SMChap012

Chapter 12 - Compensation

Chapter 12 Compensation SOLUTIONS MANUAL Discussion Questions: 1.

[LO 1] {Planning}Shane is an employee who has had a relatively consistent income over the years. His withholding is pretty much right on target with his actual tax liability, so he rarely has much of a tax refund or tax due with his tax return. At the beginning of this year, Shane sold some property at a large gain. What issues relating to withholding should Shane consider? What would you advise him to do? The primary issue for Shane is deciding how to pay the taxes that he will owe due to the gain on the property. It appears that his current withholding will not be enough to cover the tax liability. Shane has several options with respect to withholding. First, he could immediately complete a new Form W4 to decrease the number of withholding allowances in order to increase the amount of taxes withheld from each paycheck so that by the end of the year he will have enough tax withheld. Instead of decreasing allowances, he could simply specify an additional amount to be withheld from each paycheck so that the tax liability is covered by the end of the year. Second, because tax withholding is generally treated as though it is made evenly throughout the year, he could wait until his last few paychecks and have enough extra tax withheld to cover the liability. This approach has the advantage of providing Shane with an interest-free loan from the government until he pays the taxes. But, it may mean that Shane won’t have much cash flow for the last few paychecks of the year. Finally, he could make an estimated tax payment, or he could wait and pay the tax with the return. He may end up paying interest and penalties if he waits to pay tax with the return.

2.

[LO 1] {Planning} Juanita recently started employment for Maple Corporation. For tax purposes, Juanita files as a head-of-household filing status with three dependents. Juanita needs to determine the number of “withholding exemptions” to claim on her W-4 form. Should she claim four withholding exemptions or should she claim more? What factors should she consider in making this determination? When she files her tax return, Juanita will be able to claim one personal exemption and three dependency exemptions. These exemptions will reduce her taxable income and correspondingly reduce her tax liability. So, when Juanita completes her W-4 form, should she claim four withholding exemptions? In general, the withholding tables are designed so that taxpayers will have withholding taxes fairly close to the amount of their

12-1 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


actual tax liability when they claim the same number of withholding allowances as the number of personal and dependency exemptions they are claiming on their tax return. However, this is only a general rule. In certain circumstances, the taxpayer may need to adjust her withholding exemptions in order to have the proper amount of taxes withheld. For example, the withholding tables anticipate that the taxpayer will use the standard deduction and will not itemize deductions. So, if the taxpayer is itemizing deductions, the taxpayer may need to claim more withholding exemptions than personal and dependency exemptions to ensure that she doesn’t have more taxes than necessary withheld. Also the tables assume that the taxpayer’s salary is her only source of income. Consequently, taxpayers with an income earning (employed or self-employed) spouse may need to adjust their exemptions to account for this. Further, because taxpayers with high incomes may be subject to the alternative minimum tax or may have certain tax benefits phased-out, taxpayers with high incomes may need to report a different number of withholding exemptions than personal exemptions. Finally, because the tables don’t anticipate that the taxpayer will have deductible losses, taxpayers with deductible losses (e.g., capital losses, flow through losses from owned entities, and rental losses), may need to increase their withholding exemptions above the number of personal and dependency exemptions. Juanita may have these and other reasons why she should claim more or less withholding exemptions than the number of personal and dependency exemptions she will be claiming on her tax return. She will need to project her income and tax liability for the year in order to determine the appropriate amount of withholding tax to be withheld and the corresponding number of withholding exemptions to claim. 3.

[LO 1] Nicole and Braxton are each 50 percent shareholders of NB Corporation. Nicole is also an employee of the corporation. NB is a calendar-year taxpayer and uses the accrual method of accounting. The corporation pays its employees monthly on the first day of the month after the salary is earned by the employees. What issues must NB consider with respect to the deductibility of the wages it pays to Nicole if Nicole is Braxton’s sister? What issues arise if Nicole and Braxton are unrelated? If Nicole and Braxton are sister and brother, according to §267(b) of the Internal Revenue Code Nicole and NB Corporation are considered to be “related parties.” Nicole is treated as owning her 50 percent and her brother’s 50 percent for a total of 100 percent ownership. Because NB and Nicole are related, NB is not allowed to deduct the salary expense it accrued for book purposes on the salary it owes to Nicole until the year in which Nicole recognizes income. This does not cause any issues until the last paycheck of the year. For book purposes, NB accrues and deducts Nicole’s



December salary but for tax purposes, NB is not able to deduct the salary until January 1 when Nicole receives her check. If Nicole and Braxton are unrelated, Nicole would own 50 percent of NB, and she would not be considered a related party to NB because she does not own more than 50 percent of NB. NB is allowed to deduct the compensation earned by Nicole in December of the prior year as long as it pays the compensation within 2 ½ months of year end (by March 15). In this case, NB pays the compensation at the beginning of January, so it would be allowed to deduct the compensation expense it accrued in December for Nicole. 4.

[LO 1] Holding all else equal, does an employer with a higher marginal tax rate or lower marginal tax rate have a lower after-tax cost of paying a particular employee’s salary? Explain. Holding all else equal (including the amount of the employee’s salary) an employer with a higher marginal tax rate will have a lower after-tax cost of paying an employee’s salary. The reason is that the employer’s after-tax cost of the salary is the before tax cost minus the tax savings from deducting the employee’s salary. The tax savings from a deduction are greater with the higher the marginal tax rate. Because the high marginal tax rate employer has greater tax savings from deducting the employee’s salary, the high marginal tax rate employer has a lower after-tax cost of paying the employee’s salary.

5.

[LO 1] What are nontax reasons why a corporation may choose to cap its executives’ salaries at $1 million? A corporation may choose to cap its executives’ salaries at $1 million, even if it is not concerned about the loss of the tax deduction, to send a signal to shareholders. Not exceeding the limit signals to the shareholders that the corporation is being fiscally responsible by (1) not overpaying executives, and (2) ensuring that all compensation paid to executives is tax deductible. Again, the focus here is the signal this policy sends to the shareholders and not the actual tax benefits derived by capping salaries at $1 million.

6.

[LO 1] What are tax reasons why a corporation may choose to cap its executives’ salaries at $1 million? Corporations may cap their executives’ salaries at $1 million to ensure that the company is able to deduct the compensation expense for the full amount of the (nonperformance based) salary. This is important because the government effectively subsidizes the (non-performance based) salary up to $1 million dollars. This means for a corporation in a 35 percent marginal tax bracket, the government would effectively be paying $350,000 of the first $1 million in salary.



However, for salary above $1 million, if the executive is the CEO or one of the other four highest compensated officers, the government does not allow a tax deduction. Consequently, the government does not subsidize this excess salary which makes the salary above $1 million more expensive to provide, on an after-tax basis, than salary up to $1 million. 7.

[LO 1] Lea is a highly paid executive with MCC, Inc., a publicly traded corporation. What are the circumstances under which MCC will be able to deduct more than $1 million of compensation paid to Lea during the year? This question deals with the §162(m) limitation on salary deductibility and its exceptions. First, the §162(m) limitation applies to the CEO and the four other most highly compensated officers. If Lea does not fit this description, MCC would be able to deduct the full salary paid to Lea even if it exceeds $1 million. Second, §162(m) provides exceptions to the general rule limiting the deductibility of compensation paid to the CEO and the other four most highly compensated officers. The $1 million deduction limitation does not apply to compensation that is (1) based on the company’s performance, (2) commission based, (3) in the form of a contribution to a qualified retirement plan, and (4) compensation provided in the form of tax free benefits.

8.

[LO 2] From an employee perspective, how are incentive stock options treated differently than nonqualified stock options for tax purposes? In general, for a given number of options, which type of stock option should employees prefer? Unlike nonqualified stock options, the bargain element of incentive stock options is not included in the employee’s regular taxable income on the exercise date. Instead, the bargain element present on the exercise date is deferred until the stock acquired from the option exercise is sold. Further, with incentive stock options, the bargain element is treated as long-term capital gain rather than ordinary income when the stock is sold. For these reasons, employees generally prefer incentive stock options over an equivalent number of nonqualified options.

9.

[LO 2] From an employer perspective, how are incentive stock options treated differently than nonqualified stock options for tax purposes? In general, for a given number of options, which type of stock option should employers prefer? In contrast to nonqualified options, employers never receive a deduction related for incentive stock options. Thus, employers generally prefer (unless the employer’s marginal rate is 0 percent) nonqualified options over an equivalent number of incentive stock options.



10.

[LO 2] Why do employers use stock options in addition to salary to compensate their employees? For employers, are stock options treated more favorably than salary for tax purposes? Explain. Because stock options reward employees for making choices that increase the share price of the corporations where they are employed, this form of compensation is considered to be superior to salary in terms of motivating employees to behave more like owners—stock options align the incentives of employees and owners. In addition, employers may use stock options to compensate their employees without a cash outlay. Employers also use stock options to circumvent the $1 million §162(m) deduction limitation on non-performance based salary payments to key executives because options are considered to be a form of performance-based pay. Other than this advantage, there is no other tax advantage to using options over regular salary to compensate employees, because, at best, the bargain element from options exercises provides an ordinary deduction for employers in the year of exercise.

11.

[LO 2] What is a “disqualifying disposition” of incentive stock options, and how does it affect employees who have exercised incentive stock options? In order to receive the favorable tax treatment afforded incentive stock options, employees acquiring shares by exercising ISO’s must hold the shares for at least 2 years after the grant date and 1 year after the exercise date. Shares acquired with ISOs and sold prior to meeting these holding period requirements trigger a “disqualifying disposition.” Because disqualifying dispositions cause incentive stock options to be treated as nonqualified options for tax purposes, the bargain element is taxed at the time of sale at ordinary rates.

12.

[LO 2] Compare and contrast how employers record book and tax expense for stock options. Under ASC 718, employers expense the economic value of option grants (determined on the grant date) ratably over the vesting period for book purposes for both incentive and nonqualified stock options. For tax purposes, employers expense the bargain element when nonqualified options are exercised. However, employers never receive a tax deduction for incentive stock options.



13.

[LO 2] How is the tax treatment of restricted stock different from that of nonqualified options? How is it similar? Employees with nonqualified options are taxed at ordinary rates on the bargain element of the shares received on the date of exercise. In contrast, employees receiving restricted stock are taxed at ordinary rates on the fair market value of the shares on the date the restricted stock vests. The tax treatment of the two is similar in that both are taxed at ordinary rates.

14.

