Compensation and Tax Planning

1
Compensation and Tax Planning

• Recall the three types of tax planning
• Converting income from one type to another
• Shifting income from one time period to another
• Shifting income from one pocket to another
• Applications to compensation
• Cash versus non-cash forms of compensation
• Current versus deferred compensation
• Pension income versus other deferred compensation
  (Chapter 9)

2
Compensation Questions

• Why not pay all compensation now, in cash?
• Why pay compensation in non-cash forms (either
  current or deferred)?
• Why promise future payments in return for current
  effort?
• When wouldnt an employee prefer to simply
  receive cash now?
• Both tax and non-tax reasons apply

3
Cash versus Non-Cash Compensation

• When is it value-maximizing for the employer to
  provide non-cash benefits to employees rather
  than paying employees cash to purchase the
  benefits themselves?
• Employer after-tax cost to provide benefits may
  be less than employee after-tax cost to purchase
  directly
• How do taxes impact this cost comparison?
• Either type of compensation is deductible by
  employer, but value of non-cash benefits may not
  be taxable to employee

4
Example Cash Salary versus Fringe Benefits

• Como Corporation wishes to hire Mr. Job. Comos
  marginal tax rate is 35 and Mr. Jobs marginal
  tax rate is 40.
• If Como pays Mr. Job 200,000 of salary, what is
  Comos after-tax cost? What is Mr. Jobs
  after-tax income?
• If Mr. Job pays 5,000 to purchase health
  insurance, how much of his after-tax cash flow
  remains?
• If Como pays Mr. Job 195,000 of salary and pays
  5,000 to provide his health insurance, is Mr.
  Job better off? Is Como? What if comparable
  health insurance only costs Como 3,500?

5
Current versus Deferred Compensation

• What are some non-tax reasons for deferred
  compensation arrangements, defined as payment to
  be made in the future in exchange for services
  rendered currently?
• Forced savings for retirement
• Deferred compensation contingent on long-term
  outcomes provides incentives for performance

6
Current versus Deferred Compensation continued

• Benefits of deferral depend on relative tax rates
  and after-tax rates of return on investment for
  employer and employee
• When can tax advantages be gained by deferring
  compensation?
• Typically most effective when either
• Employers tax rate will be higher in future, or
• Employees tax rate will be lower in future, or
• Both
• Conditions under which these rate changes are
  likely to occur?

7
Current versus Deferred Compensation continued

• Employer preferences
• Employer is indifferent between paying 1 of
  current compensation and paying Dn dollars of
  deferred compensation in n periods, where
• Dn (1rcn)n (1-tc0)/(1-tcn)
• rcn is the employers annualized after-tax rate
  of return on investments of n periods
• tc0 is the employers tax rate today
• tcn is the employers tax rate in n periods

8
Current versus Deferred Compensation continued

• Employee preferences
• Employee prefers to receive 1 of current
  compensation rather than receiving Dn dollars of
  deferred compensation in n periods, if
• 1(1-tp0)(1rpn)n gt Dn(1-tpn)
• Or (1-tp0)(1rpn)n gt (1-tco)
  (1-tpn)(1rcn)n (1-tcn)
• Where rpn is the employees annualized after-tax
  rate of return on investments of n periods
• tp0 is the employees tax rate today
• tpn is the employees tax rate in n periods

9
Example Current versus Deferred Compensation

• Employer with MTR of 35 and an after-tax rate of
  return of 8 can offer current compensation of
  1,000 or defer payment for one year
• How much does the employers after-tax cash flow
  increase by not paying 1,000 of compensation
  now?
• How much can the employer pay in one year and be
  indifferent between current and deferred
  compensation, if its MTR doesnt change?
• What if its MTR next year is 40? 30?

10
Example continued

• Employee with MTR of 40 and an after-tax rate of
  return on investments of 6
• What is the employees after-tax cash flow from
  1,000 of current compensation? What will that
  receipt be worth in one year if invested by the
  employee, if employees MTR next year is 40?
  30? 20?
• Would the employee prefer the deferred
  compensation offered by the employer under each
  of its potential future tax rates, for each of
  the employees potential future tax rates?

