Module 12

Compensation and Fringe Compensation and Fringe BenefitsBenefits

Module Topics

Employer-Employee MotivationsEmployer-Employee Motivations Forms of CompensationForms of Compensation Property TransfersProperty Transfers Fringe BenefitsFringe Benefits Flow-Through EntitiesFlow-Through Entities IRS ChallengesIRS Challenges Equity-Based CompensationEquity-Based Compensation

Employer-Employee Motivations

Key Learning ObjectiveKey Learning Objective

Distinguish the preferences that employersDistinguish the preferences that employersand employees may have for certain types ofand employees may have for certain types ofcompensationcompensation

Parties to Consider

EmployerEmployer EmployeeEmployee GovernmentGovernment

Why Pay Compensation?

To attract, motivate, and retain employeesTo attract, motivate, and retain employees To distribute closely-held corporate To distribute closely-held corporate

earnings at lowest tax costearnings at lowest tax cost To compensate family membersTo compensate family members

Motivations

Different employees are attracted to Different employees are attracted to different types of compensation packagesdifferent types of compensation packages

Employers often use performance-based Employers often use performance-based bonuses as motivationbonuses as motivation

Forms of Compensation

Key Learning ObjectiveKey Learning Objective

Distinguish between current and deferred Distinguish between current and deferred forms of compensationforms of compensation

Current Compensation and Short-Term Bonuses

Paid in year services are performed and generally Paid in year services are performed and generally subject to payroll taxessubject to payroll taxes Salary and wagesSalary and wages Prizes and awardsPrizes and awards Vacation and sick payVacation and sick pay Property transfersProperty transfers Fringe benefits (many excluded fromFringe benefits (many excluded from

payroll tax) payroll tax) CommissionsCommissions Bonuses (often short-term performance based)Bonuses (often short-term performance based)

Deferred Compensation

Paid in future for services performed Paid in future for services performed currentlycurrently e.g., retirement plane.g., retirement plan

Employer and/or employee may prefer this Employer and/or employee may prefer this timing arrangementtiming arrangement e.g., lower marginal rate after retiremente.g., lower marginal rate after retirement

Often used to reward long-term performance Often used to reward long-term performance

Forms of Deferred Compensation

Qualified planQualified plan Meets certain tax law requirementsMeets certain tax law requirements

*Coverage*Coverage*Nondiscrimination*Nondiscrimination*Vesting*Vesting*Funding*Funding

Nonqualified planNonqualified plan Does not meet the requirementsDoes not meet the requirements

Qualified Plans--Potential Benefits

Immediate deduction for employeeImmediate deduction for employee Nontaxable to employee until payments are Nontaxable to employee until payments are

receivedreceived Deferral of tax on earnings until funds Deferral of tax on earnings until funds are are

distributeddistributed Reduced or deferred tax on lump-sum Reduced or deferred tax on lump-sum

distributionsdistributions

Deferred Compensation--Nonqualified Plans

No deduction by employer until employee No deduction by employer until employee reports incomereports income

Often limited to a select group of Often limited to a select group of employeesemployees

Generally not currently fundedGenerally not currently funded

Nonqualified Plans--Funded vs Unfunded

FundedFunded Generally income to employee when funded Generally income to employee when funded Not income if creditors can reach fundsNot income if creditors can reach funds Key factor: Are funds subject to a substantial Key factor: Are funds subject to a substantial

risk of forfeiture?risk of forfeiture? UnfundedUnfunded

No tax consequences to employer or employee No tax consequences to employer or employee until payment is madeuntil payment is made

Property Transfers

Key Learning ObjectiveKey Learning Objective

Determine the tax treatment of Determine the tax treatment of compensation paid in propertycompensation paid in property

Property Transfers

Use FMV of property to measure Use FMV of property to measure compensationcompensation

Employer gets deduction when employee Employer gets deduction when employee reports incomereports income

Property is generally income when received Property is generally income when received unless it is:unless it is: Not freely transferable, andNot freely transferable, and Subject to a substantial risk of forfeitureSubject to a substantial risk of forfeiture

Research Query

An employee receives property from an An employee receives property from an employer subject to a requirement that it be employer subject to a requirement that it be returned if the total earnings of the returned if the total earnings of the employer do not increase.employer do not increase.

Does the employee have income when the Does the employee have income when the property is received?property is received?

Solution--Research Query

No. The property is subject to a substantial No. The property is subject to a substantial risk of forfeiture.risk of forfeiture. Reg. § 1.83-3(c)(2) Reg. § 1.83-3(c)(2)

Note that conditioning a property’s Note that conditioning a property’s return upon not accepting a job withreturn upon not accepting a job withanother firm or being discharged for cause another firm or being discharged for cause are generally not treated as resulting in a are generally not treated as resulting in a substantial risk of forfeiture.substantial risk of forfeiture.

Fringe Benefits

Key Learning ObjectiveKey Learning Objective

Identify the most common forms of fringe Identify the most common forms of fringe benefits offered to employeesbenefits offered to employees

Some Common Fringe Benefits Group-term life insuranceGroup-term life insurance Accident and health care coverageAccident and health care coverage Dependent care assistanceDependent care assistance Employee discountsEmployee discounts Employer provided meals and lodgingEmployer provided meals and lodging Moving expense reimbursementMoving expense reimbursement Employee death benefitsEmployee death benefits Qualified transportation benefitsQualified transportation benefits

Non-Cash Fringe Benefits

Key Learning ObjectiveKey Learning Objective

Determine the tax treatment of Determine the tax treatment of compensation paid in the form of non-cash compensation paid in the form of non-cash fringe benefitsfringe benefits

