Deferred Compensation

1. Deferred Compensation Rely on Concept Summaries, 19-2 through 19-4 in Text

2. Qualified Plans • Pension, profit-sharing, stock bonus and ESOPs, cash balance plans • Pensions are either defined benefit or defined contribution plans • Must not discriminate in favor of high-paid employees, must cover 21 year-olds and up after 1 year of service. • Vesting: cliff after 5 years, graded is 20% after 3 years and fully vested in 7 years.

3. Some Important Definitions • Defined Contribution Plan • Limited to lower of employee’s compensation or $46,000 2008 indexed • Includes profit sharing plan, money purchase plan, stock bonus plan, but max limits differ • Limited to lower of 25% employee’s compensation or $46,000 indexed • Defined Benefit Plan • Benefit payable is lesser of $195,000 or 100% of avg. of highest paid 3 years, up to $245,000; $10,000 de minimis floor: 2009 • Special rules where employee has worked <10 years • Must retire at 65 or later (staggered retirement ages)

4. 401(k) • Participant contributes, employer matches portion up to max; 100% vested; tax deferred contributions and earnings • Max tax break on $16,500 indexed (2009) • Max reduced $-4-$ by tax-sheltered annuities and SEPs • If excess exceeded, extra is taxable or may be distributed tax-free before 4/15 of following year. • 10% excise tax for excess contributions; possible loss of qualified status • Catch-up contributions of extra $5k for those over 50 • 403(b) similar to 401(k)

5. Savings Incentive Match Plan for Employees • So named, presumably, because tax legislators get punchy after working long hours during legislative session • EZ 401 (k) for Smalls • Less than 100 employees, receiving at least $5,000 over 3yr pd including this year may contribute up to $11,500/year, 2009; indexed w/ $2,500 catch-up provision • Employee contributes % of compensation; matching of 3% or direct contribution of 2%, • Employer deducts up to cost or 25% of compensation paid/accrued • Subject to IRA withdrawal rules, except if withdrawn early in first 2 years of employment, subject to 25% penalty instead of 10% penalty

6. Regular IRAs • Established by due date of return; Contributions: due date of return • Ltd: $5,000 (2008, indexed) or 100% combined compensation with $1,000 catch-up provision for those over 50. • Ltd: reduced by active participation in another plan, but nondeductible contributions can be made which increase (0) basis in IRA. Limitations begin at $85,000 MFJ • 10% Penalty for early withdrawal (before 59 ½) • Can be rolled over up to once yearly • 6% excise penalty on excess contributions

7. Keoghs • Established by end of tax year; Contributions: due date of return • Can be defined contribution: ltd. $49,000 ( 2009, indexed) or 100% earned income • Profit-sharing: ltd 25% of employee pay (20% if self-employed, after ½ SE) • Personal Service business: ltd to earned income • Defined benefit: Ltd: smaller of $195,000 indexed or 100% of average highest 3-yrs of compensation • Top-heavy: restrictive rules

8. Roth IRAs • Established by due date of return; Contributions: due date of return • Same limits and penalties, but no current tax break for contribution; after-tax contribution + earnings are tax-free if withdrawn timely • Withdraw after 59 ½, with 5 year holding period • High-income phase-out starts at $166,000 2009 MFJ

9. Coverdell IRAs • For education, but sometimes lumped with pensions because of the “IRA” title. • Max $2,000/year non-deductible contribution for qualified education expenses for minor: • Tuition, fees, books, supplies, equipment • Room, board if > ½ time • If withdrawn for non-qualified expenses, use annuity rule to figure return of capital. • Must be withdrawn or rolled over before beneficiary reaches 30 • AGI Phase-out of $190,000 MFJ, 2008

10. Simplified Employee Pension Plan • Useful because of extended set-up deadline (great for small, family-owned procrastinating clients!) • Employer contributes up to lesser of $49,000 (2009) indexed or 15% employee’s earned income to individual employee IRAs; For each eligible employee who is 21 or older and been employed 3 of last 5 years

11. Minimum Distribution Rules • Must begin April 1 in later of year employee is 70 ½ or retirement year, unless Roth (no required distribution date for Roth) • Minimum Required Distributions spread over IRS life expectancy • 10% penalty on early distribution (before 59 ½, unless due to death, disability, annuity, early retiree who is at least 55, medical expenses or medical insurance premiums, higher ed, first-time home buyers).

