Lesson 5

1
Lesson 5

• Nonqualified Plans
• Employee Benefits and Business Insurance
• Cafeteria Plans

2
Non-Qualified Plans

• These are deferred compensation arrangements not
  meeting IRC Section 401 requirement.
  
• They are used to benefit key employees beyond the
  qualified plan 415 limit.
  

3
Types of Non-qualified Plans

• Non-qualified deferred compensation plans.
• Supplemental Executive Retirement Plan (SERPs).
• Insurancesplit-dollar plans.
• Stock options NQSOs and ISOs.
• Employee Stock Purchase Plans (ESPPs).
• Phantom stock.
• Loans.

4
Advantages of Non-Qualified Plans

• They do NOT have to meet nondiscrimination
  requirements of qualified plans.
  
• The benefits and contributions can exceed IRS
  Section 415 limits.
  
• They are NOT subject to the same ERISA
  requirements as qualified plans.

5
Taxation and Economic Arrangements of
Non-Qualified Plans

• Generally, just a promise to pay from the
  employer.
  
• There must be a substantial risk of forfeiture
  (i.e., subject to the classes of general
  creditors)
  
• Otherwise, there will be constructive receipt
  and, therefore, taxable income to the
  participant.
  
• NOT deductible by the employee at the time of
  receipt.
  
• Includible by the employee at the time of receipt
  (withdrawal).
  
• Generally, there are no deferrals, rollovers, or
  averaging.

6
Non-Qualified Deferred Compensation Plans

• A non-qualified deferred compensation plan is any
  employer retirement, savings, or deferred
  compensation plan for employees that does NOT
  meet the the tax and labor law (ERISA)
  requirements applicable to qualified pension and
  profit sharing plans.

7
Non-Qualified Deferred Compensation Plan
Application

• Appropriate when an employer wants to provide a
  deferred compensation benefit to an executive or
  group of executives, but the cost of a qualified
  plan is prohibitive because of the large number
  of non-executive employees who would need to be
  covered.
• Appropriate when an employer wants to provide
  additional deferred compensation benefits to an
  executive who is already receiving the maximum
  benefits or contributions under the companys
  qualified retirement plan.

8
Non-Qualified Deferred Compensation Plan
Application (cont)

• Appropriate when the business wants to provide
  certain key employees with tax-deferred
  compensation under terms or conditions different
  from those applicable to other employees.
• Appropriate when an executive or key employee
  wants to use the employer to, in essence, create
  a forced, automatic investment program that uses
  the employers tax savings to leverage the future
  benefit.
• Appropriate when an employer needs to recruit,
  retain, reward, or retire.
  
• Appropriate when a closely held corporation wants
  something to attract and hold non-shareholder
  employees.

9
Non-Qualified Deferred Compensation Plan
Advantages

• Design is much more flexible than that of
  qualified plans
  
• Allows coverage of any group of employees or even
  a single employee, without any nondiscrimination
  requirements.
  
• Generally, nonqualified plans benefit key
  executives.
  
• Can provide an unlimited benefit to any one
  employee
  
• Subject to the reasonable compensation
  requirements for deductibility.
  
• Allows the employer to provide different benefit
  amounts for different employees, on different
  terms and conditions.

10
Non-Qualified Deferred Compensation Plan
Advantages (cont)

• Involves minimal IRS, ERISA, and other
  governmental regulatory requirements, such as
  reporting and disclosure, fiduciary, and funding
  requirements.
• Can provide deferral of taxes to employees
• But, the employers deduction is ALSO deferred.
• Can be used by an employer as a form of golden
  handcuffs that can help bind the employee to the
  company.
  
• Security to the executive CAN BE provided through
  informal financing arrangements such as
  
• A corporate-owned life insurance policy or
• A rabbi trust arrangement.

11
Non-Qualified Deferred Compensation Plan
Disadvantages

• The companys tax deduction is generally NOT
  available for the year that compensation is
  earned.
  
• Tax deduction is deferred until the year that the
  income is taxable to the employee.
  
• From the executives point of view, the principal
  problem with deferred compensation plans is the
  lack of security as a result of depending solely
  on the companys unsecured promise to pay.
• Disclosure of executive nonqualified plans in
  financial statements may be required.
  
• Not all employers are equally well suited to take
  advantage of non-qualified plans
  
• S Corporations and partnerships cannot take full
  advantage of nonqualified plans.
  
• The employer must be one that is likely to
  contiunue in existence long enough to make the
  payments promised under the plan.

