 183 days presence in a year before being subject to tax
    • Treaties frequently exempt teachers and students from foreign income tax