Chapter 15

Compensation and
Retirement Planning

McGraw-Hill Education Copyright © 2016 by McGraw-Hill Education. All rights reserved.

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Objectives

• Differentiate between employees and

independent contractors
• Summarize the tax consequences of wage and
salary payments to employees and employers
• Identify the most common nontaxable employee
fringe benefits
• Describe the tax and financial accounting
consequences of stock options
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Objectives (continued)

• Discuss the deductibility of employment-related

expenses
• Explain the tax advantages of qualified over
nonqualified retirement plans
• Contrast defined-benefit, defined-contribution,
and nonqualified deferred compensation plans
• Describe the tax benefits offered by IRAs and
Roth IRAs
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Employee versus Contractor

• Employee is an individual
• Whose duties are controlled (as to
how, when, and where) by an
employer
• Who works according to a regular
schedule in return for a wage or salary
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Employee versus Contractor

• Independent contractor is a self-employed

individual
• Who performs services for a fee
• Who controls the way the services are performed
• Whose work relationship with
client is temporary
• Who can have many clients
at the same time
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Employee versus Contractor

• Employees
• Employer withholds income and payroll taxes
from salary or wage payments
• Independent contractors
• Clients don’t withhold tax from fee payments
• Contractor reports fees as Schedule C business income
• Contractor pays income and self-employment tax directly
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Employee versus Contractor

• Self-employed individuals have relatively low level

of compliance because they fail to file or they
understate income
• How is worker classification decided?
• Based on facts and circumstances including:
• Degree of supervision
• Materials provided
• Person versus job
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Compensation payments

• Employers treat compensation payments as either:

• Deductible ordinary and necessary business expenses
• Capitalized costs
• Compensation is ordinary income to recipient
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Employee Fringe Benefits

• General rule: fringe benefits are taxable

• Nontaxable fringe benefits include:
• Health and accident insurance
• $50,000 group-term life insurance
• Dependent care assistance
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Employee Stock Options

• Stock option is the right to buy stock in the future for

a set price (option price or strike price) for limited
period of time
• Option price usually is less than or equal to market price
of the stock on date the option is granted
• Stock options are a form of compensation that
requires no cash outlay by corporate employer
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Stock Options - Grant Date

• Under GAAP, firms must record compensation

expense equal to FMV of option at grant date
• Tax rules:
• No deduction to employer when option is granted
• No income to employee on receipt of option
• Tax consequences when employee exercises an
option depends on whether the option is a:
• Nonqualified stock option (NSO)
• Incentive stock option (ISO)
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Nonqualified Stock Option (NSO)

• Employee has taxable compensation equal to

excess of FMV of stock over exercise price
• Taxable excess is referred to as the bargain element
• Employee’s basis in stock is FMV at exercise date
• Employer is allowed a deduction in the year of
exercise equal to employee’s taxable compensation
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Incentive Stock Option (ISO)

• No compensation income to employee on

exercise of ISO
• Employee’s basis in stock is cost
• Untaxed bargain element is AMT preference item
• No employer deduction for bargain element
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Wallace Corporation needs an additional worker on a multiyear project. It could hire an

employee for a $30,000 annual salary. Alternatively, it could engage an independent
contractor for a $35,000 annual fee. Which of the following is true?

A. Wallace must withhold payroll tax from the salary or the fee.

B. Wallace must withhold federal and state income tax from the salary or the fee.

C. Wallace must issue a Form W-2 to the employee or the independent contractor.

D. None of the above is true.

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Which of the following statements regarding employee versus independent contractor

status is false?

A. The determination as to whether a worker is an employee or an independent

contractor is based on a subjective set of guidelines.

B. An employer has a financial incentive to classify a worker as an independent

contractor instead of an employee.

C. The IRS has a higher probability of collecting income and payroll taxes from an
independent contractor than from an employee.

D. If the IRS reclassifies a worker from independent contractor to employee, the

employer can become liable for the employee's share of unpaid payroll taxes.
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A sole proprietor in the 39.6% tax bracket pays her 16-year-old son a reasonable
salary of $10,000 for services performed for the proprietorship. Compute the family's
tax savings if the son has no other income, is claimed as a dependent on his parents'
return, and takes a $6,300standard deduction.

A. $3,590

B. $3,960

C. $2,455

D. None of the above.

$3,960 tax savings from deduction ($10,000 * 39.6%) - $370 tax on

child's $3,700 taxable income ($10,000 - $6,300).
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Which of the following statements regarding the foreign earned income exclusion is
false?

A. Expatriates may not claim a foreign tax credit for foreign tax paid on
excluded income.

B. The exclusion is limited to an inflation-adjusted annual dollar amount.

C. The exclusion is available to any U.S. citizen employed by a foreign

company.

D. The exclusion is available to any U.S. citizen working and residing in a

foreign country.
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Lansing Corporation, a publicly held company with a 35% marginal tax

rate, paid its CEO an annual salary of $2.3 million. Ignoring payroll taxes,
calculate the after-tax cost of this payment.

A. $2.3 million

B. $1.495 million

C. $1.95 million

D. $0

Because the salary is not performance-based, only $1 million is deductible.

After-tax cost is $1.95 million ($2.3 million - $350,000 tax savings [$1 million *
35%]).
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Lansing Corporation, a publicly held company with a 35% marginal tax rate, paid
its CEO an annual salary of $1 million plus a bonus of $1.3 million. The bonus
was based a targeted amount of annual gross revenue. Ignoring payroll taxes,
calculate the after-tax cost of this payment.

A. $2.3 million

B. $1.495 million

C. $1.95 million

D. $0

Because the bonus is performance-based compensation, it is deductible. After-

tax cost is $1.495 million ($2.3 million * [1-35%]).
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Lawrence is a U.S. citizen who has worked in his employer's Paris office for the
past five years. Compute Lawrence's 2015 AGI if his only item of income was his
$130,000 salary.

A. $130,000

B. $100,800

C. $29,200

D. $0

$130,000 - $100,800 foreign earned income exclusion.

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