12. Tax on Distribution • Employee’s basis in annuity returned tax-free • Distributions can be rolled over within 60 days tax-free, but with 20% withholding • If taxpayer has basis (contributed after-tax $), use annuity calculation to determine amount of distribution excludable from tax • Special rules fro pre-1987 lump-sum distributions

13. 55. Louise terminated her employment and received a cash distribution from her qualified retirement plan in the amount of $120,000. She made a qualified rollover contribution of $100,000. If her marginal tax rate is 30%, and she is 45 years old, what is the total amount of taxes she must pay on the distribution? A) $ 6,000 B) $36,000 C) $ 8,000 D) $18,000

14. Annuity Example • Assume an employee invested $10,000 in an annuity that will begin paying $100/mo for the next 30 years. If the annuity begins paying April 1st of this year, how much is taxable? • [10,000/($100*30*12)]*(100*9) = Excludable amount • $250 of $900 received is excludable; the remaining $650 is includable

15. Annuity, # Payments Unknown • Assume an employee invested $10,000 in an annuity that will begin paying $100/mo for life. If the annuity begins paying April 1st of this year when the recipient turns 56, how much is taxable? • Look up the table, Sec. 72 (d)(3) • [10,000/($100*310)]*(100*9) = Excludable amount • $290.32 of $900 received is excludable; the remaining $609.68 is includable

16. 14. The taxpayer purchased a 10-year annuity for $96,000 late in 2005. The annuity will pay him $4,000 per month for ten years starting on September 1, 2005. How much of the $16,000 received this year will be taxable? A) $12,800 B) $16,000 C) $ 0 D) $3,200

17. Corporate Deductions for Defined Benefit Pensions • Aggregate Cost, + up to 10% past service costs, • w/ carryover • 10% excise tax on nondeductible contributions

18. Nonqualified Deferred Compensation Plans • …When your executives just don’t make enough… • As dependable as the company that is promising to pay you later • Employee taxed when payment is made, which is either: separation, disability, death, fixed schedule, change in employer control, unforeseeable emergency • May be in the form of “phantom stock options”

19. Golden Parachutes • Excess severance pay • Deductible to employer unless payment is contingent on change of ownership of corp AND amt of comp > 3x employee’s annual comp. • Disallowed amount subject to 20% excise tax

20. Excess Compensation Limit • Only first $1million deductible by publicly-traded corp. unless based on performance

21. Restricted Property Plans • Employer transfers property (e.g. stock) at bargain price contingent upon services performed. • Employee includes as gross income when substantial risk of forfeiture is removed, or if elected, earlier when restricted property is received

22. Stock Options • Right to purchase shares at stated price within stated time period. • Generally Incentive Stock options • Not included in $1million cap on top 5 executives *if* the options are disclosed, shareholder-approved, and not issued in money. • May also be employee stock purchase plan or nonqualified options or restricted property

23. Incentive Stock Options • At time of grant: no tax consequences to employee or grantor, because exercise price > FMV, however this difference is a tax preference item for AMT. • If option exercised, employee taxed later, when stock is sold, as ltcg. (Employee must hold option for >2 years; stock >1) • No deduction for employer • Ltd. To $100,000 ISO exercise per year per employee • If option lapses, capital loss to employee for amt pd, if any.

24. 3. In the current year, employee F is given an incentive stock option (ISO) entitling him to purchase 100 shares of his employer Sigma Corporation’s stock for $50 per share. He exercises the option in the following year when the shares are selling for $80 per share. If F sells these 100 shares four years later for $200 per share, he will recognize a. a long‑term capital gain of $120 per share. b. a long‑term capital gain of $150 per share. c. ordinary income of $30 per share and a long‑term capital gain of $120 per share. d. no income upon sale.

25. Non-Qualified Stock Options • FMV included in employees income at date of grant • That amount plus exercise price is basis against capital gain or loss at sale • Employer gets tax deduction equal to *ordinary* amount included in employee’s income.

26. Stock Appreciation Rights • Rights granted to an employee for appreciation in the value of share price, not actually stock itself. • Rights may be paid in cash and/or stock • No tax on grant date, but FMV of stock/cash taxes as ordinary income on exercise date • Employer takes equal amount as deduction

27. Rabbi Trusts, etc. • Rabbi trust: Irrevocable, unsecured, often unfunded, employer-established trust for nonqualified deferred compensation to highly-compensated employees • Corporate Owned Life Insurance (COLI): policies that grow tax-deferred and pay at death.