[LO 2] Matt just started work with Boom Zoom, Inc., a manufacturer of credit card size devices for storing and playing back music. Due to the popularity of their devices, analysts expect Boom Zoom’s stock price to increase dramatically. In addition to his salary, Matt received Boom Zoom restricted stock. How will Matt’s restricted stock be treated for tax purposes? Should Matt consider making the section 83(b) election? What are the factors he should consider in making this decision? From a tax perspective, would this election help or hurt Boom Zoom? If Matt doesn’t make the §83(b) election, the fair market value of the stock on the vesting date will be included in Matt’s salary income in the year the stock vests. Boom Zoom, Inc. will take a corresponding ordinary deduction in the same year Matt includes the value of the stock in his salary. If Matt makes an §83(b) election, he will include the fair market value of the stock on the grant date in his salary income in the year of grant and Boom Zoom will take a deduction of the same amount as compensation expense in the year of grant. Matt should consider making this election to accelerate income if the current stock price of Boom Zoom is small relative to his expectation of the future share price of Boom Zoom. Under these conditions, the current tax Matt pays now will pale in comparison to the tax savings generated by converting the appreciation in share price from the grant date to the vesting date into capital gain. However, an §83(b) election under these conditions would be detrimental to Boom Zoom because its salary deduction, although accelerated, will be much smaller at the same before-tax cost.



15.

[LO 2] What risks do employees making an §83(b) election on a restricted stock grant assume? If, after making an §83(b) election, the market value of the restricted shares stays flat (or declines), employees will have accelerated a tax payment without receiving the benefit of converting what would otherwise have been ordinary income into capital gain. Moreover, if the restricted stock doesn’t become vested subsequent to the §83(b) election, employees will have reported income that they did not actually receive (phantom income).

16.

[LO 3] Explain the differences and similarities between a fringe benefit as a form of compensation and salary. A fringe benefit is a non-cash form of compensation. In contrast, salary is cash compensation. They are similar in that both fringe benefits and salary are forms of compensation provided to an employee by an employer. Salary and taxable fringe benefits are taxable; while non-taxable fringe benefits are not taxable.

17.

[LO 3] When an employer provides group-term life for an employee, what are the tax consequences to the employee? What are the tax consequences for the employer? The premiums paid for group-term life insurance coverage of up to $50,000 by an employer on behalf of an employee is excluded from an employee’s income. When an employee receives more than $50,000 of coverage, the taxpayer must recognize taxable income based on a formula determined by the regulations. A table requires a specified amount of income (which varies according to age) per $1,000 of life insurance coverage exceeding the threshold. The required income is likely to differ from the amount paid for the insurance by the employer. The cost of group-term life premiums is always deductible by the employer.

18.

[LO 3] Compare and contrast the employer’s tax consequences of providing taxable and nontaxable fringe benefits. From an employer perspective, both non-taxable and taxable fringe benefits are both deductible as an ordinary, necessary, and reasonable compensation expense. The advantage of non-taxable fringe benefits to an employer is that employees may be willing to accept less cash compensation than it costs to provide the non-taxable fringe



benefit. This lowers the actual cost of compensating employees which is possible through an indirect government subsidy. 19.

[LO 3] Mike is working his way through college and trying to make ends meet. Tara, a friend, is graduating soon and tells Mike about a really great job opportunity. She is the onsite manager for an apartment complex catering to students. The job entails working in the office for about 10 hours a week, collecting rent each month, and answering after-hours emergency calls. The pay is $10 per hour, plus a rent-free apartment (worth about $500 per month). Tara then tells him the best part: the rent-free apartment is tax-free as well. Knowing that you are a tax student, Mike asks you if the rent-free apartment is really tax free or if this is just another scam. Explain to Mike whether the compensation for the apartment is really a nontaxable fringe benefit. The value of an apartment or lodging to an employee may be excluded from taxable income if the benefit is provided for the convenience of the employer and is required as a condition of employment. Since Mike is required to live on the premises in order to be an “onsite” manager, and he does so to provide services to the other tenants he may exclude the value of the apartment from his income as a nontaxable fringe benefit under §132.

20.

[LO 3] Assume that a friend has accepted a position working as an accountant for a large automaker. As a signing bonus, the employer provides the traditional cash incentive but also provides the employee with a vehicle not to exceed a retail price of $25,000. Explain to your friend whether the value of the vehicle is included, excluded, or partially included in the employee’s taxable income. An employer can provide a qualified employee discount from an employee’s taxable income because it is a nontaxable fringe benefit. A qualified employee discount is a discount not to exceed the cost of the good to the employer. As a result, the vehicle bonus is partially taxable. The taxable portion would be the amount of the discount below the actual cost to manufacture the vehicle. The remaining value of the vehicle may be received as a nontaxable fringe benefit.

21.

[LO 3] Explain why an employee might accept a lower salary to receive a nontaxable fringe benefit. Why might an employee not accept a lower salary to receive a nontaxable fringe benefit? Employees prefer nontaxable benefits over an equivalent amount of salary or taxable benefits assuming that they need the benefits (e.g., health insurance) offered by the employer. This is because the government subsidizes the cost of qualified fringe benefits by allowing employees to receive them tax free. Therefore, the after-tax costs of receiving lower salary and fringe benefits (non-qualified) are usually higher than receiving only salary and purchasing the needed benefits with after-tax dollars. An employee might be unwilling to accept a lower salary to receive a nontaxable benefit when the employee either doesn’t value the benefit or values the benefit less than the amount of the reduced salary. 12-8

© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


22.

[LO 3] Describe a cafeteria plan and discuss why an employer would provide a cafeteria plan for its employees. A cafeteria plan is a set of fringe benefits an employer offers to employees while allowing employees to choose which benefits they prefer from the cafeteria “menu.” The simplest plans involve merely a choice between cash and a single nontaxable benefit; while others offer a large number of benefits. The benefits potentially available under a cafeteria plan are limited to cash and certain statutory benefits such as medical, disability and other accident or health plans, group-term life insurance, dependent care assistance, adoption assistance program, and §401(k) plan contributions. Employers provide cafeteria plans to employees because different employees may have different needs. With cafeteria plans, the employer provides employees with benefits of equal value but allow each employee to choose the specific benefits they desire. If the employee doesn’t want any of the fringe benefits, the employee can take cash instead. This ensures that employees will receive equal value and does not benefit one class of employees over another. For example, if an employer simply offers health insurance, employees with dependents will receive more benefits than employees without dependents. Using a cafeteria plan, an employer can provide all employees with an amount equal to health insurance for a family. Employees with dependents can take the health insurance; single employees can choose the less expensive single health insurance and receive cash or another benefit with the difference.

23.

[LO 3] Explain why Congress allows employees to receive certain fringe benefits tax-free but others are taxable? Congress allows employees to receive certain benefits (e.g. health insurance) tax free as a subsidy to encourage them. Many of these benefits are considered to be in the public’s interest. For example, if employees have health insurance they are less likely to fall under Medicaid. In addition, employers are allowed a deduction. Together these incentives should decrease the cost of health insurance and result in increased coverage. However, benefits that are considered luxuries (e.g., country club memberships) are generally taxed as compensation. If all fringe benefits were nontaxable, Congress would have to increase rates or broaden the base in order to pay for the subsidy. Further employers and employees might get very creative in their compensation arrangements such that most of what employees receive would be in fringe benefit form.

24.

[LO 3] Explain the policy reason for including the value of country club memberships provided to an executive as a taxable fringe benefit. Anytime Congress provides a tax benefit (through a nontaxable fringe benefit) they must either raise taxes, decrease spending, or increase debt. Since a country club membership creates little or no public benefit, it is likely unwise to raise taxes, cut other programs, or increase debt to provide a subsidy for executive perquisites or fringe



benefits. Companies like Google are famous for supplying benefits such as first-class dining facilities, gyms, laundry rooms, massage rooms, haircuts, carwashes, and dry cleaning however, the value of these benefits is taxable to its employees 25.

[LO 3] Describe the circumstances in which an employee may not value a nontaxable fringe benefit. If a nontaxable benefit is either duplicated or unwanted, an employee generally will not place value on the benefit. For example, if a married taxpayer’s spouse receives an incredible health insurance package then the employee probably doesn’t value an incremental health insurance plan. If an employee lives within walking distance to work they probably would not take advantage of a qualified transportation fringe benefit (e.g., employer provided parking). In these cases, the employee would likely prefer a cafeteria plan that allows them to choose an alternative nontaxable fringe benefit or the ability to choose cash (taxable) instead.

Problems 26. [LO 1] {Research} Anna is single with one four-year-old child and will file Head of Household. She earns a monthly salary in 2013 of $5,000. a. If she claims two withholding allowances, how much will her employer withhold from her monthly paycheck? (Hint: Go to www.irs.gov and search for withholding tables.) b. If she claims four withholding allowances, how much will her employer withhold from her monthly paycheck? c. Assuming that she has no other income, claims the standard deduction, and claims one personal and one dependency deduction, what is Anna’s tax liability for the year? How many withholding allowances should she claim to equalize (approximately) her withholding and her tax liability? a)

b)

c)

Publication 15 (see IRS.gov) has withholding tables for taxpayers using the wage bracket method to compute their withholding. The table on page59 indicates that a single taxpayer, like Anna, claiming 2 withholding allowances and receiving salary of between $5,000, and $5,040 per month, will have $707 withheld each month. Publication 15 (see IRS.gov) has withholding tables for taxpayers using the wage bracket method to compute their withholding. The table on page 51 indicates that a single taxpayer, like Anna, claiming 4 allowances and receiving salary between $5,000, and $5,040 per month, will have $545 withheld each month. Anna’s filing status will be Head of Household. Using the 2013 Tax Rate Schedule (not the Tax Table). AGI Standard Deduction Personal Exemption

