Vol 01 chapter 19 2015

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Individual Income Taxes

1

Chapter 19

Deferred Compensation

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The Big Picture

• Joyce is a junior finance major at State University. • Recently, Dr. Sanchez, her finance professor, delivered a

lecture on retirement savings that emphasized the need for– A long-term savings horizon, and – Multiple retirement plans.

• Dr. Sanchez mentioned that she has 4 different retirement plans.

• Joyce was surprised to hear this because she knows that her father has only a single retirement plan provided by his employer.

• Joyce drops in on the professor during office hours to find out more about how a person can have multiple retirement plans.

• What are some facts that would be helpful for Joyce?

• Read the chapter and formulate your response.

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Qualified Plans(slide 1 of 11)

• Deferred compensation defined:– Payments for services made available to the

taxpayer after the period when services were performed

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• Tax benefits of qualified deferred compensation plans– Contributions are immediately deductible by the

employer– Employees are not taxed on the contributions to

the plan or income earned by the plan until payment is made available to them under the plan

– Employer contributions to and benefits payable under qualified plans generally are not subject to FICA and FUTA taxes

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• A variety of deferred compensation arrangements are offered to employees including:– Qualified pension plans– Qualified profit sharing plans– Cash or deferred arrangement plans– Simple IRAs and § 401(k) plans– Tax-deferred annuities– Incentive stock option plans– Nonqualified deferred compensation plans– Restricted property plans– Cafeteria benefit plans– Employee stock purchase plans

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• Pension plans– Provide systematic payments of definitely

determinable amounts • Employer contributions under a qualified pension plan

must not depend on profits• Plan normally must pay benefits out as lifetime

annuities to provide retirement income to retired employees

– 2 types of pension plans• Defined benefit plan• Defined contribution plan

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• Defined benefit pension plans– Annual contributions are made by the employer

that will provide sufficient amounts to pay specified retirement benefits

– Benefits based upon years of service and average compensation

– Separate accounts for each employee are not maintained

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• Defined contribution pension plans– The annual amount the employer must contribute

is defined (e.g., a flat amount or a percentage of compensation)

– Separate accounts must be maintained for each employee

– The amount received upon retirement is dependent upon amounts contributed and income earned on contributions

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• Profit sharing plans– Established to allow employees to participate in

the profits of the company– Separate accounts are maintained for each

employee

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• Profit sharing plans– Definite predetermined formulas must be

established for the allocation of contributions to and distributions from the plan

– The company is not required to make annual contributions and contributions do not have to come from current profits

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• Stock bonus plans– Established so that the employer can contribute

shares of its stock– Subject to rules similar to profit sharing plans– Distributions must be in employer’s stock

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• Qualification requirements– For a plan to be qualified, it must satisfy the

following requirements:• Nondiscrimination requirements • Participation and coverage requirements • Vesting requirements• Distribution requirements• Minimum funding requirements

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• Qualification requirements– The qualification requirements are highly technical

and numerous• Thus, an employer should seek a determination letter

from the IRS regarding a plan’s qualified status

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Tax Consequences to Employee and Employer (slide 1 of 10)

• Employer contributions to qualified plans are generally deductible immediately

• Amounts contributed are not taxable to employees until distributed– Tax benefit to the employee amounts to a substantial tax

deferral – Another advantage of a qualified plan is that any income

earned by the trust is not taxable to the trust• Employees are taxed on such earnings when they receive the

retirement benefits• Taxation of amounts received by employees in periodic or

installment payments is generally subject to the annuity rules

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• Lump-sum distributions-generally taxable in year of distribution– Taxpayers who receive a lump-sum distribution

from a qualified plan can roll over the benefits into an IRA or into another qualified plan

• Defers tax on lump-sum distribution

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• Limitations on contributions– Defined contribution plan

• Lesser of $52,000 (in 2014) or 100% of employee’s compensation

• Employer’s deduction limit cannot exceed 25% of eligible compensation

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• Limitations on contributions– Defined benefit plan – max contribution deduction

can be calculated in one of two ways• Aggregate cost method allows an actuarially determined

amount, or • Normal cost plus up to 10% of past service costs

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• Limitations on contributions– Defined benefit plan

• Annual benefit payable under the plan is the lesser of $210,000 (in 2014), subject to certain limitations, or 100% of average compensation for the highest 3 years of employment

– Compensation considered in averaging cannot exceed $260,000 (in 2014)

– 10% penalty tax on excess contributions

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The Big Picture - Example 8 Defined Benefit Pension Plan vs.