Fringe Benefits--Potential Advantages

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

Fringe Benefits--Some Disadvantages

Can be costly to comply with statutory rulesCan be costly to comply with statutory rules Most benefits must be offered on a Most benefits must be offered on a

nondiscriminatory basis to obtain favorable nondiscriminatory basis to obtain favorable tax treatmenttax treatment

Some Specific Fringe Benefits

Accident and health plansAccident and health plans Includes self-insured plansIncludes self-insured plans

Group-term life insuranceGroup-term life insurance First $50,000 of coverage tax-freeFirst $50,000 of coverage tax-free

Dependent care assistanceDependent care assistance $5,000 annual exclusion$5,000 annual exclusion

Generic Fringe Benefits

No additional cost benefitsNo additional cost benefits Qualified employee discountsQualified employee discounts

Goods--gross profit percentageGoods--gross profit percentage Services--20%Services--20%

Working condition benefits*Working condition benefits* De minimis benefits*De minimis benefits*

*generally can discriminate*generally can discriminate

Compliance Query

T, an employee of QRS Corporation, buys a T, an employee of QRS Corporation, buys a TV from QRS for $400. The regular price TV from QRS for $400. The regular price is $600, and the gross profit percentage is is $600, and the gross profit percentage is 25%.25%.

How much income should T recognize?How much income should T recognize?

Solution--Compliance Query

T’s income is $50T’s income is $50

Discount taken ($600 - $400)Discount taken ($600 - $400) $200$200Allowable discount ($600 x 25%)Allowable discount ($600 x 25%) 150150 IncomeIncome $50 $50

Fringe Benefits--Cafeteria Plans

Allows employee to choose between cash Allows employee to choose between cash and one or more excludable fringe benefitsand one or more excludable fringe benefits

Choosing excludable fringe benefit does not Choosing excludable fringe benefit does not trigger constructive receipt of cashtrigger constructive receipt of cash

Fringe Benefits--Flexible Spending Accounts

Benefit offered within a cafeteria planBenefit offered within a cafeteria plan Available for medical or dependent careAvailable for medical or dependent care Employee pays expenses with “pre-tax Employee pays expenses with “pre-tax

dollars”dollars” Saves income and payroll taxesSaves income and payroll taxes Use-it-or-lose-it riskUse-it-or-lose-it risk

Flow-Through Entities

Key Learning ObjectiveKey Learning Objective

Determine the tax treatment of fringe Determine the tax treatment of fringe benefits offered to owners of flow-through benefits offered to owners of flow-through entitiesentities

Partners and > 2% S Corporation Shareholders

NOT entitled to tax benefits available for:NOT entitled to tax benefits available for: Cafeteria plansCafeteria plans Employee death benefitsEmployee death benefits Accident and health plansAccident and health plans Group-term life insuranceGroup-term life insurance Employer provided meals and lodgingEmployer provided meals and lodging Cafeteria plan benefitsCafeteria plan benefits Employer provided parkingEmployer provided parking

IRS Challenges

Key Learning ObjectiveKey Learning Objective

Evaluate when the IRS is most likely to Evaluate when the IRS is most likely to question the deductibility of compensation question the deductibility of compensation paymentspayments

Reasonable Compensation

Employee-shareholders of C corporation Employee-shareholders of C corporation overcompensated?overcompensated? Attempt to turn nondeductible dividend Attempt to turn nondeductible dividend

payments into deductible compensationpayments into deductible compensation Employee-shareholders of S corporation Employee-shareholders of S corporation

undercompensated?undercompensated? Attempt to avoid payroll taxes or shift incomeAttempt to avoid payroll taxes or shift income

Research Query:

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

Solution--Research Query:

Employee's qualifications and role in the Employee's qualifications and role in the companycompany

Character and condition of the companyCharacter and condition of the company Compensation paid by similar companies Compensation paid by similar companies

for comparable servicesfor comparable services Salary policy of the company for all its Salary policy of the company for all its

employeesemployees

Solution--Research Query:

Likelihood that a hypothetical, independent Likelihood that a hypothetical, independent investor would be willing to compensate the investor would be willing to compensate the employee at a similar levelemployee at a similar level

Automotive Investment Development Inc., Automotive Investment Development Inc.,

(1993) TC Memo 1993-298, 1993 RIA TC (1993) TC Memo 1993-298, 1993 RIA TC Memo ¶93298Memo ¶93298

Equity-Based Compensation

Key Learning ObjectiveKey Learning Objective

Identify different types of equity-based Identify different types of equity-based compensation and evaluate the tax and compensation and evaluate the tax and economic aspects of such arrangementseconomic aspects of such arrangements

Compensation Paid in Stock

Taxable when received unless:Taxable when received unless: Not freely transferable, andNot freely transferable, and Subject to a substantial restrictionSubject to a substantial restriction

Lapse restrictionLapse restriction Employee recognizes income when restriction Employee recognizes income when restriction

lapseslapses Section 83(b) election to recognize income Section 83(b) election to recognize income

before restriction lapsesbefore restriction lapses

Compliance Query:

ABC Corporation gives 100 shares of its stock ABC Corporation gives 100 shares of its stock to T, an employeeto T, an employee the stock is worth $200/share. the stock is worth $200/share. T cannot transfer the stock for the next 3 years T cannot transfer the stock for the next 3 years she must return the stock to ABC if she quits she must return the stock to ABC if she quits

within that 3-year period. within that 3-year period. The stock is worth $300/share 3 years later.The stock is worth $300/share 3 years later. How much income should T report, and when?How much income should T report, and when?

Solution--Compliance Query:

Stock is nontransferable and subject to a Stock is nontransferable and subject to a substantial restrictionsubstantial restriction

T should recognize $30,000 of income in 3 T should recognize $30,000 of income in 3 years when restriction lapses years when restriction lapses