Module 12

1
Module 12

• Compensation and Fringe Benefits

2
Module Topics

• Employer-Employee Motivations
• Forms of Compensation
• Property Transfers
• Fringe Benefits
• Flow-Through Entities
• IRS Challenges
• Equity-Based Compensation

3
Employer-Employee Motivations

• Key Learning Objective
• Distinguish the preferences that employers
• and employees may have for certain types of
• compensation

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Parties to Consider

• Employer
• Employee
• Government

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Why Pay Compensation?

• To attract, motivate, and retain employees
• To distribute closely-held corporate earnings at
  lowest tax cost
• To compensate family members

6
Motivations

• Different employees are attracted to different
  types of compensation packages
• Employers often use performance-based bonuses as
  motivation

7
Forms of Compensation

• Key Learning Objective
• Distinguish between current and deferred forms of
  compensation

8
Current Compensation and Short-Term Bonuses

• Paid in year services are performed and generally
  subject to payroll taxes
• Salary and wages
• Prizes and awards
• Vacation and sick pay
• Property transfers
• Fringe benefits (many excluded from payroll tax)
• Commissions
• Bonuses (often short-term performance based)

9
Deferred Compensation

• Paid in future for services performed currently
• e.g., retirement plan
• Employer and/or employee may prefer this timing
  arrangement
• e.g., lower marginal rate after retirement
• Often used to reward long-term performance

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Forms of Deferred Compensation

• Qualified plan
• Meets certain tax law requirements
• Coverage
• Nondiscrimination
• Vesting
• Funding
• Nonqualified plan
• Does not meet the requirements

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Qualified Plans--Potential Benefits

• Immediate deduction for employee
• Nontaxable to employee until payments are
  received
• Deferral of tax on earnings until funds are
  distributed
• Reduced or deferred tax on lump-sum distributions

12
Deferred Compensation--Nonqualified Plans

• No deduction by employer until employee reports
  income
• Often limited to a select group of employees
• Generally not currently funded

13
Nonqualified Plans--Funded vs Unfunded

• Funded
• Generally income to employee when funded
• Not income if creditors can reach funds
• Key factor Are funds subject to a substantial
  risk of forfeiture?
• Unfunded
• No tax consequences to employer or employee until
  payment is made

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Property Transfers

• Key Learning Objective
• Determine the tax treatment of compensation paid
  in property

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Property Transfers

• Use FMV of property to measure compensation
• Employer gets deduction when employee reports
  income
• Property is generally income when received unless
  it is
• Not freely transferable, and
• Subject to a substantial risk of forfeiture

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Research Query

• An employee receives property from an employer
  subject to a requirement that it be returned if
  the total earnings of the employer do not
  increase.
• Does the employee have income when the property
  is received?

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Solution--Research Query

• No. The property is subject to a substantial
  risk of forfeiture.
• Reg. 1.83-3(c)(2)
• Note that conditioning a propertys return
  upon not accepting a job with another firm or
  being discharged for cause are generally not
  treated as resulting in a substantial risk of
  forfeiture.

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Fringe Benefits

• Key Learning Objective
• Identify the most common forms of fringe benefits
  offered to employees

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Some Common Fringe Benefits

• Group-term life insurance
• Accident and health care coverage
• Dependent care assistance
• Employee discounts
• Employer provided meals and lodging
• Moving expense reimbursement
• Employee death benefits
• Qualified transportation benefits

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Non-Cash Fringe Benefits

• Key Learning Objective
• Determine the tax treatment of compensation paid
  in the form of non-cash fringe benefits

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Fringe Benefits--Potential Advantages

• Cost of benefits deductible by employer
• Value of benefits tax-free to employee
• Not subject to payroll taxes

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Fringe Benefits--Some Disadvantages

• Can be costly to comply with statutory rules
• Most benefits must be offered on a
  nondiscriminatory basis to obtain favorable tax
  treatment

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Some Specific Fringe Benefits

• Accident and health plans
• Includes self-insured plans
• Group-term life insurance
• First 50,000 of coverage tax-free
• Dependent care assistance
• 5,000 annual exclusion

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Generic Fringe Benefits

• No additional cost benefits
• Qualified employee discounts
• Goods--gross profit percentage
• Services--20
• Working condition benefits
• De minimis benefits
• generally can discriminate

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Compliance Query

• T, an employee of QRS Corporation, buys a TV from
  QRS for 400. The regular price is 600, and the
  gross profit percentage is 25.
• How much income should T recognize?

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Solution--Compliance Query

• Ts income is 50
• Discount taken (600 - 400) 200
• Allowable discount (600 x 25) 150
• Income 50

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Fringe Benefits--Cafeteria Plans

• Allows employee to choose between cash and one or
  more excludable fringe benefits
• Choosing excludable fringe benefit does not
  trigger constructive receipt of cash

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Fringe Benefits--Flexible Spending Accounts

• Benefit offered within a cafeteria plan
• Available for medical or dependent care
• Employee pays expenses with pre-tax dollars
• Saves income and payroll taxes
• Use-it-or-lose-it risk

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Flow-Through Entities

• Key Learning Objective
• Determine the tax treatment of fringe benefits
  offered to owners of flow-through entities

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Partners and gt 2 S Corporation Shareholders

• NOT entitled to tax benefits available for
• Cafeteria plans
• Employee death benefits
• Accident and health plans
• Group-term life insurance
• Employer provided meals and lodging
• Cafeteria plan benefits
• Employer provided parking

31
IRS Challenges

• Key Learning Objective
• Evaluate when the IRS is most likely to question
  the deductibility of compensation payments

32
Reasonable Compensation

• Employee-shareholders of C corporation
  overcompensated?
• Attempt to turn nondeductible dividend payments
  into deductible compensation
• Employee-shareholders of S corporation
  undercompensated?
• Attempt to avoid payroll taxes or shift income

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Research Query

• Which factors have been employed by the courts to
  determine the reasonableness of compensation?

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Solution--Research Query

• Employee's qualifications and role in the company
• Character and condition of the company
• Compensation paid by similar companies for
  comparable services
• Salary policy of the company for all its employees

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Solution--Research Query

• Likelihood that a hypothetical, independent
  investor would be willing to compensate the
  employee at a similar level
• Automotive Investment Development Inc., (1993) TC
  Memo 1993-298, 1993 RIA TC Memo 93298

36
Equity-Based Compensation

• Key Learning Objective
• Identify different types of equity-based
  compensation and evaluate the tax and economic
  aspects of such arrangements

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Compensation Paid in Stock

• Taxable when received unless
• Not freely transferable, and
• Subject to a substantial restriction
• Lapse restriction
• Employee recognizes income when restriction
  lapses
• Section 83(b) election to recognize income before
  restriction lapses

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Compliance Query

• ABC Corporation gives 100 shares of its stock to
  T, an employee
• the stock is worth 200/share.
• T cannot transfer the stock for the next 3 years
• she must return the stock to ABC if she quits
  within that 3-year period.
• The stock is worth 300/share 3 years later.
• How much income should T report, and when?

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Solution--Compliance Query

• Stock is nontransferable and subject to a
  substantial restriction
• T should recognize 30,000 of income in 3 years
  when restriction lapses