$60,000 $8,950 $7,800 12-10



s Taxable Income Tax

$43,250 $5,850

Anna’s tax is $5,850 which is $4,575 [($43,250- $12,750) × 15%] + $1,275. On a monthly basis, Anna should have $488 withheld ($5,850/ 12). Using the table, if Anna claims 4 withholding allowances her monthly withholding would be $545. Alternatively, if Anna claims 5 allowances her monthly withholding would be $464. If Anna claims 4 allowances, she will be over withheld. If she claims 5 allowances she will be under withheld. 27. [LO 1] North Inc. is a calendar-year, accrual-basis taxpayer. At the end of the year 1, North accrued and deducted the following bonuses for certain employees for financial accounting purposes.  $7,500 for Lisa Tanaka, a 30 percent shareholder.  $10,000 for Jared Zabaski, a 35 percent shareholder.  $12,500 for Helen Talanian, a 20 percent shareholder.  $5,000 for Steve Nielson, a 0 percent shareholder. Unless stated otherwise, assume these shareholders are unrelated. How much of the accrued bonuses can North Inc. deduct in year 1 under the following alternative scenarios? a. North paid the bonuses to the employees on March 1 of year 2. b. North paid the bonuses to the employees on April 1 of year 2. c. North paid the bonuses to employees on March 1 of year 2 and Lisa and Jared are related to each other, so they are treated as owning each other’s stock in North. d. North paid the bonuses to employees on March 1 of year 2 and Lisa and Helen are related to each other, so they are treated as owning each other’s stock in North. a. North may deduct $35,000 in year 1 because they were paid within 2 ½ months of year end. Employee Deductible Year 1 Deductible Year 2 Lisa Tanaka $7,500 Jared Zabaski $10,000 Helen Talanian $12,500 Steve Nielson $5,000 $35,000 12-11 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


b. North may not deduct any of the bonus in year 1 because the bonuses were not paid within 2 ½ months of year end. It may deduct the $35,000 of bonuses in year 2. Employee Deductible Year 1 Deductible Year 2 Lisa Tanaka $7,500 Jared Zabaski $10,000 Helen Talanian $12,500 Steve Nielson $5,000 $35,000 c. North may deduct $17,500 in both year 1 and year 2. Helen and Steve’s bonuses are deductible in year 1 because they were paid within 2 ½ months of year end. Lisa and Jared’s bonuses are deductible in year 2 which is the year they take the bonuses into income—since they are related parties (own greater than 50 percent). Employee Deductible Year 1 Deductible Year 2 Lisa Tanaka $7,500 Jared Zabaski $10,000 Helen Talanian $12,500 Steve Nielson $5,000 $17,500 $17,500 d. North may deduct $35,000 in year 1. All of the shareholders’ bonuses are deductible in year 1 because they were paid within 2 ½ months of year end. Helen and Lisa are not considered to be related parties because together they own 50 percent but not more than 50 percent of North. Employee Deductible Year 1 Deductible Year 2 Lisa Tanaka $7,500 Jared Zabaski $10,000 Helen Talanian $12,500 Steve Nielson $5,000 $35,000 28. [LO1] {Research}Jorgensen High Tech Inc. is a calendar-year, accrual-method taxpayer. At the end of year 1, Jorgensen accrued and deducted the following bonuses for certain employees for financial accounting purposes. • $40,000 for Ken. • $30,000 for Jayne. • $20,000 for Jill. • $10,000 for Justin. How much of the accrued bonuses can Jorgensen deduct in year 1 under the following alternative scenarios? a. Jorgensen paid the bonuses to the employees on March 1 of year 2. b. Jorgensen paid the bonuses to the employees on April 1 of year 2.



c. Jorgensen paid the bonuses to the employees on March 1 of year 2, and there is a requirement that the employee remain employed with Jorgensen on the payment date to receive the bonus. d. Jorgensen paid the bonuses to employees on March 1 of year 2, and there is a requirement that the employee remain employed with Jorgensen on the payment date to receive the bonus, if not the forfeited bonus is re-allocated to the other employees. a. Jorgensen may deduct $100,000 in year 1 because they were paid within 2 ½ months of year end. Employee Deductible Year 1 Deductible Year 2 Ken $40,000 Jayne $30,000 Jill $20,000 Justin $10,000 $100,000 b. Jorgensen may deduct $100,000 in year 2 because they weren’t paid within 2 ½ months of year end. Employee Deductible Year 1 Deductible Year 2 Ken $40,000 Jayne $30,000 Jill $20,000 Justin $10,000 $100,000 c. Jorgensen may deduct $100,000 in year 2 because they weren’t fixed at the end of year 1, see Reg. 1.461-1(a)(2)(i). The amounts were not considered fixed, because employees are eligible to receive the bonus only if they are employed on the date the bonuses were paid. This was the holding of the Tax Court in Bennett Paper Corp (1982) 78 TC 458. Employee Ken Jayne Jill Justin

Deductible Year 1

Deductible Year 2 $40,000 $30,000 $20,000 $10,000 $100,000

d. Jorgensen may deduct $100,000 in year 1 because they were paid within 2 ½ months of year end and the amounts to be paid by Jorgensen were fixed—see Reg. 1.461-1(a)(2)(i). The amounts would be considered to be fixed at the end of the year, because if an employee leaves before the bonus is paid, the forfeited amount is



reallocated to the other eligible employees. Thus the amount paid by Jorgensen if fixed—even if the specific recipient hasn’t been determined yet.

29. [LO 1] Lynette is the CEO of publicly traded TTT Corporation and earns a salary of $200,000 in 2013. Assume TTT has a 35 percent marginal tax rate. What is TTT Corporation’s after-tax cost of paying Lynette’s salary excluding FICA taxes? TTT’s after-tax cost is $130,000, calculated as follows: Description Amount Explanation Before tax cost of salary: (1) Salary $200,000 (2) (1 – marginal tax rate) × 65% (1 – 35%) After tax cost of salary $130,000 (1) × (2) 30. [LO 1] Marcus is the CEO of publicly traded ABC Corporation and earns a salary of $1,500,000. Assume ABC has a 35 percent marginal tax rate. a. What is ABC’s after-tax cost of paying Marcus’s salary? b. Now assume that Marcus, in addition to the $1.5 million salary, earns a performance-based bonus of $500,000. What is ABC’s after-tax cost of paying Marcus’s salary?

a. ABC’s after-tax cost is $1,150,000, calculated as follows: Description Amount Explanation Before tax cost of salary: (1) Salary $1,500,000 Taxes: (2) Deductible portion $1,000,000 Maximum deduction (3) Marginal tax rate x 35% Given (4)Tax deduction $350,000 (2) × (3) After tax cost of salary $1,150,000 (1) – (4) b. ABC’s after-tax cost is $1,475,000, calculated as follows: Description Amount Explanation Before tax cost of salary: (1) Salary $1,500,000 (2) Performance-based $500,000 bonus (3) Before tax cost of salary $2,000,000 Taxes: (4) Deductible base salary $1,000,000 Maximum deduction (5)Deductible performance$500,000 12-14 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


based bonus (6) Deductible pay (7) Marginal tax rate (8)Tax deduction After tax cost of salary

$1,500,000 × 35% $525,000 $1,475,000

(4) + (5) (6) × (7) (3) – (8)

31. [LO 1] {Planning} Ramon has finally arrived. He has interviewed for the CEO position with MMM Corporation. They have presented him with two alternative compensation offers. Alternative 1 is for a straight salary of $2,500,000. Option 2 is for a salary of $1,000,000 and performance-based compensation of up to $2,000,000. Assume that Ramon has a marginal tax rate of 40 percent, MMM has a marginal tax rate of 35 percent, and ignore FICA taxes for this problem. Answer the questions under each of the following alternative scenarios. a. If Ramon is 100 percent certain he can meet the qualifications for the full performance-based compensation, which offer should he choose? b. If Ramon believes there is only a 20 percent chance that he can meet the performance-based requirements, which offer should he choose (assume he is risk neutral)? c. What is MMM’s after-tax cost of providing Ramon with Option 1? d. What is MMM’s expected after-tax cost of providing Ramon with Option 2 if it believes there is a 40 percent chance Ramon will qualify for the performancebased compensation?

a)

a. Option 2 has a higher expected value: Option 1: $2,500,000 x (1-.4) = $1,500,000 Option 2: $3,000,000 x (1-.4) = $1,800,000

b)

Option 2 would be better from an expected value standpoint. Option 1: $2,500,000 x (1-.4) = $1,500,000 Option 2: ($1,000,000 x (1-.4)) + ($2,000,000 x (1-.4) x 20%) = $840,000

c) d) 32.

Option 1 would be better from an expected value standpoint. Option 1: ($1,000,000 × (1-.35)) + ($1,500,000 × (1-.0)) = $2,150,000 Option 2: ($1,000,000 × (1-.35)) + ($2,000,000 × (1-.35) x 40%) = $1,170,000 [LO 2] {Tax Forms}Cammie received 100 NQOs (each option provides a right to purchase 10 shares of MNL stock for $10 per share) at the time she started working for MNL Corporation four years ago when MNL’s stock price was $8 per share. Now that



MNL’s stock price is $40 per share, she intends to exercise all of her options. After acquiring the 1,000 MNL shares with her options, she held the shares for over one year and sold them at $60 per share. a. What are Cammie’s tax consequences on the grant date, the exercise date, and the date she sold the shares assuming her ordinary marginal rate is 30 percent and her capital gains rate is 15percent? b. What are MNL Corporation’s tax consequences on grant date, exercise date, and date of sale assuming its marginal tax rate is 35 percent? c. Complete Cammie’s Schedule D for the year of sale. a. Cammie recognizes $30,000 of ordinary income and pays tax of $9,000 in the year of exercise, the calculations are as follows: Description (1) Shares acquired (2) Exercise price (3) Cash needed to exercise (4) Market price (5) Market value of shares (6) Bargain Element (ordinary income) (7) Marginal Tax Rate Tax due in year of exercise

Amount 1,000 $10.00 $10,000 $40 $40,000 $30,000 30% $9,000

Explanation (100 × 10 shares) (1) × (2) (1) × (4) (5) – (3) (6) × (7)

She also recognizes $20,000 of capital gain and pays tax of $3,000 in the year of sale, the calculations are as follows: Description (7) Shares acquired with NQOs (8) Market price at sale (9) Amount Realized (10) Basis (11) Long-term capital gain (12) Marginal Tax Rate Tax due in year of exercise

Amount 1,000 $60.00 $60,000 $40,000 $20,000 15% $3,000

Explanation (1) (7) x (8) (5) (9) - (10) (11) x (12)

b. MNL has no tax consequences on the grant date or sale date. MNL does receive a deduction equal to the $30,000 (line (6) above) bargain element on the date Cammie exercises the options. This will reduce MNL’s tax burden by $10,500. c. See form below:





33. [LO 2] {Planning} Yost received 300 NQOs (each option gives Yost the right to purchase 10 shares of Cutter Corporation stock for $15 per share) at the time he started working for Cutter Corporation three years ago. Cutter’s stock price was $15 per share. Yost exercises all of his options when the share price is $26 per share. Two years after acquiring the shares, he sold them at $47 per share. a. What are Yost’s tax consequences (amount of income/gain recognized and amount of taxes payable) on the grant date, the exercise date, and the date he sells the shares, assuming his ordinary marginal rate is 35 percent and his longterm capital gains rate is 15 percent?