12
Non-Qualified Deferred Compensation Plan Tax
Issues

• We will consider the following
• Constructive receipt and substantial risk of
  forfeiture.
  
• Plan funding.
• Employers deduction fro deferred compensation.

13
Constructive Receipt

• Occurs within a nonqualified plan if the
  executive has access to funds or the funds are
  securely set aside for the executive.
  
• The funds that are deemed to be constructively
  received are required to be reported as taxable
  income by the executive, defeating the primary
  tax-advantage of nonqualified deferred
  compensation, which is tax deferred.

14
Substantial Risk of Forfeiture

• If there exists a substantial risk of forfeiture,
  the deferred compensation will NOT be treated as
  constructively received.
  
• Thus, no current taxable income.
• The following qualifies as substantial risk of
  forfeiture
  
• An unsecured promise to pay qualifies since there
  is no certainty that the executive will receive
  the deferred compensation.
  
• A rabbi trust qualifies because the funds set
  aside for the executive may be used for the
  purpose of satisfying creditors of the employer
  in the event of bankruptcy/liquidation.
• A secular trust will NOT qualify because the
  funds are secured for the benefit of the
  employeethere is no risk.

15
Plan Funding

• Nonqualified plans may be funded or unfunded.
• If the plan is funded, then the executive is
  taxed on the funds in the plan at the time funds
  are contributed or at the time the executive
  becomes vested.
• Because the tax implications of a funded plan are
  inconsistent with the objective of a nonqualified
  plan, most plans are unfunded.
  
• Since an unfunded promise to pay has an element
  of risk, there is no current taxation to the
  executive.
  
• Similarly, there is risk involved in a rabbi
  trust, resulting in it not being taxable.

16
Employers Deduction for Deferred Compensation

• The deductibility of contributions, payments, or
  funding for deferred compensation plans is
  relatively straightforward.
  
• The deduction for the employer will follow
  inclusion of income by the executive.
  
• Therefore, when the funds are constructively
  received and included in taxable income for the
  executive, the employer will then receive a
  deduction.

17
Nonqualified Deferred Compensation Plan Design

• Use either a salary continuation or a salary
  reduction approach.
  
• The salary continuation approach provides a
  specified deferral amount payable in the future
  without any stated reduction of current salary.
  
• The salary reduction design provides for the
  deferral of a specified amount of the employees
  compensation, otherwise currently payable.

18
Nonqualified Deferred Compensation Plan Design
(cont)

• Insurance Policies can be purcased on the
  employees life, owned by and payable to the
  employer, to fund the obligation under
  nonqualified deferred compensation plans.
• These funds provide for benefits in the event of
  death, before retirement (See split-dollar life
  insurance).

19
Rabbi Trusts

• Rabbi Trust is a trust that is set up to hold
  property used for financing a deferred
  compensation plan where the funds set aside are
  subject to the claims of the employers general
  creditors.
• Other than general creditors, the funds are
  secure.
  
• The risk of forfeiture is considered substantial,
  thus there is no current taxation for the
  executive.

20
Nonqualified Deferred Compensation Plans

• See Table (BQ) for a summary of deferred
  compensation funding methods.

21
Supplemental Executive Retirement Plan (SERP)

• A SERP is a nonqualified deferred compensation
  plan that focuses on providing adequate
  retirement income to executives.
  
• A SERP can complement existing retirement plans
  to bring executive benefits up to desired
  levels.
  
• SERPs are sometimes referred to as salary
  continuation plans.
  

22
SERPs are Appropriate for Employees

• Who want to provide additional retirement
  benefits for executives over those benefits
  provided for other employees.
  
• Who wish to cut back benefits under a qualified
  plan due to the higher costs of qualified plans.
  
• Who want to avoid the limit on compensation that
  can be considered in determining benefits from
  qualified plans.
  
• Attempting to recruit mid-career executives who
  otherwise would be entitled to modest retirement
  benefits due to relatively few years of service.

23
SERP Advantages

• Provides benefits to executives over and above
  the benefits available with a qualified plan.
  
• Can reward continued employment or encourage
  early retirement.
  
• Can be completely unfunded, paying benefits only
  as needed from the companys assets.
  
• Subject only to ERISA Reporting and Disclosure
  Requirements.
  
• NOT subject to nondiscrimination testing.
• Can be integrated with Social Security without
  being subject to the complex integration
  (permitted disparity) rules applicable to
  qualified plans.
• Can be set up to protect executives from
  involuntary termination if the company changes
  ownership.
  