11
Stock Options

• Options are a form of deferred compensation whose
  future value is linked to firm performance
• Impact on employer no cash outflow, possible tax
  deduction
• Impact on employee future value only if stock
  price increases, value taxable in future at
  either ordinary income or capital gains rates
• Two types of options for tax purposes
• Incentive stock options (ISOs)
• Nonqualified stock options (NQSOs)

12
Stock Options continued

• Nonqualified Stock Options
• If value is readily ascertainable when option
  granted (exercise price lt market price on date
  of grant), such value is taxed to recipient and
  deductible by employer
• Rarely true for employee stock options
• If value not ascertainable when granted (exercise
  price gt market price on date of grant), bargain
  element (difference between exercise price and
  FMV) when exercised is taxed to recipient as
  ordinary income
• Bargain element deductible by employer

13
Stock Options continued

• Incentive Stock Options
• General criteria for qualification
• Granted under a written, formal plan authorized
  by shareholders
• Issued only to employees who must remain
  employees from the date the option is granted
  until 3 months before exercise
• Must be exercisable within ten years of of grant
• Aggregate stock value covered by ISOs is limited
  to 100,000 per year per employee

14
Stock Options continued

• Incentive Stock Options continued
• Bargain element at exercise not taxed to
  recipient for regular tax purposes, but increases
  alternative minimum taxable income and potential
  AMT liability
• Recipient pays capital gains tax when stock is
  sold, on difference between exercise price and
  FMV on date of sale (if held at least 1 year
  after date of exercise and 2 years after date of
  grant)
• No tax deduction for employer (unless employee
  makes disqualifying disposition)

15
Stock Options continued

• Incentive Stock Options continued
• ISOs provide employee with opportunity to shift
  income from one time period to another AND from
  one type to another
• When would employer be willing to offer ISOs
  instead of NQSOs?

16
Tax Basis Issues

• Options granted at no cost to an employee have
  zero tax basis
• Tax basis of stock acquired through exercise of
  employee stock options exercise price
  compensation income recognized
• NQSOs basis of stock exercise price bargain
  element FMV on date of exercise
• ISOs basis of stock exercise price
• Basis differences will affect gain/loss
  recognized on sale of stock

17
Example Stock Options

• On February 1, 1999, Jane was granted an option
  to purchase 100 shares of stock from her employer
  at 20 per share. On this date, the FMV of the
  companys stock was 20 per share. Jane
  exercised the option on March 30, 2001, when the
  stock was worth 27 per share. On June 5, 2002,
  Jane sold the optioned stock for 32 per share.

18
Example continued

• What are the tax consequences to Jane and her
  employer if the options are nonqualified?
• What are the tax consequences to Jane and her
  employer if the options qualify as incentive
  stock options?
• What if Jane had sold the stock on March 1, 2002,
  instead of June 5, 2002?

19
Other Stock Option Issues

• Most options have a limited life (often 10 years)
• Most unexercised options are forfeited if the
  employee quits the employer
• At what point should the employee choose to
  exercise the options? At what point should the
  employee sell the optioned shares?
• Depends on expectations regarding future stock
  value, expectations regarding continued
  employment, cash flow needs, providing cash to
  pay tax due on exercise, current versus future
  tax rates, risk diversification and other
  investment opportunities

20
Cashless Exercise of Stock Options

• Popular alternatives
• Broker finances exercise, immediately selling
  shares acquired and paying profit to option
  holder
• Pyramiding
• Option holder uses existing shareholdings to
  cover exercise price of options
• After such exercise, shareholdings increase, but
  not by as much as if options were exercised with
  cash

21
Some Interesting New Compensation Forms

• Phantom stock
• Intangible units paying an amount equal to the
  appreciation in value of the stock between the
  date of issue and some designated future date
• Performance units
• Stock appreciation rights
• Usually issued with stock options, allowing
  employee to take appreciation in cash in lieu of
  exercising the options
• Stock depreciation rights