b. What are Cutter Corporation’s tax consequences (amount of deduction and tax savings from deduction) on the grant date, the exercise date, and the date Yost sells the shares assuming its marginal tax rate is 25 percent? c. Assume that Yost is cash poor and needs to perform a same-day sale in order to buy his shares. Due to his belief that the stock price is going to increase significantly, he wants to maintain as many shares as possible. How many shares must he sell in order to cover his purchase price and taxes payable on the exercise? d. Assume that Yost’s options were exercisable at $20 and expired after five years. If the stock only reached $18 dollars during its high point during the five-year period, what are Yost’s tax consequences on the grant date, the exercise date, and the date the shares are sold, assuming his ordinary marginal rate is 35 percent and his long-term capital gains rate is 15 percent? a. Yost has no tax consequences on the grant date. Yost recognizes $33,000 of ordinary income and pays tax of $11,550 in the year of exercise, the calculations are as follows: Description (1) Shares acquired (2) Exercise price (3) Cash needed to exercise (4) Market price (5) Market value of shares (6) Bargain Element (ordinary income) (7) Marginal Tax Rate (8) Tax due in year of exercise

Amount 3,000 $15.00 $45,000 $26 $78,000 $33,000 35% $11,550

Explanation (300 x 10 shares) (1) × (2) (1) × (4) (5) – (3) (6) x (7)

He also recognizes $63,000 of capital gain and pays tax of $9,450 in the year of sale, the calculations are as follows: Description (9) Shares acquired with NQOs (10) Market price at sale (11) Amount Realized (12) Basis (13) Long-term capital gain (14) Marginal Tax Rate Tax due in year of sale

Amount 3,000 $47.00 $141,000 $78,000 $63,000 15% $9,450

Explanation (1) (9) × (10) (5) (11) - (12) (13) × (14)

b. Cutter has no tax consequences on the grant date or sale date. Cutter does receive a deduction equal to the $33,000 (line (6) above) bargain element on the date Yost exercises the options. Cutter’s taxes are reduced by $8,250. 12-19 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


(1) Bargain Element (ordinary income) (2) Marginal Tax Rate (3) Tax benefit in year of exercise

$33,000 25% $8,250

(6) above (1) × (2)

c. Yost must sell 2,175 shares to pay the $56,550 ($45,000 to exercise plus $11,550 of tax) to complete the same day sale, the calculations are as follows: Description (1) Cash needed to exercise (2) Tax due at exercise (3) Cash needed for same-day sale (4) Market price (5) Shares needed to be sold

Amount $45,000 $11,550 $56,550 $26 2,175

Explanation (3) from part a (8) from part a (1) + (2) (3) / (4)

d. Yost would not have exercised the options because the market price never exceeded the strike price. As a result the options would expire unexercised and there will be no tax consequences for either Yost or Cutter. 34.

[LO 2] Haven received 200 NQOs (each option gives him the right to purchase 20 shares of Barlow Corporation stock for $7 per share) at the time he started working for Barlow Corporation three years ago when its stock price was $7 per share. Now that Barlow’s share price is $50 per share, he intends to exercise all of his options. After acquiring the 4,000 Barlow shares with his options, he intends to hold the shares for more than one year and then sell the shares when the price reaches $75 per share. a. What are the tax consequences of these transactions to Haven assuming his ordinary marginal rate is 30 percent and his long-term capital gains rate is 15 percent? b. What are the tax consequences for Barlow Corporation resulting from Haven’s option exercise if Barlow’s marginal tax rate is 35 percent?



a. Haven has no tax consequences on the grant date. Haven has an outflow of $28,000 on the exercise. Haven recognizes $172,000 of ordinary income and pays tax of $51,600 in the year of exercise, the calculations are as follows: Description (1) Shares acquired (2) Strike price (3) Cash needed to exercise (4) Market price (5) Market value of shares (6) Bargain Element (ordinary income) (7) Marginal Tax Rate Tax due in year of exercise

Amount 4,000 $7.00 $28,000 $50 $200,000 $172,000 30% $51,600

Explanation (200 x 20 shares) (1) × (2) (1) × (4) (5) – (3) (6) × (7)

He also recognizes $100,000 of capital gain and pays tax of $15,000 in the year of sale, the calculations are as follows: Description (9) Shares acquired with NQOs (10) Market price at sale (11) Amount Realized (12) Basis (13) Long-term capital gain (14) Marginal Tax Rate Tax due in year of sale

Amount 4,000 $75.00 $300,000 $200,000 $100,000 15% $15,000

Explanation (1) (9) × (10) (5) (11) - (12) (13) × (14)

b. Barlow has no tax consequences on the grant date or sale date. Barlow does receive a deduction equal to the $172,000 (line (6) above) bargain element on the date Haven exercises the options.



(1) Bargain Element (ordinary income) (2) Marginal Tax Rate (3) Tax benefit in year of exercise

35.

$172,000 35% $60,200

(6) above (1) × (2)

[LO 2] Mark received 10 ISOs at the time he started working for Hendricks Corporation five years ago when Hendricks’s price was $5 per share (each option gives him the right to purchase 10 shares of Hendricks Corporation stock for $5 per share). Now that Hendricks’s share price is $35 per share, he intends to exercise all options and hold all of his shares for more than year. Assume that more than a year after exercise, Mark sells the stock for $35 a share. a. What are Mark’s tax consequences on the grant date, the exercise date, and the date he sells the shares assuming his ordinary marginal rate is 30 percent and his long-term capital gains rate is 15 percent? b. What are Hendricks’s tax consequences on these dates assuming its marginal tax rate is 25 percent? a. Mark has no tax consequences on the grant date. Mark has no regular income tax consequences on the exercise date, but recognizes $3,000 for AMT, the calculations are as follows:

Description (1) Shares acquired (2) Exercise price (3) Cash needed to exercise (4) Market price (5) Market value of shares (6) Bargain Element (AMT

Amount 100 $5.00 $500 $35 $3,500 $3,000

Explanation (10 x 10 shares) (1) × (2) (1) × (4) (5) – (3)

preference)* *The bargain element is includable in AMTI, which may cause Mark to pay AMT.



In the year of sale, Mark recognizes $3,000 of long-term capital gain and pays tax of $450, the calculations are as follows: Description (7) Shares acquired with NQOs (8) Market price at sale (9) Amount Realized (10) Basis (11) Long-term capital gain (12) Marginal Tax Rate Tax due in year of sale

Amount 100 $35.00 $3,500 $500 $3,000 15% $450

Explanation (1) (7) × (8) (3) above (9) - (10) (11) × (12)

b. Hendricks has no tax consequences on the grant date, exercise, or sale date because the options are ISOs. 36.

[LO 2] Antonio received 40 ISOs at the time he started working for Zorro Corporation six years ago (each option gives him the right to purchase 20 shares of Zorro stock for $3 per share). Zorro’s share price was $3 per share at the time. Now that Zorro’s share price is $50 per share, he intends to exercise all of his options and immediately sell all the shares he receives from the options exercise. a. What are Antonio’s tax consequences on the grant date, the exercise date, and the date the shares are sold assuming his ordinary marginal rate is 30 percent and his long-term capital gains rate is 15 percent? b. What are Zorro’s tax consequences on these dates assuming its marginal tax rate is 25 percent? c. What are the cash flow effects of these transactions to Antonio assuming his ordinary marginal rate is 25 percent and his long-term capital gains rate is 15 percent? d. What are the cash flow effects to Zorro Corporation resulting from Antonio’s option exercise if Zorro’s marginal tax rate is 35 percent?



a. Antonio has no tax consequences on the grant date. Since Antonio exercises and sells the shares immediately he has a disqualifying disposition of ISOs, so they are treated like NQOs. Antonio recognized $37,600 of ordinary income and pays $11,280 in taxes, the calculations are as follows: Description (1) Shares acquired (2) Exercise price (3) Cash needed to exercise (4) Market price (5) Amount Realized (6) Basis (7) Bargain Element/Ordinary Income (8) Marginal Tax Rate Tax paid in year of sale

Amount 800 $3.00 $2,400 $50 $40,000 $2,400 $37,600 30% $11,280

Explanation (40 x 20 shares) (1) × (2) (1) × (4) (3) above (5) - (6) (7) × (8)

b. Because the options are treated like NQOs, Zorro has a deduction of $37,600 and tax savings of $9,400, calculated as follows: Description (1) Bargain Element (4) Ordinary Marginal Tax Rate Tax benefit when shares vest

Amount $37,600 25% $9,400

Explanation From line 7 above (1) × (2)

c. Antonio has no cash flow consequences on the grant date. Since Antonio exercises and sells the shares immediately he has a net cash inflow of $28,200. The disqualifying disposition of ISOs is treated like NQOs. Antonio recognized $40,000 (see line 5) of cash and he pays $2,400 (see line 3) for the stock and $9,400 (see last line) in taxes, the tax calculations are as follows:



Description (1) Shares acquired (2) Exercise price (3) Cash needed to exercise (4) Market price (5) Amount Realized (6) Basis (7) Bargain Element/Ordinary Income (8) Marginal Tax Rate Tax paid in year of sale

Amount 800 $3.00 $2,400 $50 $40,000 $2,400 $37,600 25% $9,400

Explanation (40 x 20 shares) (1) × (2) (1) × (4) (3) above (5) - (6) (7) × (8)

d. Zorro has positive cash flow of $15,560. Because the options are treated like NQOs, Zorro has tax savings of $13,160, and $2,400 of cash proceeds from Antonio (from line 6 above) calculated as follows: Description (1) Bargain Element (4) Ordinary Marginal Tax Rate Tax benefit when shares vest

Amount $37,600 35% $13,160

Explanation From line 7 above (1) × (2)



37.

[LO 2] {Planning} Harmer Inc. is now a successful company. In the early days (before it became profitable), it issued incentive stock options (ISOs) to its employees. Now Harmer is trying to decide whether to issue nonqualified options (NQOs) or ISOs to its employees. Initially, Harmer would like to give each employee 20 options (each option allows employees to purchase one share of Harmer stock). For purposes of this problem, assume that the options are exercised in three years (three years from now) and that the underlying stock is sold in five years (five years from now). Also assume the following facts:        

The after-tax discount rate for both Harmer, Inc. and its employees is 10 percent. Corporate tax rate is 35 percent. Personal (employee) ordinary income rate is 40 percent. Personal (employee) capital gains rate is 15 percent. Exercise price of the options is $7. Market price of Harmer at date of grant is $5. Market price of Harmer at date of exercise is $25. Market price of Harmer at date of sale is $35.

Answer the following questions: a.

Considering these facts, which type of option plan, nonqualified (NQO) or incentive (ISO), should Harmer Inc. prefer? Explain?

b.

Assuming Harmer issues NQOs, what is Harmer’s tax benefit from the options for each employee in the year each employee exercises the NQOs?

c.

Assuming Harmer issues ISOs, what is the tax benefit to Harmer in the year the ISOs are exercised?

d.