• This could be accomplished by providing
  executives with increased benefits from the SERP
  if the company is taken over.

24
SERP Disadvantages

• If the SERP is unfunded, it may be an ineffective
  recruiting tool, since there is no guarantee of
  benefits.
  
• From the executives point of view, the principal
  problem with deferred compensation plans is the
  lack of security as a result of depending solely
  on the companys unsecured promise to pay.
• Disclosure of executive nonqualified plans in
  financial statements may be required.

25
SERP Plan Design

• Definition A salary continuation design, which
  provides a specified deferred amount payable in
  the future without any stated reduction of
  current salary.
• Benefit formulas and other plan provisions are
  similar to those for qualified defined-benefit
  plans without the limits of defined-benefit
  plans.
• See Example (BR).

26
SERP Plan Design (cont)

• Typically set up with forfeiture provisions,
  which can accomplish several employee
  objectives.
  
• Qualified plan vesting schedules do not apply to
  SERPs.
  
• SERPs must be maintained primarily for a select
  group of management or highly compensated
  employees.
  
• The executives title or position typically
  determines whether or not the executive will be
  included in the SERP.
  
• An offset SERP is a special type of SERP that
  provides a desired benefit to an executive,
  taking into account the benefits the executive
  will receive under a qualified plan.

27
SERP Tax Ramifications

• The employer gets a deduction when benefits are
  paid to the executive.
  
• The executive is subject to ordinary income tax
  upon receipt of the benefits from the SERP.

28
Split-Dollar Life Insurance

• A split-dollar insurance is an arrangement,
  typically between an employer and an employee in
  which there is a sharing of both the costs and
  the benefits of the life insurance policy.
• Usually, the employer corporation pays that part
  of the annual premiums that equals the current
  years increase in the cash surrender value of
  the policy.
• If the insured employee dies, the corporation
  recovers its premium outlay.
  
• The balance of the policy proceeds is paid to the
  beneficiary chosen by the employee.

29
Split-Dollar Life Insurance Application

• Appropriate when an employer wishes to provide an
  executive with a life insurance benefit at a low
  cost and a low cash outlay to the executive.
  
• It is best suited for executives in their 30s,
  40s, and early 50s since the plan requires a
  reasonable duration in order to build up adequate
  policy cash values.
• The cost to the executive can be excessive at
  later ages.
  
• Appropriate when a pre-retirement death benefit
  for an employee is a major objective.
  
• Split-dollar can be used as an alternative to an
  insurance-finance nonqualified deferred
  compensation plan.
  
• Appropriate when an employer is seeking a totally
  selective executive fringe benefit.
  
• Appropriate when an employer wants to make it
  easier for shareholder-employees to finance a
  buyout of stock under a cross purchase buy-sell
  agreement or make it possible for
  non-stockholding employees to effect a one-way
  purchase at an existing stockholders death.

30
Split-Dollar Life Insurance Advantages

• A split-dollar plan allows an executive to
  receive a benefit of current value using employer
  funds, with minimal or no tax cost to the
  executive.
• In most types of split-dollar plans, the
  employers outlay is, at all times, fully
  secured.
  
• Upon the employees death or termination of
  employment, the employer is reimbursed from
  policy proceeds for its premium outlay.
  
• The net cost to the employer for the plan is
  merely the loss of the net after-tax income the
  funds could have earned while the plan was in
  effect.

31
Split-Dollar Life Insurance Disadvantages

• The employer receives no tax deduction for its
  share of premium payments under the split-dollar
  plan.
  
• The employee must pay income taxes each year on
  the current Table 2001 (CN) cost.
  
• The plan must remain in effect for a reasonably
  long time (10-20 years) in order for policy cash
  values to rise to a level sufficient to maximize
  plan benefits.
• The plan must generally be terminated at
  approximately age 65 since the employees tax
  cost for the plan rises sharply for later ages.
  
• Interest on policy loans is generally
  nondeductible.

32
Split-Dollar Life Insurance Design Features

• In a split-dollar arrangement between the
  employer and employee, at least three aspects of
  the policy can be subject to different types of
  splits
• The premium cost.
• The cash value.
• The policy ownership.

33
Split-Dollar Life Insurance Premium Cost Split
Categories

• The classic or standard split-dollar plan under
  which the employer pays a portion of the premiums
  equal to the increase in cash surrender value of
  the policy.
• The level premium plan under which the employees
  premium share is leveled over an initial period
  of years, such as 5 or 10 years.
  