A Defined Contribution Plan

• Return to the facts of The Big Picture on p. 19-1. • The university has offered Joyce’s professor, Dr. Sanchez, a

choice between a defined benefit pension plan and a defined contribution plan.

• Dr. Sanchez expects to work at a number of universities during her career. – A colleague has recommended that Dr. Sanchez choose the defined

contribution plan because of its mobility• She can take the plan with her.

• She needs to decide if this mobility factor is significant in making her choice and how much she can contribute annually to a defined contribution plan.

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• Limitations on contributions– Profit sharing plan or stock bonus plan

• Maximum deduction permitted to an employer each year for contributions to profit sharing and stock bonus plans is 25% of compensation

– Maximum compensation considered is $260,000 for 2014

– The maximum deduction allowed is $52,000 in 2014

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• §401(k) plans– Employee elects to receive cash (taxed currently)

or have amount contributed (pretax) to a qualified plan

– Limit for 2014 on employee contribution is $17,500

• Amount is reduced by other tax-sheltered salary reduction plans

• Person age 50 or over by year end may make catch-up contributions of up to $5,500 for 2014

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The Big Picture - Example 15 § 401(k) plan vs. § 403(b) plan

• Return to the facts of The Big Picture on p. 19-1. • Dr. Sanchez is not eligible to participate in a § 401(k)

plan.– She does participate in a § 403(b) tax-deferred annuity

plan.• A § 403(b) plan is for employees of § 501(c)(3) not-for-profit

organizations. – Similar in many respects to a § 401(k) plan.

– Dr. Sanchez indicates that because she is age 51, she is eligible to make catch-up contributions to her § 403(b) annuity.

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• SIMPLE Plans

• Employers with 100 or less employees and no other qualified plan may establish a savings incentive match plan for employees (SIMPLE plan)– In form, §401(k) or IRA– Avoids nondiscrimination rules

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• SIMPLE Plans – Employees make elective contributions (up to $12,000 in

2014) to plan• Contributions made as percentage of compensation

• Distributions from plan taxed under IRA rules

– Employers generally required to match contributions up to 3% of compensation or provide 2% nonmatching contributions

– Person age 50 or over by year end may make catch-up contributions of up to $2,500

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• Designated Roth Contributions– § 401(k) plans and § 403(b) plans may be amended to

permit employees to irrevocably designate some or all of their future salary deferral contributions as Roth § 401(k) or Roth § 403(b) contributions

• These designated amounts are currently includible in the employee’s gross income and are maintained in a separate plan account

• The earnings on these elective contributions build up in the plan on a tax-free basis

• Future qualified distributions made from designated contributions are excludible from gross income

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Retirement Plans for Self-Employed Individuals (slide 1 of 2)

• H.R. 10 (Keogh) plans– Retirement plans for self-employed and their

employees– Plan rules are similar to corporate provisions– Plan must be established before the end of the tax

year, but contributions may be made up to the due date of the return

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Retirement Plans for Self-Employed Individuals (slide 2 of 2)

• Keogh (H.R. 10) plans (cont’d)– Contribution limitations

• Defined contribution plan– Lesser of $52,000 (in 2014) or 100% of earned income

– Profit sharing plans and stock bonus plan are limited to 25%

– Defined benefit plans limit the annual benefit payable to the lesser of $210,000 (in 2014) or 100% of average compensation for 3 highest years

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The Big Picture - Example 19 Keogh Plan

• Return to the facts of The Big Picture on p. 19-1. • Joyce’s professor, Dr. Sanchez, has a forensic consulting

practice in addition to her position at the university. – Also, she receives book royalties from a textbook.