Which type of option plan should Harmer’s employees prefer?

e.

What is the present value of each employee’s after-tax cash flows from year 1 through year 5 if the employees receive ISOs?

f.

What is the present value of each employee’s after-tax cash flows from year 1 through year 5 if the employees receive NQOs?

g.

How many NQOs would Harmer have to grant to keep its employees indifferent between NQOs and 20 ISOs? a. Harmer would prefer to issue NQOs. Profitable companies receive a tax benefit equal to the employee’s bargain element upon exercise. In contrast, Harmer receives no tax benefit if ISOs are used. b. Harmer’s per employee tax benefit upon exercise of the NQOs is $126, calculated as follows:



Description (1) Shares acquired (2) Exercise price (3) Cash needed to exercise (4) Market price (5) Market value of shares (6) Bargain Element (7) Marginal Tax Rate Tax benefit in year of exercise

Amount 20 $7.00 $140 $25 $500 $360 35% $126

Explanation (20 x 1 shares) (1) × (2) (1) × (4) (5) – (3) (6) × (7)

c. Harmer’s per employee tax benefit upon exercise of the ISOs is $0, because employers receive no deduction upon an ISO exercise. d.

Harmer’s employees would prefer ISOs because the bargain element isn’t taxed upon exercise (creating tax deferral) and if held for more than one year after exercise the entire amount is taxed at preferential capital gains rates.

e. The present value of ISOs to each employee is $277.40, calculated as follows: Description (1) Shares acquired (2) Exercise price (3) Cash needed to exercise (4)Present Value Factor (5) Present Value of Cash to Exercise

Amount

Description (6) Shares acquired (7) Market Price at Sale (8) Amount Realized (9) Basis in Stock (10) Long-term capital gain (11)Marginal Tax Rate (12) Tax paid on capital gain in year of

Amount

20 $7.00 $140 .751 $105.14 20 $35.00 $700 $140 $560 15% $84

sale (13) Net cash inflow at sale (14)Present Value Factor (15) Present Value of Sale Proceeds Present Value of ISOs

$616 .621 $382.54 $277.40

Explanation (20 x 1 shares) (1) x (2) 10% discount rate for 3 years (3) x (4) Explanation (20 x 1 shares) (6) x (7) (3) (8) - (9) (10) x (11) (8) - (12) 10% discount rate for 5 years (13) x (14) (15)- (5)

f. The present value of NQOs to each employee is $202.79, calculated as follows: Description

Amount

Explanation



(1) Shares acquired (2) Exercise price (3) Cash needed to exercise (4) Market price (5) Market value of shares (6) Bargain Element (7) Marginal Tax Rate (8) Tax paid on bargain element in year

20 $7.00 $140 $25 $500 $360 40% $144

of exercise (9) Cash outflows at exercise date (10)Present Value Factor (11) Present Value of Cash to Exercise Description (12) Shares acquired (13) Market Price at Sale (14) Amount Realized (15) Basis in stock (16) Long-term capital gain (17) Marginal Tax Rate (18) Tax paid on capital gain in year of

$284 .751 $213.28 Amount 20 $35.00 $700 $500 $200 15% $30

sale (19) Net cash inflow at sale (20)Present Value Factor (21) Present Value of Sale Proceeds Present Value of NQOs

$670 .621 $416.07 $202.79

(20 x 1 shares) (1) x (2) (1) x (4) (5) – (3) (6) x (7) (3)+(8) 10% discount rate for 3 years (9) x (10) Explanation (20 x 1 shares) (6) x (7) from (5) above (14)-(15) (16) x (17) (14) - (18) 10% discount rate for 5 years (19) x (20) (21)- (11)

g. The number of NQOs necessary to make employees equal to receiving ISOs would be 28. This can be solved algebraically as follows by dividing the present value of ISOs by the present value of NQOs and multiplying the product by the number of ISOs received, calculated as follows: Description (1) PV of ISOs (2) PV of NQOs (3) Ratio (4)ISOs received (5) NQOs to break even with ISOs NQOs to be received

Amount $277.40 $202.79 1.368 20 27.36 28

Explanation Part e, line 16 Part f, line 22 (1) / (2) (3) x (4) Line 5 rounded up to nearest whole option

Alternatively, the solution can be obtained algebraically as follows: 12-28 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


First, let’s find out how many additional NQOs Harmer would have to grant to their employees to keep them indifferent between receiving ISOs and NQO’s. We already determined above that the after-tax present value to each employee of receiving ISOs is $277.40. In essence, we have to give each employee enough additional NQOs so that on an after-tax basis the present value of receiving NQO’s is $277.40. By solving the following equation for the variable X, we can determine how many total NQOs each employee should be given to keep them indifferent across the two alternatives:



Cash Outflows in 3 Years

Cash Flows in 5 Years

277.40 = .751{-X options [$7 + ($25-$7)(40%)]} + .621{X shares [$35 – ($35-$25)(15%)]}

Strike Price

Tax on Bargain Element

Selling Price

Capital Gains Taxes

What? You thought the algebra you learned back in high school would never be good for anything? Solving for X: X = 27.37 NQOs. We’ll assume Harmer does not want to issue fractional shares, so we’ll round up to 28 NQOs. So, Harmer will have to give each employee 8 more NQOs than ISOs to keep them indifferent. 38.

[LO 2] On January 1, year 1, Dave received 1,000 shares of restricted stock from his employer, RRK Corporation. On that date, the stock price was $7 per share. Dave’s restricted shares will vest at the end of year 2. He intends to hold the shares until the end of year 4 when he intends to sell them to help fund the purchase of a new home. Dave predicts the share price of RRK will be $30 per share when his shares vest and will be $40 per share when he sells them. a. If Dave’s stock price predictions are correct, what are the tax consequences of these transactions to Dave if his ordinary marginal rate is 30 percent and his long-term capital gains rate is 15 percent? b. If Dave’s stock price predictions are correct, what are the tax consequences of these transactions to RRK if its marginal rate is 35 percent? a. Dave has no tax consequences on the grant date. On the vesting date he will recognize ordinary income of $30,000 and pay taxes of $9,000, which is calculated as follows:

Description (1) Shares acquired (2) FMV at vesting date (3) Ordinary income on vesting date (4) Ordinary Marginal Tax Rate (5) Tax due when shares vest

Amount 1,000 $30.00 $30,000 30% $9,000

Explanation (1) x (2) (3) x (4)



Dave will owe $1,500 on the sale date, which is calculated as follows: Description (6) Amount realized (7) Adjusted basis (8) Long-term capital gain (9) Preferential Marginal Tax Rate Tax due when shares sold

Amount $40,000 30,000 $10,000 15% $1,500

Explanation 1,000 shares x $40 per share From line 3 above. (6) – (7) (8) x (9)

b. RRK will receive a tax benefit of $10,500 on the vesting date, which is calculated as follows: Description (1) Shares acquired (2) FMV at vesting date (3) Ordinary deduction on vesting date (4) Ordinary Marginal Tax Rate Tax benefit when shares vest

Amount 1,000 $30.00 $30,000 35% $10,500


RRK receives no benefit on the grant date or when Dave sells the shares. 39.

[LO 2] On January 1, year 1, Dave received 1,000 shares of restricted stock from his employer, RRK Corporation, On that date, the stock price was $7 per share. On receiving the restricted stock, Dave made the §83(b) election. Dave’s restricted shares will vest at the end of year 2. He intends to hold the shares until the end of year 4 when he intends to sell them to help fund the purchase of a new home. Dave predicts the share price of RRK will be $30 per share when his shares vest and will be $40 per share when he sells them. Assume that Dave’s price predictions are correct and answer the following questions: a. What are the tax consequences of these transactions to Dave if his ordinary marginal rate is 30 percent and his long-term capital gains rate is 15 percent? b. What are the tax consequences of these transactions to RRK if its marginal rate is 35 percent?



a. Dave’s tax consequences on the grant date is that he will recognize $7,000 of ordinary income and pay taxes of $2,100, which is calculated as follows: Description (1) Shares acquired (2) FMV at grant date (3) Ordinary income on grant date (4) Ordinary Marginal Tax Rate (5) Tax due on grant date

Amount 1,000 $7.00 $7,000 30% $2,100


Dave will owe no tax on the vesting date since he made the §83(b) election. Dave will owe $4,950 on the sale, which is calculated as follows: Description (6) Amount realized (7) Adjusted basis (8) Long-term capital gain (9) Preferential Marginal Tax Rate Tax due when shares sold

Amount $40,000 7,000 $33,000 15% $4,950

Explanation 1,000 shares x $40 per share From line 3 above. (6) – (7) (8) x (9)

b. RRK will receive a tax benefit of $2,450 on the grant date, which is calculated as follows: Description (1) Shares acquired (2) FMV at vesting date (3) Ordinary deduction on vesting date (4) Ordinary Marginal Tax Rate Tax benefit when shares vest

Amount 1,000 $7.00 $7,000 35% $2,450


RRK receives no benefit on the vesting date or when Dave sells the shares.



40.

[LO 2] On January 1, year 1, Jessica received 10,000 shares of restricted stock from her employer, Rocket Corporation. On that date, the stock price was $10 per share. On receiving the restricted stock, Jessica made the §83(b) election. Jessica’s restricted shares will all vest at the end of year 4. After the shares vest, she intends to sell them immediately to fund an around-the-world cruise. Unfortunately, Jessica decided that she couldn’t wait four years and quit her job to start her cruise on January 1, year 3. a. What are the year 1 tax consequences of these transactions to Jessica, assuming her marginal tax rate is 33 percent and her long-term capital gains rate is 15 percent? b. What are the year 3 tax consequences of these transactions to Jessica, assuming her marginal tax rate is 33 percent and her long-term capital gains rate is 15 percent? a. If Jessica makes the §83(b) election, she will owe $33,000 which is calculated as follows: Description (1) Shares acquired (2) FMV at section 83(b) election (3) Ordinary income on election date (4) Ordinary Marginal Tax Rate Tax due at election

Amount 10,000 $10.00 $100,000 33% $33,000


b. If Jessica leaves before the shares vest there are no tax consequences. She will recognize no loss and lose her compensatory basis in the restricted stock (the $33,000 recognized at the §83(b) election). 41.