• The employer pays all arrangements, with the
  employer paying the entire premium and the
  employee paying nothing.
  
• The offset plan under which the employee pays an
  amount equal to the cost for the coverage.

34
Split-Dollar Life Insurance Design Features (cont)

• The purpose of the split of cash value and death
  proceeds is to reimburse the employer, in whole
  or in part, for its share of the premium outlay,
  in the event of the employees death or
  termination of the plan.

35
Split-Dollar Life Insurance Policy Ownership
Methods

• The endorsement method.
• The employer owns the policy and is primarily
  responsible to the insurance company for paying
  the entire premium.
  
• The beneficiary designation provides for the
  employer to receive a portion of the death
  benefits equal to its premium outlay, with the
  remainder of the death proceeds going to the
  employees designated beneficiary.
• The collateral assignment method.
• The employee is the owner of the policy and is
  responsible for premium payments.
  
• The employer makes what are, in effect,
  interest-free loans of the amount of the premium
  the employer has agreed to pay under the
  split-dollar plan.
• To secure these loans, the policy is assigned as
  collateral to the employer.
  
• At the employees death, the employer recovers
  its aggregate premium payments from the policy
  proceeds as collateral assignee.
  
• The remainder of the policy proceeds is paid to
  the employees designated beneficiary.

36
Split-Dollar Life Insurance Income Tax Treatment

• Notice 2002-2 revoked Notice 2001-10 and provided
  some guidance regarding the taxation of
  split-dollar life insurance.
  
• However, the IRS intends to issue regulations
  addressing the tax treatment of split-dollar life
  insurance arrangements.
  
• Currently, these proposed regulations have not
  been issued.
  
• It is expected that the regulations will provide
  that any payment made by an employer under a
  split-dollar arrangement must be accounted for
  either as a loan to the employee under IRC
  Section 7872 or as compensation to the employee.
• This move closely reflects economic reality.

37
Split-Dollar Life Insurance Income Tax Treatment
(cont)

• Death benefits from a split-dollar plan, both the
  employers share and the employees beneficiarys
  share, are generally free from income tax.
  
• The tax-free nature of the death proceeds is lost
  if the policy has been transferred for value in
  certain situations.
  
• Transfers of insurance policies that are exempt
  from the transfer for value rules will not cause
  the loss of the death proceeds tax-free nature.
  Examples
• A transfer of the policy to the insured.
• A transfer to a partner of the insured or to a
  partnership of which the insured is a partner.
  
• A transfer to a corporation of which the insured
  is a shareholder or officer.
  
• A transfer in which the transferees basis is
  determined in whole or in part by reference to
  the transferors basis. (i.e., substituted or
  carryover basis).

38
Stock Options (NQSOs and ISOs)

• Stock options give the employee the right to
  purchase a fixed number of shares of employer
  stock at a fixed price over a stated period.
  
• The grant of a stock option is generally a
  nontaxable event, because the option price is
  usually made equal to the stocks market price on
  the grant date.
• The option will therefore have no ascertainable
  value and the grant will not be a taxable event.

39
Types of Options

• Nonqualified stock options (NQSO)a NQSO is any
  option that is NOT an Incentive Stock Option.
  
• Incentive Stock Option (ISO)an ISO is an option
  that meets the requirements of IRS Code Section
  422.

40
Non-Qualified Stock Options (NQSO)

• Requirements
• There are no special requirements under the IRS
  code for NQSOs.
  
• The employer may grant the employee an NQSO on
  any terms, exercisable over any period of years.
  
• The option may be granted to an employee, an
  independent contractor, a family member, or any
  other beneficiary of the employee or independent
  contractor.

41
Taxation of NQSOs

• At exercise
• W-2 income and subject to payroll taxes for the
  difference between the option exercise price and
  the current fair market value.
  
• Taxable basisafter the exercise, the basis in
  the stock for capital gains or losses is the
  exercise price plus the ordinary income
  recognized (i.e., approximately equal to the FMV
  of the stock on the date of exercise.
• Sale on shares acquired through the exercise of
  NQSOs.
  
• Results in either a capital gain or loss.
• Long term or short term depends on the holding
  period.
  
• See Example (BS).

42
Transfer and Gifting of NQSOs

• Transfer to family members and other persons
• Income tax consequences
• The employee does not recognize gain on the
  transfer date.
  
• The employee (or employees estate, if the
  employee is deceased) will have compensation
  income when the transferee exercises the option.
  
• The transferee will have an adjusted taxable
  basis in the stock equal to the fair market value
  of the stock at the time of exercise.
  