• Since she is self-employed (she will report her earnings on a Schedule C), she is able to establish a Keogh plan.

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Individual Retirement Accounts(slide 1 of 15)

• Contribution ceiling is lesser of $5,500 ($11,000 for spousal IRAs) or 100% of earned income

• Person age 50 or over by year end may make catch-up contributions

– Max contribution limit is increased by $1,000

• Deductible IRA contribution may be reduced if taxpayer is an active participant in another qualified plan

• To extent individual is ineligible to make deductible contributions, a nondeductible IRA contribution may be made – Income accrues on account tax deferred

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• If taxpayer is covered by a qualified plan, IRA deduction is phased out within the AGI ranges listed below:

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• For distributions made in 2006 through 2013, an exclusion from gross income is available for traditional IRA distributions made to charity– The amount of the distribution that is eligible for

this beneficial exclusion treatment is limited to $100,000

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• Roth IRA– Contributions are nondeductible

• Maximum allowable annual contribution is the smaller of– $5,500 ($11,000 for spousal IRAs) or – 100% of the individual’s compensation for the year

– Qualified distributions are tax-free after an initial five year holding period if:

• Made on or after age 59 ½ • Made to beneficiary on or after participant’s death• Participant becomes disabled• Used to pay for qualified first-time home buyer’s expenses

($10,000 limit)

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• Roth IRA (cont’d)– Other distributions may be taxable

• Distributions first treated as nontaxable return of capital to extent of contributions

• Remaining distribution treated as taxable payout of earnings

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• Roth IRA (cont’d)– Annual contributions in 2014 are subject to

phase out within the AGI ranges listed below:

Phase-out begins Phase-out ends

Single $ 114,000 $129,000

MFJ 181,000 191,000

MFS 0 10,000

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The Big Picture - Example 29 Roth IRAs Income Limits

• Return to the facts of The Big Picture on p. 19-1.

• Joyce’s professor, Dr. Sanchez, also contributes annually to a traditional IRA. – She would prefer a Roth IRA, but her AGI exceeds

the phaseout limit.

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• Coverdell Education Savings Account– Distributions to pay for qualified education

expenses (QEE) are tax-free• Exclusion may be available in year American

Opportunity credit or lifetime learning credit is claimed

– Maximum annual nondeductible contribution for a beneficiary is $2,000

• No contributions allowed after beneficiary reaches 18 years of age

• No contribution allowed in year contribution made to qualified tuition program for same beneficiary

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Coverdell Education Savings Account (cont’d) Annual contributions are subject to phase out within the AGI ranges listed below:

Phase-out begins Phase-out ends

Single $95,000 $110,000

MFJ 190,000 220,000

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• Coverdell Education Savings Account (cont’d)– Distributions in excess of QEE are treated, pro rata, as a

return of capital and a distribution of earnings• The exclusion for the distribution of earnings is calculated as

follows:Exclusion = (QEE/Total Distributions) × Earnings

– Qualified higher education expenses (QEE) include:• Tuition, fees, books, supplies and equipment

• Room and board if enrolled for at least one-half of full-time course load

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• Simplified employee pension (SEP) plans– Employer contributes to employee’s IRA

• Contribution limited to lesser of $52,000 (in 2014) or 25% of compensation

• Subject to most restrictions of qualified plans

– Elective contributions by employee are limited to $17,500 in 2014

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• Spousal IRAs– If both spouses have earned income, ceiling on

deductible contributions is $11,000 or combined earned income

– If only one spouse has earned income, ceiling is $11,000 or earned income of that spouse

– Must file jointly to use spousal IRA rules

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• Alimony is considered to be earned income for purposes of IRA contributions– Thus, a person whose only income is alimony can

contribute to an IRA

• Timing of Contributions– Contributions (both deductible and nondeductible)

can be made to an IRA anytime before the due date of the individual’s tax return (without extensions)