[LO 2] On May 1, year 1, Anna received 5,000 shares of restricted stock from her employer, Jarbal Corporation. On that date, the stock price was $5 per share. On receiving the restricted stock, Anna made the §83(b) election. Anna’s restricted shares will all vest on May 1, year 3. After the shares vest, she intends to sell them immediately to purchase a condo. True to her plan, Anna sold the shares immediately after they were vested. a. What are the tax consequences of these transactions to Anna in year 1? b. What are the tax consequences of these transactions to Anna in year 3 if the stock is valued at $1 per share on the day the shares vest? c. What are the tax consequences of these transactions to Anna in year 3 if the stock is valued at $9 per share on the day the shares vest?



d. What are the tax consequences of these transactions to Anna in year 3 if the stock is valued at $5 per share on the day the shares vest? a. If Anna makes the section 83(b) election, she will recognize $25,000 on the election date which is calculated as follows: Description (1) Shares acquired (2) FMV at section 83(b) election Ordinary income on election date

Amount 5,000 $5.00 $25,000

Explanation (1) x (2)

b. There are no tax consequences to Anna when the stock vests. When Anna sells her stock for $1 a share, she will recognize a long-term capital loss of $4 per share because her basis in each share is $5 ($20,000 loss in total). c. There are no tax consequences to Anna when the stock vests. When Anna sells the stock for $9 per share, she will recognize a long-term capital gain of $4 per share because her basis in each share is $5 ($20,000 gain in total). d. There are no tax consequences to Anna when the stock vests. When Anna sells the stock for $5 per share, she will not recognize any capital gain or loss because her basis in the stock is $5 per share. 42.

[LO 2] {Planning} On January 1, year 1, Tyra works for Hatch Corporation. New employees must choose immediately between receiving seven NQOs (each NQO provides the right to purchase for $5 per share 10 shares of Hatch stock) or 50 restricted shares. Hatch’s stock price is $5 on Tyra’s start date. Either form of equity-based compensation will vest in two years. Tyra believes that the stock will be worth $15 per share in two years and $25 in four years when she will sell the stock. Tyra’s marginal tax rate is 30 percent and her long-term capital gains rate is 15 percent. Assume that Tyra’s price predictions are correct, answer the following questions (ignore present value, use nominal dollars): a. What are the cash-flow effects to Tyra in the year she receives the options, the year the options vest and she exercises the options, and in the year she sells the stock if she chooses the NQOs? b. What are the cash-flow effects to Tyra in the year she receives the restricted stock, in the year the stock vests, and in the year she sells the stock if Tyra chooses the restricted stock?



c. What are the cash-flow effects to Tyra in the year she receives the restricted stock, the year the stock vests, and the year she sells the stock if she makes a §83(b) election? d. What recommendation would you give Tyra? Explain. a. Tyra’s net cash flow for the NQOs is $1,085, which calculated as follows: Description (1) Amount Realized (2) Cash outflow for shares at exercise (3) Cash outflow for taxes at exercise (4) Cash outflow for taxes at sale Net cash flow

Amount $1,750 $350 $210 $105 $1,085

Explanation Line 11 from table below Line 3 from table below Line 8 from table below Line 15 from table below (1)-(2)-(3)-(4)

There is no cash flow on the grant date. The cash flow is negative $560 on the exercise date ($350 for the share purchase + $210 in taxes due at exercise). The cash flow on the sale date is $1,645 ($1,750 in sale proceeds less $105 in taxes due on the sale date). She must pay $350 for the shares on the exercise and pay $210 in taxes, the calculations are as follows: Description (1) Shares acquired (2) Exercise price (3) Cash needed to exercise (4) Market price (5) Market value of shares (6) Bargain Element (ordinary income) (7) Marginal Tax Rate Tax due in year of exercise

Amount 70 $5.00 $350 $15 $1,050 $700 30% $210

Explanation (7 x 10 shares) (1) x (2) (1) x (4) (5) – (3) (6) x (7)



She realizes $1,750 on the sale and pays $105 in taxes on the sale, the calculations are as follows: Description (9) Shares acquired with NQOs (10) Market price at sale (11) Amount Realized (12) Basis (13) Long-term capital gain (14) Marginal Tax Rate Tax due in year of exercise

Amount

Explanation

70 $25.00 $1,750 $1,050 $700 15% $105

(1) (9) x (10) (5) (11) - (12) (13) x (14)

b. Tyra’s net cash flow for the restricted stock is $950, which is calculated as follows: Description (1) Amount Realized (2) Cash outflow for taxes at exercise (3) Cash outflow for taxes at sale Net cash flow

Amount $1,250 $225 $75 $950

Explanation Line 6 from table below Line 5 from table below Line 10 from table below (1)-(2)-(3)

There is no cash flow on the grant date. The cash flow is negative $225 on the vesting date for taxes due. The cash flow on the sale date is $1,175 ($1,250 in sale proceeds less $75 in taxes due on the sale date). Tyra will owe $225 of taxes on the vesting date. Description (1) Shares acquired (2) FMV at vesting date (3) Ordinary income on vesting date (4) Ordinary Marginal Tax Rate Tax due when shares vest

Amount 50 $15.00 $750 30% $225




She realizes $1,250 on the sale and pays $75 in taxes on the sale, the calculations are as follows: Description (6) Amount realized (7) Adjusted basis (8) Long-term capital gain (9) Preferential Marginal Tax Rate Tax due when shares sold

Amount $1,250 750 $500 15% $75

Explanation 50 shares x $25 per share From line 3 above. (6) – (7) (8) x (9)

c. Tyra’s net cash flow for the restricted stock is $1,025, which calculated as follows: Description (1) Amount Realized (2) Cash outflow for taxes at election (3) Cash outflow for taxes at sale Net cash flow

Amount $1,250 $75 $150 $1,025

Explanation Line 6 from table below Line 5 from table below Line 10 from table below (1)-(2)-(3)

There is $75 negative cash flow on the grant date for taxes paid. There is no cash flow on the vesting date. The cash flow on the sale date is $1,100 ($1,250 in sale proceeds less $150 in taxes due on the sale date). Tyra will owe $75 of taxes on the vesting date. Description (1) Shares acquired (2) FMV at election date (3) Ordinary income on election date (4) Ordinary Marginal Tax Rate Tax due when election is made

Amount 50 $5.00 $250 30% $75




She realizes $1,250 on the sale and pays $150 in taxes on the sale, the calculations are as follows: Description (6) Amount realized (7) Adjusted basis (8) Long-term capital gain (9) Preferential Marginal Tax Rate Tax due when shares sold

Amount $1,250 250 $1,000 15% $150

Explanation 50 shares x $25 per share From line 3 above. (6) – (7) (8) x (9)

d. Tyra should elect the NQOs because it has the highest net cash flow of the three options. The additional shares that can be purchased through the NQOs is superior to the ability to lower the tax bill through the §83(b) election on the restricted stock.

43.

[LO 3] Nicole’s employer, Poe Corporation, provides her with an automobile allowance of $20,000 every other year. Her marginal tax rate is 30 percent. Poe Corporation has a marginal tax rate of 35 percent. Answer the following questions relating to this fringe benefit. a. What is Nicole’s after-tax benefit if she receives the allowance this year (ignore FICA taxes)? b. What is Poe’s after-tax cost of providing the auto allowance? a. Nicole’s after tax benefit is $$14,000, calculated as follows:

Description (1) Automobile allowance (2) Marginal tax rate (3) Income tax on allowance Total after-tax benefit

Amount $20,000 30% $6.000 $14,000

Explanation Taxable fringe benefit (1) x (2) (1) - (3)



b. Poe’s after tax cost is $13,000, calculated as follows: Description (1) Automobile allowance (2) Marginal tax rate (3) Tax benefit of allowance Total after-tax cost 44.

Amount $20,000 35% $7,000 $13,000

Explanation Taxable fringe benefit (1) x (2) (1) - (3)

[LO 3] {Research} Bills Corporation runs a defense contracting business that requires security clearance. To prevent unauthorized access to its materials, Bills requires its security personnel to be on duty except for a 15-minute break every two hours. Since the nearest restaurants are a 25-minute round trip, Bills provides free lunches to its security personnel. Bills has never included the value of these meals in its employee’s compensation. Bills is currently under audit, and the IRS agent wants to deny Bills a deduction for past meals. The agent also wants Bills to begin including the value of the meals in employee compensation starting with the current year. As Bills’ tax advisor, give it a recommendation on whether to appeal the agent’s decision (Hint: see Boyd Gaming Corp., CA-9, 99-1 USTC ¶50,530 (Acq.), 177 F3d 1096). The primary question is whether the meals are “for the convenience of the employer.” In Boyd Gaming, the Ninth Circuit held that a casino providing a cafeteria on its premises for security and logistic reasons was allowed to exclude the meals as a de minimis fringe benefit because they were provided for the employer’s convenience. One important fact is that Boyd Gaming had a policy requiring employees to stay on the business premise during lunch breaks. The IRS subsequently acquiesced (will not challenge other taxpayers with similar fact patterns) in Announcement 99-77 (1999-32 CB 243). Bills Corporation should be



able to rely on the Boyd Gaming decision; however, whether or not Bills requires employees to stay on its business premises is likely to be an important fact. 45.

[LO 3] {Planning} Lars Osberg, a single taxpayer with a 35 percent marginal tax rate, desires health insurance. The health insurance would cost Lars $8,500 to purchase if he pays for it himself (Lars’s AGI is too high to receive any tax deduction for the insurance as a medical expense). Volvo, Lars’s employer, has a 40 percent marginal tax rate. Answer the following questions about this benefit (ignore FICA taxes in your analysis). a. What is the maximum amount of before-tax salary Lars would give up to receive health insurance from Volvo? b. What would be the after-tax cost to Volvo to provide Lars with health insurance if it could purchase the insurance through its group plan for $5,000? c. Assume that Volvo could purchase the insurance for $5,000. Lars is interested in getting health insurance and he is willing to receive a lower salary in exchange for the health insurance. What is the least amount by which Volvo would be willing to reduce Lars’s salary while agreeing to pay his life insurance? d. Will Volvo and Lars be able to reach an agreement by which Volvo will provide Lars’s health insurance? a. Lars would be willing to trade at most $13,077 of before-tax salary to receive $8,500 [i.e., $8,500 / (1 – 35%)] of health insurance benefits. Lars should be indifferent between receiving $13,077 of compensation and $8,500 of nontaxable fringe benefits. b. The after-tax cost of providing Lars with the $5,000 of health insurance (a nontaxable fringe benefit) is $3,000 [$5,000 x (1 - .40)]. c. Volvo would reduce Lars’s salary by a minimum of $5,000 if it pays his health insurance. This is because whether the compensation is in the form of salary or fringe benefits the amounts are deductible. d. Lars would be indifferent between reducing his before-tax salary by $13,077 or receiving the health insurance benefits. Lars would prefer to reduce his salary by less than $13,077 and still receive the benefits. Volvo, on the other hand would be indifferent between reducing his salary by reducing his salary by $5,000 or providing the health insurance (not both the salary and the health insurance are tax deductible to Volvo so the after-tax cost of these expenses for a given before-tax cost is equivalent). Although, Volvo is better off if it reduces his salary by more than $5,000. Consequently, given that Volvo provides the insurance, any salary reduction of less than $13,077 makes Lars better off and any salary reduction greater than $5,000 makes Volvo better off. So, any salary reduction greater than $5,000 and less than $13,077 makes both parties better off. 12-40





46.