• Gift and estate tax consequences
• The transfer of an NQSO is a completed gift on
  the date of transfer (or date of vesting, if
  later).
  
• The option must be valued at the date of the
  gift.
  
• In some cases, the Black-Scholes option valuation
  model may be used.
  
• The options and shares of stock acquired upon
  exercise are NOT included in the employees gross
  estate upon death.

43
Transfer of NQSO to Charity

• Income Tax Consequences
• The employee does NOT recognize gain on the
  transfer date.
  
• The employee will have compensation income when
  the charity exercises the option, If the employee
  is still living when the options are exercised.
  
• There is NO compensation income if the charity
  exercises the option after the death of the
  employee.
  
• The employee will be allowed a charitable income
  tax deduction on the date of transfer (or date of
  vesting, if later).
  
• Gift and estate tax consequences
• The transfer of a NQSO is a completed gift on the
  date of transfer (or the date of vesting, if
  later).
  
• The value of any unexercised option is included
  in the employees gross estate upon death.
  
• If the employee dies within three years after the
  option is exercised by charity, the employees
  gross estate must include the value that the
  options would have had at the date of death.
• The employees estate is eligible for the estate
  tax charitable deduction for the transfer of the
  options to charity.
  
• See Table (BT) for a summary of Charitable
  transfer rules.

44
Incentive Stock Options (ISOs) (IRC Section 422)

• ISOs must be part of a written plan approved by
  the stockholders.
  
• The exercise period cannot exceed 10 years from
  the date of grant.
  
• The option (strike) price cannot be less than the
  market price of the stock at the time of grant.
  
• There is an annual limit of 100,000 on the value
  of the ISOs granted during one year to a single
  employee.
  
• ISOs may only be granted to employees of the
  company.
  
• ISOs are NOT transferable by the employee during
  life, but may be transferred at death by will.
  
• ISOs must be exercised within three months from
  the date of retirement or termination.
  
• The shares received through the exercise of an
  ISO cannot be sold within two years from the date
  of grant or one year from the date of exercise.
  
• Otherwise, the favorable tax treatment treatment
  of the ISO will be lost.

45
ISO Exercise of OptionTaxation

• Upon exercise there is NO regular taxable
  income.
  
• However, there is an AMT adjustment to the extent
  the FMV exceeds the option exercise price
  
• The excess of the fair market value of the stock
  over the exercise price is sometimes referred to
  as the bargain element.
  
• The AMT adjustment can be large enough for
  executives who exercise a large number of ISOs to
  cause them to pay AMT.

46
ISO Exercise of OptionTaxable Basis

• The taxable basis for the regular tax is the
  option exercise price.
  
• For AMT purposes, the basis equals the option
  price plus appreciation at the exercise date
  
• This is equivalent to the market price of the
  stock on the date of exercise.

47
ISO Exercise of OptionEffect on Company

• The employer does NOT receive an income tax
  deduction when an employee exercises an ISO.
  
• However, if the employee disposes of the ISO
  shares in a disqualifying disposition, then the
  employee will generally have ordinary income and
  the employee will receive a tax deduction.

48
Sale of Shares Acquired Through the Exercise of
ISOs

• If shares are sold within the calendar year of
  exercise, it is considered W-2 income equal to
  the difference between the exercise price and the
  market price of the stock on the date of
  exercise.
• This is the same tax treatment as a NQSO.
• If shares are sold within 1 year from the date of
  exercise or 2 years from the date of grant, but
  not in the calendar year of exercise, the gain is
  considered ordinary income, but not W-2 income.
• If sold after 1 year from the date of exercise
  and 2 years from the date of grant, it is
  considered a long-term capital gain.
  
• See Example (BU).

49
Tax Benefits of ISOs

• The gain (bargain element) from the exercise of
  the ISO is NOT included in the employers gross
  income, whereas the gain is taxable as W-2 income
  for a NQSO.
• The gain for ISOs will be taxed at capital gains
  rate (20) instead of ordinary income tax rates
  (38.6).
  
• The gain for NQSOs are taxed as W-2.

50
Disqualifying Dispositions of ISOs

• A disqualifying disposition occurs when an
  employee disposes of an ISO stock before the
  statutory holding period expires.
  
• If a disqualifying disposition occurs, then the
  employee will generally recognize as ordinary
  income the difference between the fair market
  value of the stock at exercise and the exercise
  price of the option.
• The employee recognizes the income in the tax
  year which the disqualifying disposition occurs.
  
