Question

Learning Objective 12-1: Discuss and explain the tax implications of compensation in the form of salary and wages from the employee's and employer's perspectives.

Team member 1: Employee's Perspective:

Team member 2: Employer's Perspective:

Learning Objective 12-2: Describe and distinguish the tax implications of various forms of equity-based compensation from the employee's perspective and the employer's perspectives. Team member 3: Employee's Perspective:

Team member 4: Employer's Perspective:

Learning Objective 12-3: Compare and Contrast taxable and nontaxable fringe benefits and explain the employee and employer tax consequences associated with fringe benefits.

Team member 5: Compare and Contrast taxable and nontaxable fringe benefits.

Team member 6: Explain the employee and employer tax consequences associated with fringe benefits.

Answer 1

Chapter 12: Compensation

Learning Objectives:

1. Discuss and explain the tax implications of compensation in the form of salary and wages from the employee’s and employer’s perspectives.

? Employees are taxed on salary at ordinary income rates.

? Employees use Form W-4 to supply their employer with withholding information. Employees can use the W-4 to manage withholding throughout the year because withholding is treated as though it is withheld evenly throughout the year for estimated tax purposes.

? Cash-method employers deduct wages when paid. Accrual-method employers deduct wages when accrued as long as the wages are paid within 2.5 months of year-end. If paid after 2.5 months of year-end, wages are deductible when the employee recognizes the income (when paid). When an employer accrues wages to a related-party employee (more than 50 percent ownership), the wages are not deductible until the employee recognizes the income (when paid).

? Employer's’ after-tax cost of wages is the cost of the wages minus the tax benefit of the deduction for the wages.

? For publicly traded corporations, the tax deduction for nonperformance-based compensation paid to the CEO and the three other most highly compensated officers, not including the CFO, is limited to $1,000,000 per year per individual.

• Salary and Wages:

1. Employee Considerations for Salary and Wages - Salary, bonus, and wages are taxed to employees as ordinary income. Employees generally report income from salary and wages as they receive it. Employees must pay FICA taxes on their wages that consist of both a Social Security and a Medicare component. Summarized in W-2 form.

1. Tax withholding - When employees begin employment with a firm, they complete a Form W-4 to supply the information the firm needs in order to withhold the correct amount of tax from each paycheck.

• Specifically, employees use Form W-4 to indicate:

1. Whether to withhold at the single rate or at the lower married rate,
2. The number of withholding allowances the employee chooses to claim (the more withholding allowances claimed, the less the withholding amount), and
3. Whether the employee wants an additional amount of tax withheld each period above the amount based on the number of allowances claimed.

1. Employer Considerations for Salary and Wages -

1. Deductibility of Salary Payments - Employers computing taxable income under the cash method of accounting generally deduct salary and wages when they pay the employee.

• Compensation expense accrued at end of year is deductible in year accrued if paid to an unrelated party within 2½ months of year-end.
• Compensation expense accrued at end of year is not deductible when paid if paid to related party owning > 50% of corporate employer.

• Limits on Salary Deductibility - $1,000,000 maximum annual compensation deduction per person.
• Limit applies to CEO and three other highest compensated officers (not including the CFO).
• Does not apply to performance-based compensation.

2.   Describe and distinguish the tax implications of various forms of equity-based compensation from the employee’s and employer’s perspectives.

? Stock options and restricted stock are common forms of equity-based compensation. Although both reward employees for increases in the stock price of their employers, there are fundamental economic differences between them.

?Stock options are treated as either non-qualified or incentive stock options for tax purposes.

? Employees recognize ordinary income equal to the bargain element on NQOs when they are exercised. Employers are able to deduct the bargain element when NQOs are exercised. Any appreciation in the value of shares subsequent to the exercise of NQO’s is treated as capital gain by employees when the shares are sold.

? If certain holding period requirements are met, employees exercising ISOs don’t recognize any income until the shares received from the exercised options are sold. When the shares are sold, the difference between the exercise price and the share price is long-term capital gain (assuming appreciation). Employers are not permitted a deduction for ISOs.

? Generally, employees prefer ISOs and employers prefer NQOs because of differences in the way the two types of options are taxed.

? Employers treat stock options differently for book and tax purposes.

? Employees recognize ordinary income from restricted stock equal to the fair market value of the stock on the vesting date. Employers receive a corresponding tax deduction.

? Employees may elect to recognize taxable income from restricted stock on the date it is received rather than on the vesting date if they make an §83(b) election. Although this election accelerates the recognition of income, it gives the employee the ability to convert ordinary income from further appreciation into a capital gain.