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• Taxation of Benefits– A participant has zero basis in deductible contributions to

a traditional IRA because the contributions were deducted• Therefore, all withdrawals from a deductible IRA are taxed as

ordinary income in the year of receipt

– A participant has a basis equal to the contributions made for a nondeductible traditional IRA

• Therefore, only the earnings component of withdrawals is included in gross income

• Such amounts are taxed as ordinary income in the year of receipt

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• Distributions before age 59 1/2 subject to 10% penalty tax except to pay for:– Medical expenses in excess of 10% of AGI (or

7.5% of AGI if at least age 65)– Qualified higher education expenses– Qualified first-time home buyer expenses up to

$10,000– Health insurance premiums for person (and family)

who has received unemployment comp for at least 12 consecutive weeks

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• Rollovers– Distribution from qualified plan transferred within

60 days to IRA (or another qualified plan) not includible in gross income

– One tax-free rollover from IRA within 12-month period

• Direct transfers not subject to this limitation

– Employer must withhold 20% of any lump-sum distribution that is not a direct transfer

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The Big Picture - Example 37 Tax-free Rollover

• Return to the facts of The Big Picture on p. 19-1. • Dr. Sanchez withdraws $15,000 from her traditional

IRA on May 2, 2014, but she redeposits it in the same IRA on June 28, 2014. – The withdrawal and redeposit was a partial rollover and Dr.

Sanchez may have used the funds for a limited time. – This is a tax-free rollover.

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Nonqualified Deferred Compensation Plans (slide 1 of 3)

• Special rules apply to nonqualified arrangements that defer the receipt of compensation income – If the plan does not meet certain conditions in § 409A, all

amounts deferred under the arrangement may be included in the participant’s gross income to the extent they are not subject to a substantial risk of forfeiture

– In addition, a 20% penalty tax is imposed on such income along with interest at the underpayment rate plus 1%

• In general, a § 409A deferral occurs where an employee has a legally binding right to compensation that has been deferred to the future

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• Golden parachute payments– Defined: Excess severance payments

– Employer is denied deduction for golden parachute payments if

• Payment is contingent on change of ownership through a stock or asset acquisition

• Aggregate present value of payment equals or exceeds three times the employee's average annual compensation

– Disallowed amount is excess of payment over statutory base (five-year average taxable compensation) and a 20% excise tax is imposed on the recipient

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• Compensation limitations– Publicly traded companies have a limitation of $1

million on deductible compensation for each of the top 5 executives

• Limit may be reduced to $500,000 under TARP

– Certain types of compensation are not subject to the limit

• e.g., Commissions, certain performance-based amounts, qualified retirement plan contributions, and excludible amounts such as employee fringe benefits

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Restricted Property Plans(slide 1 of 2)

• Restricted property plan defined:– Generally, an incentive compensation arrangement

where the employee receives property (e.g., stock in the employer) at little or no cost

– Time for inclusion in income is the earlier of:• When the property is no longer subject to substantial

risk of forfeiture, or• When the property is transferable by the employee

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Restricted Property Plans(slide 2 of 2)

• Employee can elect to recognize any ordinary income from the restricted property immediately

• Employer is allowed a tax deduction at the same time the employee includes the compensation in income

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Stock Options(slide 1 of 5)

• Stock option defined:– The right to purchase a stated number of shares of

stock at a certain price within a specified time period

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• Incentive stock options (ISO)– No tax consequences to issuer or recipient when

granted• The spread between FMV and option price at exercise

date is a tax preference item for AMT

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• Incentive stock options (ISO)– Employee will qualify for long-term capital gain

treatment on the sale of stock received by exercising the option if stock is held more than

• 2 years after the option is granted, or• 1 year after the option is exercised

– May produce no compensation deduction for employer

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• Nonqualified stock options (NQSO)– NQSO are stock options that do not qualify as ISO– If the NQSO has an ascertainable value at the date

of grant, it is included in the employee’s income on that date

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• Nonqualified stock options (NQSO)– If the NQSO does not have an ascertainable value

at date of grant, employee will recognize ordinary income at the exercise date equal to the difference between FMV and the option price

– Employer receives a deduction for the same amount as is included in the employee’s income

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The Big Picture - Example 47 Stock Options (slide 1 of 2)


• Dr. Sanchez is on the board of directors of Wren Corp. – Wren Corp. granted an ISO for 100 shares of its stock to

Dr. Sanchez on March 18, 2013. • The option price was $100 and the FMV was $100 on the date of

the grant.