• The recognized ordinary income will be added to
  the ISO stocks basis to determine the capital
  gain that must be recognized because of the
  disqualifying disposition.
• If the FMV of the stock on the date of sale is
  less than the FMV on the date of exercise, there
  will be no capital gain or loss at sale.
  
• Instead, the employee will recognize ordinary
  income based on the excess of the proceeds
  received from the sale over the exercise price of
  the option.
• See Example (BV)

51
Cashless Exercise of Options

• In general
• A cashless exercise involves the exercise of
  options, without any cash outlay by the
  employee.
  
• The arrangement typically works as follows
• The stock option is exercised by the employee.
• After exercise, a sufficient amount of the
  employers stock is sold to satisfy the exercise
  price and any other costs associated with the
  exercise, such as income taxes.
• The employee receives the net amount of the stock
  (the stock remaining after the sale of the
  shares), or all cash.
  
• The cashless exercise is typically suitable for
  employees who do not have the liquid assets
  sufficient to satisfy the exercise price of the
  option.
• A cashless exercise is typically suitable for
  employees who do not have the liquid assets
  sufficient to satisfy the exercise price of the
  option.
• See Example (BW)

52
Cashless Exercise of Incentive Stock Options

• To receive the favorable tax treatment of
  incentive stock options, the shares must be held
  at least one year from the date of exercise and
  two years from the date of grant.
• A cashless exercise will result in a
  disqualifying disposition with respect to the
  shares sold because the holding requirements are
  not met.
• As a result, the employee will recognize ordinary
  income equal to the excess of the fair market
  value of the stock sold over the exercise price
  (the bargain element).
• See Exhibit (BX) for a summary of Regular Tax and
  AMT treatment of ISOs and NQSOs.

53
Employee Stock Purchase Plans (ESPPs)

• ESPPs are options that give the employees the
  right to purchase employer stock.
  
• The employee generally pays no income tax on the
  option or the stock until the shares are disposed
  of.
  
• The plan must be nondiscriminatory (see
  exceptions below).
  
• The plan can limit the amount of stock an
  employee can buy.
  
• Often, the amount of stock available to an
  employee is tied to the employees compensation.
  

54
ESPP Requirements

• Must be a written plan that is approved by the
  shareholders.
  
• The option price must be at least 85 of the fair
  market value of the stock at the time of grant.
  
• The shares acquired must be held by the employee
  for at least two years from the grant of the
  option and one year after the exercise.
  
• A similar rule applies to Incentive Stock
  Options.
  
• If the employee does not remain employed by the
  company, any outstanding stock options must be
  exercised within three months after leaving the
  company.
• Employees owning more than 5 of the corporation
  cannot participate in the ESPP.

55
ESPP Requirements (cont)

• The plan must be nondiscriminatory.
• All employees must be included in the plan
  except
  
• Employees with less than two years of
  employment.
  
• Highly-compensated employees.
• Part-time employees and seasonal workers.
• No employee can acquire the right to buy more
  than 25,000 of stock per year, valued at the
  time the option is granted.

56
Tax Treatment of ESPPs

• No tax ramification at date of grant or date of
  exercise.
  
• No AMT consequences.
• At the date of disposition of the shares
• The employee will recognize ordinary income based
  on the lesser of
  
• The FMV of the stock at the grant date less the
  option price or
  
• The FMV of the stock on the disposition date (or
  the date of death, if sooner) less the option
  price.
  
• The balance of any gain is treated as capital
  gain.

57
Tax Treatment of ESPPs

• NOTE If the option price is equal to the FMV of
  the stock at the date of grant, all gain at
  disposition will be capital gain (if the shares
  are held by the employee for at least two years
  from the grant of the option and one year after
  the exercise.
• See Example (BY).

58
Phantom Stocks (Shadow Stocks)

• A fictional deferred compensation units account
  is created as an accounting entry.
  
• The assigned base value is equal to the current
  value of the companys common stock.
  
• When dividends are declared an equivalent credit
  is made to the account.
  
• The plan may provide for adjustments to the
  account for appreciation of the common stock.
  
• Upon retirement of some other termination event,
  the participant receives the value of the account
  either as a lump sum or in installments.
  
• The payment will be in the form of cash.
• No actual common stock is ever issued to the
  participant (avoids dilution if a closely held
  company).

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Phantom Stock Tax Treatment

• Employee is taxed (at ordinary rates) when
  payment is received.
  
• The employer receives a tax deduction at the time
  of payment to the participant.