• Equity Based Compensation:

1. Stock Options - Stock Options allow employees to purchase stock at a discount.

• Incentive stock options - satisfy certain tax code requirements to provide favorable tax treatment to employees.
• Nonqualified stock options - are any options that don’t meet the requirements for being classified as incentive stock options.
• The grant date - is the date employees are initially allocated stock options.
• The exercise date - is the date that employees purchase stock using their options.
• The exercise price (or strike price) - is the amount paid to acquire shares with stock options.
• The bargain element - is the difference between the fair market value of stock and the exercise price on the exercise date.
• The vesting date - is the time when stock options granted can be exercised.

1. Employee Considerations for Stock Options - For either type of option, ISO’s or NQO’s, employees experience no tax consequences on the grant date and vesting date.

• However, when they exercise non qualified stock options, employees report ordinary income equal to the total bargain element on the shares of stock acquired (as if they were sold)—whether they hold the shares or sell them immediately.
• When incentive stock options are exercised, employees don’t report any income for regular tax purposes (as long as they don’t immediately sell their shares).
• When taxpayers exercise incentive stock options, the bargain element is added to their alternative minimum taxable (AMT) income.

1. Employer Considerations for Stock Options - As is true for employees, an employer’s tax treatment of stock options depends on whether the options are NQOs or ISOs.

• With NQOs, employers deduct the bargain element that employees recognize as income when the employees exercise the NQOs. From the employer’s perspective, no other date is relevant for tax purposes.
• Employers typically don’t view incentive stock options as favorably as NQOs, because:

1. ISOs don’t provide them with the same tax benefits (no tax deduction) and
2. The IRS regulatory requirements for ISOs can be cumbersome.

• For tax purposes, employers deduct the bargain element of NQOs on exercise date but receive no tax deduction for ISOs unless they become disqualified.
• For GAAP purposes, employers expense the estimated value of the option pro rata over the vesting period.

1. Restricted Stock - form of compensation that provides actual stock ownership to employee after restrictions lapse.

• Unlike the stock acquired through options exercises, employees receive restricted stock on the vesting date without having to pay for it, after which they can either sell it immediately or retain it.
• No tax consequences on grant date.
• Employee recognizes ordinary income on fair market value of stock on vesting date.
• Holding period for stock begins on vesting date.
• Employer deducts fair market value of stock on vesting date.

1. Employee Considerations for Restricted Stock - employees receiving restricted stock are taxed on the full fair market value of the shares on the date the restricted stock vests.

• They are taxed on the fair market value of the stock because they are entitled to receive the stock without any payment requirements.
• Any subsequent appreciation in the value of the stock is taxed as either long-term or short-term capital gain(s) or loss(es) when the taxpayer sells the stock, depending on the holding period and future movement of the stock price.
• Restricted Stock with Section §83(b) Election:

1. On grant date, employee recognizes market value of stock as ordinary income.
2. Employee takes fair market value basis in stock.
3. Holding period for stock begins on grant date.
4. If employee never vests, no deduction for basis in stock.
5. Employer deducts value of stock on grant date.

1. Employer Considerations for Restricted Stock - Like the tax treatment of NQOs, the employer’s deduction for restricted stock equals the amount of ordinary income reported by its employees.

3.   Compare and contrast taxable and nontaxable fringe benefits and explain the employee and employer tax consequences associated with fringe benefits.

? Fringe benefits are taxable to the employee unless the Code specifically excludes the benefit from gross income. Taxable fringe benefits are generally luxury perks, such as corporate air travel and security.

? Nontaxable fringe benefits include up to $50,000 of group-term life insurance, health benefits, meals and lodging for the convenience of the employer, educational assistance, dependent care benefits, qualified employee discounts, and qualified transportation benefits (among others).

• Fringe Benefits:

1. Taxable Fringe Benefits -

1. Employee Considerations for Taxable Fringe Benefits - Employees recognize compensation income on all benefits received unless specifically excluded by tax laws.

• Employees treat benefits received like taxable cash compensation.
• Employees recognize ordinary compensation income when they receive taxable benefits and, just as they do with salary, pay FICA taxes on the value of the benefit.

1. Employer Considerations for Taxable Fringe Benefits - Employer deducts cost and pays employer’s share of FICA taxes on benefit.

• Employers treat taxable fringe benefits like cash compensation.
• The employer deducts the cost of the benefit not the value of the benefit to the employee.

1. Nontaxable Fringe Benefits -

1. Group-Term Life Insurance -

1. Health and Accident Insurance and Benefits -
2. Meals and Lodging for the Convenience of the Employer -
3. Employee Educational Assistance -
4. Dependant Care Benefits -
5. No-Additional-Cost Services -
6. Qualified Employee Discounts -
7. Working Condition Fringe Benefits -
8. De Minimis Fringe Benefits -
9. Qualified Transportation Fringe -
10. Qualified Moving Expense Reinbursement -
11. Cafeteria Plans and Flexible Spending Accounts (FSAs) -

1. Employee and Employer Considerations for Nontaxable Fringe Benefits - Specifically identified in the Code. Employee excludes benefit from taxable income. Employer deducts cost when benefit is paid.