– Dr. Sanchez exercised the option on April 1, 2013, when the FMV of the stock was $200 per share.

– She sells the stock on April 6, 2014, for $300 per share.

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The Big Picture - Example 47 Stock Options (slide 2 of 2)


• Dr. Sanchez did not recognize any ordinary income on the grant date or the exercise date.– The option qualified as an ISO. – Wren received no compensation deduction.

• Dr. Sanchez has a $10,000 tax preference item on the exercise date.

• She has a long-term capital gain of $20,000 on the sale of the stock in 2014 [($300 − $100) × 100].– The one-year and two-year holding periods and other

requirements have been met.

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The Big Picture - Example 48 Stock Options

• Return to the facts in Example 47, except that Dr. Sanchez was not an employee of Wren Corp. for 6 months before she exercised the options. – Dr. Sanchez must recognize $10,000 [($200 − $100) × 100]

of ordinary income on the exercise date, to the extent of the spread.

• She was not an employee of Wren Corp. at all times during the period beginning on the grant date and ending three months before the exercise date.

– Wren is allowed a deduction at the same time Dr. Sanchez reports the ordinary income.

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The Big Picture - Example 49 Stock Options

• Assume the same facts as in Example 47, except that Dr. Sanchez sells the stock on March 22, 2014, for $290 per share. – Because Dr. Sanchez did not hold the stock for

more than one year, $10,000 of the gain is treated as ordinary income in 2014.

– Wren Corp. is allowed a $10,000 compensation deduction in 2014.

• The remaining $9,000 is short-term capital gain ($29,000 − $20,000).

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Refocus On The Big Picture (slide 1 of 4)

• From her discussion with Dr. Sanchez, Joyce learns that her professor has the following retirement plans:– Defined contribution plan - The university offered its

faculty members a choice between a defined benefit pension plan and a defined contribution plan.

• Dr. Sanchez expects to work at a number of universities during her career, so she chose the defined contribution plan because of its mobility.

• The maximum annual contribution the university could make to the plan is $52,000 for 2014.

• Since the university contribution rate is 15%, the actual contribution is $22,500 ($150,000 X 15%).

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• § 403(b) annuity - Dr. Sanchez makes contributions to a § 403(b) annuity – This is the equivalent of a § 401(k) plan, but

available to educators. – She has the university deduct the maximum annual

contribution in 2014 of $17,500. – In addition, because she is at least age 50, she has

the university deduct an additional $5,500 as a catch-up contribution.

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• Keogh (H.R. 10) plan - Dr. Sanchez also has a forensic consulting practice.– Since she is self-employed, she is able to establish

a Keogh plan.

– She makes contributions of 20% of her net earnings from the consulting practice, about $8,000 per year ($40,000 X 20%), to the plan.

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• IRA - Dr. Sanchez also contributes annually to a traditional IRA. – She would prefer a Roth IRA, but her AGI exceeds the

$129,000 phaseout limit. – Likewise, she cannot deduct her IRA contribution of

$5,500 (the maximum) because her AGI is above the limit. • Since she cannot deduct her contributions, her basis in the IRA is

equal to the amount of her contributions. – The $15,000 that Dr. Sanchez withdrew from her

traditional IRA is not subject to current taxation and does not reduce her basis for the IRA.

• This result occurs because Dr. Sanchez successfully recontributed the $15,000 to her IRA within 60 days.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 64

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

Vol 01 chapter 19 2015

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