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Restricted Stock

• Restricted stock is employer stock that is
  forfeited if the executives performance is
  sub-par of if the executive terminates employment
  before a stated period of time (substantial risk
  of forfeiture).
• The value of the stock will not be subject to
  income tax as long as the stock is subject to a
  substantial risk of forfeiture.
  
• Any of the following could be considered a
  substantial risk of forfeiture
  
• A forfeiture if the employee doesnt remain with
  the employer for a specified period of time.
  
• A forfeiture if the employee doesnt meet certain
  sales or performance goals.
  
• A forfeiture if the employee goes to work for a
  competitor.
  
• When the stock is no longer subject to a
  substantial risk of forfeiture, the value of the
  stock (less any amounts paid for the stock by the
  employee) will be taxed as W-2 income to the
  employee.

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Restricted StockSection 83(b) Election

• An employee who receives restricted stock may
  elect to recognize the income immediately rather
  than waiting until there is no longer a
  substantial risk of failure.
• This election NOT to defer the income is called a
  Section 83(b) election.
  
• The election must be made within 30 days of
  receiving the restricted stock.
  
• If the election is made, the employee will
  include (in W-2 gross income) the fair market
  value of the stock at receipt, less any amount
  paid for the property.
• Any subsequent appreciation in the value of the
  stock will be treated as capital gain and may be
  taxed at lower capital-gain rates when the stock
  is sold.
• See Example (BZ).
• If the employee makes the Section 83(b) election
  and then forfeits the stock, the employee is not
  allowed a deduction or refund of tax previously
  paid on income reported.
• However, the employee will have a capital loss at
  the time of forfeiture.

62
Group Life and Health Insurance as Employee
Benefits

• Group life and health insurance are used by many
  employers as a part of the compensation package
  for their employees.
  
• Group term life insurance premiums that are paid
  by the employer are tax exempt to the employee
  for the first 50,000 of face amount of
  insurance.
• The premium per 1,000 must appear on the
  employees W-2 for any amount of coverage greater
  than 50,000.
  
• To qualify for the tax treatment, a group plan
  must be nondiscriminatory
  
• The plan must cover 70 or more of all employees
  and
  
• Must cover at least 85 of the employees that are
  NOT key employees.

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Group Life and Health Insurance as Employee
Benefits (cont)

• The premiums paid by the employer for health
  insurance are tax exempt to the employee and they
  are deductible business expense for the
  employer.
• If the employer provides ordinary life coverage
  and pays the entire premium, the employee is
  taxed on any non-term portion of the premium.
  
• This portion is deductible by the employer as
  wages.
  
• Group paid up life insurance is paid by employee
  contributions.
  
• Group universal life does NOT provide any tax
  advantage to the employer and the premiums are
  usually paid by the employee.

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Specialized Uses of Life Insurance in Business

• Business continuation insurance is designed to
  provide the funding for the other parties in a
  business to continue operation in the event of
  death of a key employee by purchasing the
  interest of the decedent
• Premiums are paid by the partners, partnership,
  stockholders, or corporation who would receive
  the benefits.
  
• Premiums are not tax deductible.
• Under an entity plan, the firm is the owner and
  beneficiary of the policy, but the premiums paid
  are not tax deductible.

65
Specialized Uses of Life Insurance in Business
(cont)

• Key person insurance covers employees who are
  considered critical to the success of the
  business and whose death might cause financial
  loss to the company.
• The company has an insurable interest in the
  person.
  
• Therefore, the company pays the premiums and is
  the beneficiary.
  
• Premiums are NOT deductible.

66
Specialized Uses of Life Insurance in Business
(cont)

• Split-dollar insurance is a plan where an
  employer and employee share the cost of a life
  policy on the employee (usually permanent
  insurance such as whole life or variable
  universal).
• The employer pays the portion of premium equal to
  the increase in the cash value and is owner of
  the policy and beneficiary to the extent of cash
  value.
• The employees spouse or other person designated
  by the employee is the beneficiary of the death
  proceeds in excess of the employers premium.

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Specialized Uses of Life Insurance in Business
(cont)

• Deferred Compensation is an arrangement between
  the employer and the employee where the employer
  will make payments to an employee after
  retirement or the employees spouse if the
  employee should die prior to retiring.
• It provides the benefit of shifting the income to
  the employee to a period when the tax burden is
  not as heavy (i.e., retirement).
  
• Some employers fund deferred compensation through
  a permanent life insurance policy on the
  employee.
  
