Compensation and Retirement Planning

15-1

Chapter 15

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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Employee versus ContractorEmployee versus Contractor

• Employee is an individual• Whose duties are controlled (as to

how, when, and where) by an employer

• Who works according to a regular schedule in return for a wage or salary

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Employee versus ContractorEmployee versus Contractor

• Independent contractor is a self-employed individual• Who performs services for a fee• Who controls the way the services are performed• Whose work relationship with a client is

temporary • Who can have many clients

at the same time

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Employee versus ContractorEmployee versus Contractor

• Employees• Employer withholds income and payroll taxes from salary

or wage payments• Employer issues Form W-2 to employees

• Independent contractors • Clients do not withhold tax from fee payments

• Contractor reports fees as Schedule C business income• Contractor pays income and self-employment tax directly

• Client issues Form 1099-MISC to independent contractors

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Employee versus ContractorEmployee versus Contractor

• Self-employed individuals have a relatively low level of compliance because they either fail to file or they understate income• For this reason, the IRS takes an aggressive stance

regarding worker classification• How is worker classification decided?

• Based on facts and circumstances including:• Degree of supervision• Materials provided• Person versus job

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Compensation payments Compensation payments

• Employers treat compensation payments as either:• Deductible ordinary and necessary business expenses• Capitalized costs

• Compensation is ordinary income to recipient

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Foreign Earned Income ExclusionForeign Earned Income Exclusion

• Expatriates are U.S. citizens who reside and work overseas on an extended basis• Can exclude $95,100 (2012) foreign salary or wages from

gross income for U.S. tax purposes • Can’t claim foreign tax credit (see Chapter 13) on

excluded income

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Employee Fringe BenefitsEmployee Fringe Benefits

• General rule: fringe benefits are taxable• Nontaxable fringe benefits include:

• Health and accident insurance• $50,000 group-term life insurance• Dependent care assistance

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Employee Stock OptionsEmployee Stock Options

• A stock option is the right to buy stock in the future for a set price (option price or strike price) for a limited period of time• Option price usually is less than or equal to the market

price of the stock on the date the option is granted• Stock options are a form of compensation that

requires no cash outlay by the corporate employer

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Stock Options - Grant DateStock Options - Grant Date

• Under GAAP, firms must record compensation expense equal to FMV of option at grant date

• Tax rules:• No deduction to employer when option is granted• No income to employee on receipt of option• Tax consequences when employee exercises an option

depends on whether the option is a:• Nonqualified stock option (NSO) • Incentive stock option (ISO)

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Nonqualified Stock Option (NSO)Nonqualified Stock Option (NSO)

• Employee has taxable compensation equal to excess of FMV of stock over exercise price• Taxable excess is referred to as the bargain element• Employee’s basis in stock is FMV at exercise date

• Employer is allowed a deduction in the year of exercise equal to employee’s taxable compensation

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Incentive Stock Option (ISO)Incentive Stock Option (ISO)

• No compensation income to employee on exercise of ISO• Employee’s basis in stock is cost• Untaxed bargain element is an AMT preference

item• No employer deduction for bargain element

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Employee ExpensesEmployee Expenses

• When employers reimburse employees for employment-related expenses, the employee neither reports the cash reimbursement as income nor deducts the expense

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Employee Expenses Employee Expenses

• Employees may deduct unreimbursed business expenses as miscellaneous itemized deductions• Miscellaneous itemized deductions are deductible only to

the extent they exceed 2% of AGI• Consequently, employees may derive no tax benefit from

unreimbursed business expenses

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Moving ExpensesMoving Expenses

• Employee unreimbursed moving expenses are an above-the-line deduction• Costs to transport household goods and personal

belongings• Certain travel costs for family members

• Household move must be required by commencement of employment in a new principal place of work

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Retirement PlanningRetirement Planning

• Key concepts• Qualified plans provide deferral of tax on earned income.