[LO 3] {Tax Planning} Seiko’s current salary is $85,000, and she fancies European sports cars. She purchases a new auto each year. Seiko is currently a manager for an office equipment company. Her friend, knowing of her interest in sports cars, tells her about a manager position at the local BMW and Porsche dealer. The new position pays only $75,000 per year, but it allows employees to purchase one new car per year at a discount of $15,000. This discount qualifies as a nontaxable fringe benefit. In an effort to keep Seiko as an employee, her current employer offers her a $10,000 raise. Answer the following questions about this analysis (ignore FICA taxes in your analyses). Assume that Seiko’s marginal tax rate is 30%. a. What is the annual after-tax cost to her current employer (office equipment company that has a 35 percent marginal tax rate) to provide Seiko with the $10,000 increase in salary? b. Financially, which offer is better for Seiko on an after-tax basis and by how much? (Assume that Seiko is going to purchase the new car whether she switches jobs or not.) c. What salary would Seiko need to receive from her current employer to make her financially indifferent (after taxes) between receiving additional salary from her current employer and accepting a position at the auto dealership? a. The after-tax cost of providing Seiko with $10,000 of additional salary is $6,500. This is calculated as follows:

Description (1) Additional salary (2) Marginal tax rate (3) Income tax benefit After-tax cost of additional salary

Amount $10,000 35% $3,500 $6,500

Explanation Given Given (1) x (2) (1) - (3)

b. The after-tax value to the employee of the current employer’s package is $66,500, calculated as follows:: Salary with $10,000 raise

$95,000 x (1-.30) $66,500

After-tax benefit from salary

The after-tax value to the employee of the car dealer’s package is $67,500, calculated as follows: Salary

$75,000 x (1-.30) $52,500 15,000 $67,500

After-tax benefit After-tax benefit of discount After-tax value of second package



c. The current employer would have to offer her $96,429, because the after-tax difference between the two offers is $1,000. Therefore, if Seiko’s current employer provided her with $1,429 of additional salary [$1,000/(1-.3)] she would be indifferent. Salary increase

$1,429 x (1-.30) $1,000

After-tax benefit of extra salary Salary (with $10,000 + 1,429 raise)

$96,429 x (1-.30) $67,500

After-tax benefit from salary 47.

[LO 1, 3] JDD Corporation provides the following benefits to its employee, Ahmed (age 47):       

Salary Health insurance: Dental insurance: Life insurance: Dependent care: Professional dues: Personal use of company jet:

$300,000 $10,000 $2,000 $3,000 $5,000 $500 $200,000

Assume the life insurance is a group-term life insurance policy that provides $200,000 of coverage for Ahmed. Assuming Ahmed is subject to a marginal tax rate of 30 percent, what is his after-tax benefit of receiving each of these benefits (ignoring FICA taxes)? The after-tax benefit of Ahmed’s salary and benefits is $370,419, calculated as follows: Description Taxable Benefits (1) Salary (2) Personal use of company jet (3) Life Insurance (taxable portion)

Amount

(4) Taxable Total (5) Marginal tax rate (6) Income tax on benefits (7) After-tax benefit of taxable items Nontaxable Benefits (8) Health Insurance (9) Dental Insurance (10) Life Insurance (nontaxable portion)

$500,270 30% $150,081 $350,189

$300,000 $200,000 $270

$10,000 $2,000 $2,730

Explanation

($150,000 x (.15 cents per $1,000) x 12 (1) + (2) + (3) (4) x (5) (4) – (6)

$3,000 – (3)



(11) Dependent Care (12) Professional Dues (13) Nontaxable Total

$5,000 $500 $20,230

After-tax benefit of salary and benefits 48.

$370,419

(8) + (9) + (10) + (11) + (12) (7) + (13)

[LO3] Gray’s employer is now offering group-term life insurance. The company will provide each employee with $100,000 of group-term life insurance. It costs Gray’s employer $300 to provide this amount of insurance to Gray each year. Assuming that Gray is 52 years old, determine the monthly premium that Gray must include in income as a result of receiving the group-term life benefit. Because Gray is 52, the amount included into income is 23 cents per $1,000 of coverage. The monthly premium that must be included in income is as follows:

(1) Amount of Life Insurance (2) Tax free benefit limit (3) Taxable Benefit (4) Divide by 1,000 (5) Cost Per $1,000 Monthly Premium 49.

$100,000 ($50,000) $50,000 50 0.23 $11.50

Statutory limit (1)-(2) Exhibit 12-11 (4) x (5)

[LO3] Brady graduated from SUNY New Paltz with his bachelor’s degree recently. He works for Makarov & Company CPAs. The firm pays his tuition ($10,000 per year) for him so that he can receive his Masters of Science in Taxation which will qualify him to sit for the CPA exam. How much of the $10,000 tuition benefit does Brady need to include in income?

Section 127(a)(2) allows individuals to exclude up to $5,250 of tuition benefits from income annually. Brady’s taxable amount is calculated as follows: (1) Tuition benefit (2) Excludable amount Taxable amount 50.

$10,000 ($5,250 Statutory limit ) $4,750 (1)-(2)

[LO3] Meg works for Freedom Airlines in the accounts payable department. Meg and all other employees receive free flight benefits (for the employee, family, and 10 free buddy passes for friends per year) as part of their employee benefits package. If Meg uses 30 flights with a value of $12,350 this year, how much must she include in her compensation this year? The flight benefits qualify as a no additional cost service and may be excluded from gross income under §132(a)(1). The Treasury Regulations (§1.132-2) specifically exclude airline benefits from gross income.



51.

[LO3] {Tax Research} Sharmilla works for Shasta Lumber, a local lumber supplier. The company annually provides each employee with a Shasta Lumber shirt so that employees look branded and advertise for the business while wearing the shirts. Are Shasta’s employees required to include the value of the shirts in income? §132(a)(4) excludes de minimis fringe benefits from taxable income. However, §132(e) defines fringe benefits “any property or service the value of which is (after taking into account the frequency with which similar fringes are provided by the employer to the employer's employees) so small as to make accounting for it unreasonable or administratively impracticable.” The Treasury regulations under §132 (§1.132-1) give specific examples which suggest that a shirt with a company logo may be excluded from gross income. However, the authority doesn’t explicitly mention the benefit received by Sharmilla. As a practical matter, most employers provide similar types of benefits and exclude the amount from employees’ income.

52.

[LO3] {Tax Research} LaMont works for a company in downtown Chicago. The firm encourages employees to use public transportation (to save the environment) by providing them with transit passes at a cost of $250 per month. a. If LaMont receives one pass (worth $250) each month, how much of this benefit must he include in his taxable income each year? b. If the company provides each employee with $250 per month in parking benefits, how much of the parking benefit must LaMont include in his taxable income each year? a) Under §132(f)(5)(A), an employer may exclude transit passes as a qualified transportation fringe benefits. The amounts described in the Code are not indexed, but the IRS annually provides the indexed amounts in a Revenue Procedure. For 2013, the amount is $245 for qualified transportation fringe as described in Rev. Proc.2013-15. LaMont must include $60 per year into taxable income ($5($250 of benefits less $245 exclusion) per month into income). b) Under §132(f)(5)(C), an employer may exclude qualified parking as a qualified transportation fringe benefits. The amounts described in the Code are not indexed, but the IRS annually provides the indexed amounts in a Revenue Procedure. For 2013, the amount is $245 for qualified parking as described in Rev. Proc.2013-15. LaMont must include $60 per year into taxable income ($5($250 of benefits less $245 exclusion) per month into income).

53.

[LO3] Jasmine works in Washington, D.C. She accepts a new position with her current firm in Los Angeles. Her employer provides the following moving benefits:    

Temporary housing for one month—$3,000 Transportation for her household goods—$4,500 Flight and hotel for a house-hunting trip—$1,750 Flights to Los Angeles for her and her family—$2,000



What amount of these benefits must Jasmine include in her gross income? Employers can exclude qualified moving expense reimbursements from income under §132(g). However, the amounts must be deductible under the moving expense rules contained in §217. Amounts that can be excluded include a reasonable amount for moving household belongings and the cost of traveling to the new residence. Therefore, Jasmine can exclude $4,500 for the transportation of the household goods and $2,000 for flights to Los Angeles. Jasmine must include the $3,000 of temporary housing and $1,750 for house hunting into her taxable income. 54.

[LO 3] Jarvie loves to bike. In fact, he has always turned down better paying jobs to work in bicycle shops where he gets an employee discount. At Jarvie’s current shop, Bad Dog Cycles, each employee is allowed to purchase four bicycles a year at a discount. Bad Dog has an average gross profit percentage on bicycles of 25 percent. During the current year, Jarvie bought the following bikes: Description

Retail Price

Cost

Employee Price

Specialized road bike

$3,200 $2,000

$2,240

Rocky Mountain mountain bike

$3,800 $3,200

$3,040

Trek road bike

$2,700 $2,000

$1,890

Yeti mountain bike

$3,500 $2,500

$2,800

a. What amount is Jarvie required to include in taxable income from these purchases? b. What amount of deductions is Bad Dog allowed to claim from these transactions? a) Under §132(a)(2), an employer may exclude from an employee’s income discounts that do not exceed the employer’s cost of goods it provides in the ordinary course of its business. Therefore, Jarvie must include $270 into taxable income:



Description

Retail price less average gross profit percentage

Employee Price

Incom e

Specialized road bike

$2,400

$2,240

$160

Rocky Mountain mountain bike

$2,850

$3,040

$0

Trek road bike

$2,025

$1,890

$135

Yeti mountain bike

$2,625

$2,800

$0

Income

$295

b) Bad Dog is not allowed a deduction for the employee discounts it provides its employees. It may include the $9,700 ($2,000 + $3,200 + $2,000 +$2,500) for the cost of the goods sold to employees in its cost of goods sold. 55.

[LO 1, 3] Matt works for Fresh Corporation. Fresh offers a cafeteria plan that allows each employee to receive $15,000 worth of benefits each year. The menu of benefits is as follows: Benefit

Cost

Health insurance--single

$5,000

Health insurance--with spouse

$8,000

Health insurance--with spouse and dependents Dental and vision

$11,000 $1,500

Dependent care--any specified amount up to $5,000

Variable

Adoption benefits--any specified amount up to $5,000

Variable

Educational benefits--any specified amount (no limit)

Variable

401(k)--any specified amount up to $10,000

Variable

Cash-- any specified amount up to $15,000 plan benefit

Variable



For each of the following independent circumstances, determine the amount of income Matt must recognize and the amount of deduction Fresh may claim (ignore FICA taxes): a.