• Premiums for this type of insurance are not
  deductible by the employer, but amounts paid to
  the employee or to the employees dependent are
  deductible by the employer when paid.

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Business Uses of Disability Income Insurance

• Disability overhead insurance is designed to
  cover the expenses that are usual and necessary
  expenses in the operation of a business should
  the owner become disabled.
• Premiums are deductible as a business expense.
• Benefits are taxable income to the entity.
• Disability Buyout Policies are policies that
  cover the value of the individuals interest in
  the business should they become disabled.

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Cafeteria Plans

• A cafeteria plan is a plan in which employees
  may, within limits, choose the form of employee
  benefits from a selection of benefits provided by
  their employer.
• Cafeteria plans must include a cash option.
• A cash option is an option to receive cash in
  lieu of non-cash benefits of equal value.

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Cafeteria Plans (Application)

• A cafeteria plan is appropriate when the employee
  benefit needs vary within the employee group
  
• Appropriate when the employee mix includes young,
  unmarried people with minimal life insurance and
  medical benefits needs, as well as older
  employees with families who need maximum medical
  and life insurance benefits.
• Appropriate when employees want to choose the
  benefit package most suited to their individual
  needs.
  
• Appropriate when an employer seeks to maximize
  employee satisfaction with the benefit package
  thereby maximizing the employers benefit from
  its compensation expenditures.
• Appropriate when the employer is large enough to
  afford the expense of such a plan.
  
• A cafeteria plan is a way of managing fringe
  benefit costs to the employer by individually
  pricing each benefit and providing a total dollar
  equivalency to each employee to effectively shop
  for the best mix of benefits for that person.

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Cafeteria Plan Advantages

• Help give employees an appreciation of the value
  of their fringe benefit package.
  
• The flexibility of a cafeteria benefit package
  helps meet varied employee needs.
  
• Cafeteria plans can help control employer costs
  for the benefit package because the cost of
  provisions for benefits that employees do not
  need is minimized.

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Cafeteria Plan Disadvantages

• Cafeteria plans are more complex and expensive to
  design and administer.
  
• Benefit packages usually include some insured
  benefits.
  
• Medical and life insurance benefits are usually
  included.
  
• Complex tax requirements apply to the plan under
  Section 125 of the Internal Revenue Code.
  
• Highly compensated employees may lose the tax
  benefits of the plan if it is discriminatory.

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Cafeteria Plan Tax Implications

• A cafeteria plan must comply with the provisions
  of IRC Section 125 that provides an exception for
  cafeteria plans from the constructive receipt
  doctrine.
• If the terms of Section 125 are NOT met in a
  cafeteria plan, an employee is taxed on the value
  of any taxable benefits available from the plan,
  even if the participant chooses nontaxable
  benefits such as medical insurance.

74
Cafeteria Plan Tax Implications (cont)

• Limitations on nontaxable benefits to key
  employees.
  
• The nontaxable benefits provided to key employees
  must NOT be greater than 25 of the total
  nontaxable benefits provided under the plan to
  all employees.
• See Top Heavy for definition of key employee.

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Cafeteria Plan Tax Implications (cont)

• Under Section 125 and its regulations, only
  certain qualified benefits can be made available
  in the cafeteria plan.
  
• Qualifying benefits include cash and most
  tax-free benefits provided under the code,
  except
  
• Scholarships and fellowships.
• Educational assistance.
• Employee discountsno additional cost services
  and other fringe benefits provided under Code
  Section 132.
  
• Retirement benefits such as qualified or
  nonqualified deferred compensation
  
• However, a 401(k) arrangement can be included.

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Cafeteria Plan Tax Implications (cont)

• A cafeteria plan must meet certain
  nondiscrimination requirements
  
• Participationthe plan must be made available to
  a group of employees in a manner that does NOT
  discriminate in favor of highly compensated
  employees.
• Benefitsthe plan must not discriminate in favor
  of highly compensated employees as to
  contributions and benefits.

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Alternatives to Cafeteria Plans

• The flexible spending account (FSA) is a
  cafeteria plan funded through salary reductions.
  
  
• An FSA is a special type of cafeteria plan that
  should be considered whenever cafeteria benefits
  are reviewed.
  
• FSAs are discussed in detail in the next
  section.
  
• Fixed benefit programs without employee choice
  may be adequate where most employees have the
  same benefit needs or where the employer cannot
  administer a more complex program.
• Cash compensation, as an alternative to benefits,
  forfeits tax advantages in favor of maximum
  employee choice, and assumes that employees will
  have adequate income to provide benefits on their
  own.