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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. - PowerPoint PPT Presentation
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EmployeeCompensation
Chapter 4
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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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Payroll Taxes for Employees
FICA rate is 7.65% 6.2% for Social Security + 1.45% for
MedicareSocial security portion is only charged on
the first $106,800 for 2009
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Employer withholds FICA tax from employee; employer matches employee FICA and forwards total to government
Employer can deduct employer’s share of taxNo deduction for employee’s share of
tax
Payroll Taxes for Employers
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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
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Employee vs.Independent Contractor
Independent contractors (and other self-employed individuals) pay their own Social Security and Medicare taxesThis 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 accomplishedRev. Rul. 87-41 provides 20-factor test
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Timing of Compensation
Salaries and bonuses are usually deductible by the employer when accrued
ExceptionsCompensation 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
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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
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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
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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 representCompensation based on individual performance
goals (if approved in advance by outside directors)Compensation paid on a commission basisEmployer contributions to a qualified retirement plan Tax-free employee benefits
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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
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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 2009; this amount can be paid to a child without tax consequences
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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)
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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
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Group Term Life InsuranceMonthly amount per $1,000 of taxable coverage
Employee’s Age Monthly Amount
Under 25 $.05
25 to 29 .06
30 to 34 .08
35 to 39 .09
40 to 44 .10
45 to 49 .15
50 to 54 .23
55 to 59 .43
60 to 64 .66
65 to 69 1.27
70 and above 2.06
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Group Term Life Insurance
If the insurance plan is discriminatory, key employees must report gross income equal to the greater ofEmployer’s actual premiums paid orBenefit determined from the table
(without $50,000 exclusion)
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Health and Accident Insurance
Value of insurance premiums paid by employers on behalf of employees and their families are tax-freeSelf-insured discriminatory plans may result
in taxable income to highly-compensated employees
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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
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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
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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)
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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
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Meals and Lodging
Value of meals and lodging provided by an employer to an employee are excluded if:
1) Provided for the employer's convenience and2) Provided on the employer's business premises
and3) 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
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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 incomeExample: Free or discounted seats on an
airplane when the employee does not displace a paying customer
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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
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Employee Discounts
Property or services provided to employee at below FMV treated as taxable income to employee, unless within the qualified employee discount limitsOnly 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%
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Employee Awards
Employee awards generally are treated as taxable compensation
Exceptions for length of service or safety awardsQualifying 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
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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.
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Transportation & Parking
Exclusions limited: Free or discounted parking (up to $230
per month in 2009) 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
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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
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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
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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 (55¢ in 2009)Commuting method (valued at $1.50 per one-
way trip)
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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 routeNo dollar limit (but mileage rate if driving
limited to 27¢ per mile)Indirect expenses such as house-hunting or
temporary living expenses do not qualify
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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 metDistance 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
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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 arrivalExceptions 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
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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
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Job-Related Education
No dollar limit if education expenses are related to the current job of the employeeQualified 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
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Other Education Provisions
Qualified Tuition ReductionSchools can provide a tuition waiver for employees
and their immediate family membersOnly undergraduate tuition can be waived as a tax-
free benefit; graduate tuition waivers are taxable
Other education provisions discussed in Ch. 11Deduction for up to $4,000 of tuitionAmerican opportunity credit ($2,500 maximum)Lifetime learning credit ($2,000 maximum)
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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
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Substantiating Expenses
Nonaccountable plan does not require the employee to substantiate expenses or refund excess advanced fundsEmployer must report all of the reimbursed
expenses on employee’s W-2Employees 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
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Restricted Stock
Value not taxed until stock vestsEmployee recognizes ordinary income = FMV
of stock when vestedDividends taxed as ordinary income prior to
vesting Election to accelerate income made by
recognizing income = FMV in year of receiptNo deduction for loss if forfeited
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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
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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 elementEmployee’s basis for stock is cash paid +
income recognized
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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
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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
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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
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Distributions
When funds are withdrawn, taxes must be paid by employee onAll earningsAll employer contributionsAll pre-tax (deductible) employee contributions
Employee must begin distributions by age 70½
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Distributions
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
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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
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401(k) Plans
Employees can elect to have employer contribute part of their salary to plan on pretax basis In 2009, 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
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Other Plans
Employee stock ownership plans (ESOPs) Simplified employee pension plans (SEPs) Savings incentive match plans for employees
(SIMPLE) SIMPLE 401k plans
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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
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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
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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
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IRA Phaseout Limits
Deductible contribution phased out in 2009 for AGI over a range Single $55,000 - $65,000 Married filing jointly $89,000 - $109,000
Zero if married filing separately
If spouse an active participant, phaseout over AGI of $166,000 - $176,000
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Roth IRA
Taxpayers may make nondeductible contributions to a Roth IRA
Contributions phase out if AGI between$105,000 - $120,000 if single$166,000 -$176,000 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)
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Roth IRA
Primary advantage of Roth IRA – able to withdraw earnings & contributions tax-free
Distributions from Roth IRAs are not subject to minimum distribution rulesDo not have to begin by age 70½But cannot be made for first 5 years and taxpayer
must usually be at least age 59½
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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 20092.9% (1.45% x 2) for Medicare – no income
limit
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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 taxesCalculated 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
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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
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Retirement Plans for Self-Employed
Keogh (HR 10) plan has limits on contributions similar to corporate retirement plans
Contributions are deductible for AGI
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
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Foreign Earned Income
Qualifying earned income includes most income earned from working in a foreign country including salary, bonuses, allowances and noncash benefitsU.S. government employees not eligible
Exclusion is $91,400 per year for 2009 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
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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 employerHouse 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 2009, up to $12,796 of housing costs can be excluded
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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 governmentThe 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
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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
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Tax Reimbursement Plans
Typical reimbursement arrangements includeTax 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 countriesTax 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
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Tax Treaties
Treaties generally provide tax exemptions to residents of one treaty country on short-term assignments to the other countryA typical treaty allows no more than 183 days
presence in a year before being subject to taxTreaties frequently exempt teachers and students
from foreign income tax
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The End