Matt selects the single health insurance and places $10,000 in his 401(k).

b.

Matt selects the single health insurance, is reimbursed $5,000 for MBA tuition, and takes the remainder in cash.

c.

Matt selects the single health insurance and is reimbursed for MBA tuition of $10,000.

d.

Matt gets married and selects the health insurance with his spouse and takes the rest in cash to help pay for the wedding.

e.

Matt elects to take all cash.

a. Matt must recognize $0, because each of the benefits is a nontaxable fringe benefit. b. Matt must recognize $5,000, because he receives cash and two nontaxable fringe benefits. Educational assistance benefits have a maximum nontaxable amount of $5,250. c. Matt must recognize $4,750 of taxable income because his MBA tuition exceeded the maximum nontaxable amount of $5,250. d. Matt must recognize $7,000 of taxable income for the cash received. The $8,000 of health insurance is a nontaxable fringe benefit. e. Matt must recognize $15,000 of taxable income for the cash received.



Comprehensive Problems 56.

[LO 1, 2] {Planning}{Tax Forms} Pratt is ready to graduate and leave College Park. His future employer offers the following four compensation packages from which Pratt may choose. Pratt will start working for Ferndale on January 1, year 1. Benefit Description Salary

Option 1

Option 2

Option 3

Option 4

$60,000

$50,000

$45,000

$45,000

Health Insurance

$0

$5,000

$5,000

$5,000

Restricted stock

$0

$0

1,000 shares

$0

NQO’s

$0

$0

$0

100 options

Assume that the restricted stock is 1,000 shares that trade at $5 per share on the grant date (January 1, year 1) and are expected to be worth $10 per share on the vesting date at the end of year 1 and that no §83(b) election is made. Assume that the NQOs (100 options that each allow the employee to purchase 10 shares at $5 exercise price). The stock trades at $5 per share on the grant date (January 1, year 1) and is expected to be worth $10 per share on the vesting date at the end of year 1 and that the options are exercised and sold at the end of the year. Also assume that Pratt spends on average $3,000 on health-related costs that would be covered by insurance if he has coverage. Assume that Pratt’s marginal tax rate is 35 percent. Assume that Pratt spends $3,000 in after-tax dollars for health expenses when he doesn’t have health insurance coverage (treat this as an outflow), and that there is no effect when he has health insurance coverage. a. What is the after-tax value of each compensation package for year 1? b. If Pratt’s sole consideration is maximizing after-tax value for year 1, which option should he select? c. Assuming Pratt chooses Option 3 and sells the stock on the vesting date (on the last day of year 1), complete Pratt’s Schedule D for the sale of the restricted stock. a. The solution assumes that no §83(b) election is made for Option 3. Pratt’s after-tax value for each of the options is $36,000, $32,500, $35,750, and $30,750 respectively, calculated as follows:



Description (1) Salary (2) Restricted Stock (3) Taxable Total

Option 1 Amount $60,000

Explanation

$0 $60,000

(1) + (2)

(4) Tax Rate

35%

(5) Tax Paid

$21,000

(3) x (4)

(6) After-tax cash value

$39,000

(3) – (5)

(7) NQO’s (8) Health care expenses After-tax value

$0 $3,000 $36,000

Description (1) Salary


(2) Restricted Stock

$0

(3) Taxable Total

$50,000

(6) + (7) – (8)

Explanation

(1) + (2)

(4) Tax Rate

35%

(5) Tax Paid

$17,500

(3) x (4)


$32,500

(3) – (5)

(7) NQO’s

$0

(8) Health care expenses

$0

After-tax value

$32,500



(2) Restricted Stock

$ 10,000

(3) Taxable Total

$55,000

(6) + (7) – (8)

Explanation

(1) + (2)

(4) Tax Rate

35%

(5) Tax Paid

$19,250

(3) x (4)


$35,750

(3) – (5)

(7) NQO’s

$0 12-50



(8) Health care expenses

$0

After-tax value

$35,750


(6) + (7) – (8)


(2) NQO’s

$5,000

(3) Taxable Total

$50,000

(4) Tax Rate

35%

(5) Tax Paid

$17,500

(6) Cash paid at exercise

$5,000


$32,500

(8) Health care expenses After-tax value

Explanation Bargain element – 1000 shares * ($10 – $5)

(1) + (2) (3) x (4) $5 x 1,000 shares (3) – (5)

$0 $32,500

(7) - (8)

c. Pratt should select Option 1 ($36,000) because it maximizes his after-tax value. d. ADD SCHEDULE D and Form 8949. 57. Santini’s new contract for 2013 indicates the following compensation and benefits: Benefit Description

Amount

Salary

$130,000

Health insurance

$9,000

Restricted stock granted

$2,500

Bonus

$5,000

Hawaii trip

$4,000

Group-term life insurance

$1,600

Parking ($275 per month)

$3,300

Santini is 54 years old at the end of 2013. He is single and has no dependents. Assume that the employer matches $1 for $1 for the first $6,000 that the employee contributes to his 401(k) during the year. The 100 ISOs each allow the purchase of 10 shares of stock at a strike price of $5 (also the market price on the date of grant). The ISOs vest in two 12-51 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


years when the stock price is expected to be $15 and Santini expects to sell the shares in three years when the market price is $20. The restricted stock grant is 500 shares granted when the market price was $5 per share. Assume that the stock vests on December 31, 2013, and that the market price on that date is $7.50 per share. Also assume that Santini is willing to make any elections to reduce equity-based compensation taxes. The Hawaii trip was given to him as the outstanding sales person for 2012. The group-term life policy gives him $150,000 of coverage. Assume that Santini does not itemize deductions for the year. Determine Santini’s taxable income and income tax liability for 2013. Santini’s taxable income is $132,136 , and his income tax liability is $30,291 , each is calculated as follows: Description Taxable Benefits (1) Salary (2) Restricted stock grant

Amount

Explanation

$130,000 $2,500

$130,000 (given) 500 shares x $5 on grant date with an §83(b) election Given Given $100,000= (.23 cents per $1,000) x 12 months $30 per month ($275 per month - $245 (statutory limit)) x 12 months Sum of items (1) through (6) 2013 single standard deduction 2013 personal exemption (7) – (8) – (9) [((10) -$87,850) x 28%]+ $17,891.25

(3) Bonus (4) Hawaii trip (5) Life Insurance (taxable portion)

$5,000 $4,000 $276

(6) Parking

$360

(7) AGI (8) Standard Deduction

$142,136 $6.100

(9) Personal Exemption (10) Taxable Income (11) Income Tax Liability

$3,900 $132,136 $30,291

58.

[LO 1, 3] {Planning} Sylvana is given a job offer with two alternative compensation packages to choose from. The first package offers her $250,000 annual salary with no qualified fringe benefits. The second package offers $235,000 annual salary plus health and life insurance benefits. If Sylvana were required to purchase the health and life insurance benefits herself, she would need to pay $10,000 annually after taxes. Assume her marginal tax rate is 33 percent.



a. Which compensation package should she choose and by how much would she benefit in after-tax dollars by choosing this package? b. Assume the second package offers $240,000 plus the benefits instead of $235,000 plus benefits. Which compensation package should she choose and by how much would she benefit in after-tax dollars by choosing this package? a. Sylvana is better off by $50 by choosing Option 1. Option 1 ($157,500) has a higher after-tax value than Option 2 ($157,450). So Sylvana would be better off taking Option 1 and purchasing her own health insurance. Option 1 Salary

$250,000 (1-.33)

ATCF from salary Cost of benefits

$167,500 ($10,000 )

After tax dollars

$157,500

Option 2 $235,00 0 (1-.33) $157,45 0 $0 $157,45 0

b. Sylvana is better off by $3,300 by choosing Option 2. Option 2 ($160,800) now has a higher after-tax value than Option 1 ($157,500). So Sylvana would be better off taking Option 2.

Salary ATCF from salary Cost of benefits After tax dollars

Option 1 $250,00 0 (1-.33) $167,50 0 ($10,00 0) $157,50 0

Option 2 $240,00 0 (1-.33) $160,80 0 $0 $160,80 0

59. {Planning} In 2013, Jill, age 35, received a job offer with two alternative compensation packages to choose from. The first package offers her $90,000 annual salary with no qualified fringe benefits, requires her to pay $3,500 a year for parking, and pay her life insurance premiums at a cost of $1,000. The second package offers $80,000 annual salary, employer provided health insurance, annual free parking (worth $300 per month), $200,000 of life insurance (purchasing on her own would have been $1,000 annually), and free flight benefits (she figures that it will save her $5,000 per year). If Jill chooses the first package, she would purchase the health and life insurance benefits herself at a cost of $5,000 annually after taxes and spend another $5,000 in flights while traveling. Assume her marginal tax rate is 28 percent. 12-53 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


a. Which compensation package should she choose and by how much would she benefit in after-tax dollars by choosing this compensation package instead of the other compensation package? b. Assume the first package offers $100,000 salary with no qualified benefits instead of $90,000 salary plus benefits. Which compensation package should



she choose and by how much would she benefit in after-tax dollars by choosing this package? a. Jill is better off by $7,935 by choosing Option 2. Option 2 ($58,235) has a higher after-tax value than Option 1 ($50,300). So Jill would be better off taking Option 2. Salary Includible health insurance Includible life insurance Includible parking Includible flight benefits ATCF from salary Cost of health insurance Cost of parking Cost of life insurance Cost of flights After tax dollars

Option 1 $90,000 0 0 0 0 (1-.28) $64,800 ($5,000 ) ($3,500) $(1,000) ($5,000) $50,300

Option 2 80,000 0 $162 $660 0 (1-.28) $58,192 $0 0 0 0 $58,192

b. Jill is better off by $692by choosing Option 2. Option 2 ($58,192) still has a higher after-tax value than Option 1 ($57,500). So Jill would be better off taking Option 2.

Salary Includible health insurance Includible life insurance Includible parking Includible flight benefits ATCF from salary Cost of health insurance Cost of parking Cost of life insurance Cost of flights After tax dollars

Option 1 $100,00 0 0 0 0 0 (1-.28) $72,000 ($5,000 ) ($3,500) $(1,000) ($5,000) $57,500

Option 2 80,000 0 $162 $660 0 (1-.28) $58,192 $0 0 0 0 $58,192


SMChap012

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