The compounding effect of this deferral can be significant!• Individuals must include withdrawals from qualified plans

in ordinary gross income • Withdrawals before age 59½ subject to 10% penalty• Withdrawals must begin when individual reaches age 70½

• Types of qualified plans• Employer-provided• Self-employed (Keogh)• IRAs

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Employer-provided PlansEmployer-provided Plans

• Two policy objectives• Employer-provided plans should carry minimum risk for

participating employees• Employer-provided plans should provide benefits in an

equitable manner to all participating employees• Plans cannot discriminate in favor of highly compensated

employees

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Defined Benefit PlansDefined Benefit Plans

• Employer assumes risk and promises a certain retirement income stream (pension) to participating employees

• Annual pension limited to the lesser of:• Average compensation for employee’s three highest

compensation years• $200,000 (2012)

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Defined Contribution PlansDefined Contribution Plans

• Employer contributes a defined amount each year to each participating employee’s retirement account• Employee may choose how the balance in the account is

invested• Employee bears investment risk

• Annual contribution limited to the lesser of:• 100% of annual compensation or• $50,000 (2012)

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Types of Defined Contribution PlansTypes of Defined Contribution Plans

• Types of defined contribution plans• Profit-sharing plans – Employer contributes a percentage

of current earnings to employees’ retirement accounts• Employee Stock Ownership plans (ESOPs) – employer

contributions are invested in the employer’s stock• 401(k) plans – Participating employees elect to contribute

current compensation to their retirement accounts• Contributions are excluded from current income• Contribution limit = $17,000 (2012)

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Nonqualified PlansNonqualified Plans

• Nonqualified deferred compensation• Employee does not recognize deferred compensation as

income until payment is received• Employer can’t deduct deferred compensation expense

until payment is made • Employer accrues a liability for unfunded deferred

compensation • Used to compensate top executives on a discriminatory

basis

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Self-Employed Plans - KeoghSelf-Employed Plans - Keogh

• Self-employed individuals can contribute and deduct the lesser of:• 20% of earned income from self-employment• $50,000 (2012)

• If individual’s business has employees, the Keogh plan must provide them with retirement benefits on a nondiscriminatory basis

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Individual Retirement AccountsIndividual Retirement Accounts

• Any person who earns employee compensation or self-employment income can save for retirement through an individual retirement account (IRA)

• IRAs are tax-exempt so that earnings on the account grow at a before-tax rate• With a traditional IRA, earnings on the account are taxed when

the owner withdraws them• With a Roth IRA, withdrawals are tax-exempt so the earnings on

the account are never taxed

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IRA ContributionsIRA Contributions

• Individuals can contribute up to $5,000 to an IRA in 2012• Contribution limited to 100% of compensation/self-employment

income• Additional $1,000 catch-up contribution for individuals who reach

age 50 by year-end

• Special rules:• Traditional IRAs – no contribution after age 70½• Roth IRAs – amount of contribution phased down to zero for

higher-income individuals

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Deduction of IRA ContributionsDeduction of IRA Contributions

• Traditional IRAs – contributions can be fully deductible, partially deductible, or nondeductible based on two factors• Participation or nonparticipation by the individual in another

qualified retirement plan• AGI level (deduction phased down to zero for higher-income

taxpayers)

• Roth IRAs – contributions are nondeductible

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IRA WithdrawalsIRA Withdrawals

• Traditional IRAs• Withdrawals must begin when owner reaches age 70½• Tax consequences of withdrawals:

• Amount attributable to deductible contributions and accumulated earnings is taxed as ordinary income

• Amount attributable to nondeductible contributions is excluded from income

• Roth IRAs• Qualified withdrawals are tax-exempt• Contributions are qualified if they occur after:

• Owner has reached age 59½• Five-year period beginning with year of initial contribution

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Rollover IRAsRollover IRAs

• Individuals can avoid tax (and premature withdrawal penalty) on distributions from qualified plans by rolling the distribution over into a traditional IRA• Rollover continues the tax deferral on retirement

income until the owner makes a withdrawal from the IRA

• Individuals can roll over distributions into a Roth IRA, regardless of their income level• Rollover from a tax-deferred retirement account to a

tax-exempt Roth IRA is a taxable event