Lesson 5 of Retirement Benefits: Deferred Compensation and Employee Benefits Flashcards

Question 1

Q

Deferred Compensation and NonQualified Plans!!

Answer

A

Employers establish deferred compensation arrangements to provide benefits to a select group of employees without the limitations, restrictions, and rules of a qualified plan.

These types of arrangements, usually in the form of non-qualified plans or other executive compensation, often discriminate in favor of key employees and can exceed the dollar limits imposed on qualified plans.

The general characteristics of the deferred compensation arrangements are:

They do not have the tax advantages of qualified plans.
They usually involve some deferral of income to the executive.
The employer generally does not receive an income tax deduction until the key employee receives the payment and it becomes recognizable as taxable income, thus following the traditional income tax matching principle of deduction by one party only upon inclusion by another party.
There is generally a requirement that the employee/executive has a “substantial risk of forfeiture”, or else the government will claim that the executive, while perhaps not having actual receipt of the money, has “constructive receipt”of the money and, therefore, current income subject to income tax .

Question 2

Q

Deferred Compensation and NonQualified Plans!

Deferred compensation arrangements are most often used for one or all of the 3 following reasons:

Answer

A

To increase the executives wage replacement ratio,
To defer the executives compensation, or
In lieu of qualified plans.

Lieu = Replace

Question 3

Q

Deferred Compensation and NonQualified Plans!

Examples of deferred compensation arrangements:

Answer

A

Golden Handshakes - severance package often designed to encourage early retirement;
Golden Parachutes - substantial payments made to executives being terminated due to changes in corporate ownership; and
Golden Handcuffs - designed to keep the employee with the company.

Question 4

Q

Deferred Compensation and NonQualified Plans!

Wage Replacement Ratio

Answer

A

Executives who earn substantially more than the qualified plan covered compensation limit, $330,000 for 2023, cannot attain a significant wage component replacement ratio from qualified plans because qualified plans adhere to strict limits on either contributions (e.g., $66,000 per year in 2023 for defined contribution plans) or benefits (e.g., a defined benefit limit of $265,000 in 2023).

The purpose of deferred compensation is often to increase the executive’s wage replacement ratio to a level commensurate with the executive’s actual compensation instead of a wage replacement ratio limited by the qualified covered compensation limit and the other limits of qualified plans.

Question 5

Q

Deferred Compensation and NonQualified Plans!

IRC Section 409A

Answer

A

The purpose of this section is to provide clear structure and guidance for deferred compensation plans.

The new rules also enact harsh penalties for those plans that do not comply with Section 409A.

Plans failing to meet the requirements of this section are subject to acceleration of prior deferrals, interest, penalties, and a 20% additional tax on the amount of the deferrals.

These are serious ramifications for plans that fail to comply with the new rules.

Question 6

Q

Deferred Compensation and NonQualified Plans!

Deferred Executive Compensation

Answer

A

Deferred compensation arrangements may also be established simply to defer an executive’s
compensation to a future year. Such agreements must be made prior to the compensation being earned.

Deferred compensation arrangements usually create income tax benefits for both the executive and the employer.

Question 7

Q

Deferred Compensation and NonQualified Plans!

Deferred Executive Compensation - For Employee Tax Benefit and Employer Tax Benefit

Answer

A

Employee Tax Benefit:

If the executive chooses to defer the compensation, the executive generally defers thecompensation to a time when he expects to be in a lower marginal income tax bracket and thus, at the date of receipt, expects to pay less income tax on the compensation than would have been paid currently.

Employer Tax Benefit:

The IRC places a $1,000,000 limit on a public company’s deduction for compensation payable to any one of the top five executives of a publicly traded company.
If the executive elects to defer any income over the $1,000,000 limit to a year in which the executive earns less than the limit, the employer would be able to deduct the total compensation over the period of deferral and subsequent payment.

Question 8

Q

Deferred Compensation and NonQualified Plans!

Deferred Executive Compensation For Alternative to Qualified Plans

Answer

A

Deferred compensation plans are also used where the employer does not have a qualified plan because the employer does not desire to cover a broad group of employees.
The employer may nonetheless be compelled to provide retirement benefits to certain key executives and can accomplish this goal by using a deferred compensation plan.

Question 9

Q

Income Tax Issues (This is the BIG Issue with all Non-Qualified Plans)

Answer

A

For deferral of income tax to be realized, the deferred compensation plan must comply with certain income tax provIsions.

Question 10

Q

Income Tax Issues (This is the BIG Issue with all Non-Qualified Plans)

Constructive Receipt

Answer

A

Constructive receipt is an income tax concept that establishes when income is includable by a taxpayer and, therefore, subject to income tax.

Income, although not actually in a taxpayer’s possession, is nonetheless constructively received by the taxpayer in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given.

(The Taxpayer exercises “dominion & control” over the asset - even if it is not to receive it.)

Deferred compensation plans are structured so that employees benefiting under the plan will AVOID constructive receipt and will, therefore, be allowed the deferral of income taxation.

The following are some examples of what is NOT considered constructive receipt:

an unsecured promise to pay;
the benefits are subject to substantial limitations or restrictions; and
the triggering event is beyond the recipient’s control (i.e., company is acquired).

Question 11

Q

Income Tax Issues (This is the BIG Issue with all Non-Qualified Plans)

Substantial Risk of Forfeitures

Answer

A

Substantial risk of forfeiture is another income tax concept that relates to when income is subject to income tax.

A substantial risk of forfeiture exists when rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a condition related to a purpose of the transfer and the possibility of forfeiture is substantial if the condition is not satisfied.

As long as there is a substantial risk of forfeiture, the taxpayer is NOT required to include the income as taxable income.

Question 12

Q

Income Tax Issues (This is the BIG Issue with all Non-Qualified Plans)

Economic Benefit Doctrine

Answer

A

The economic benefit doctrine provides that an employee will be taxed on funds or property set aside for the employee if the funds or property are unrestricted and nonforfeitable,even if the employee was not given a choice to receive the income currently

Deferred compensation plans may provide for a trust to hold the funds for the employee prior to retirement or termination. To be subject to income tax, the funds simply have to be unrestricted and nonforfeitable, which could occur once the employee becomes partially or fully vested.

An exception to this rule can be achieved through use of a rabbi trust.

Question 13

Q

Income Tax Issues (This is the BIG Issue with all Non-Qualified Plans)

IRC Section 83: Property Transferred in Connection with Performance of Service

Answer

A

When an employer transfers property to an employee in connection with performance of service, the employee will be taxed on the difference between the FMV of the property and the amount paid for the property.

Generally, the gain or difference between the FMV of the property and any amounts paid by the employee will be taxed as ordinary income to the employee.

These rules are typically applicable to:

grants of stock,
especially restricted stock, and
employee stock options
but can also be applied to other transfers of property to an employee.

Question 14

Q

Income Tax Issues (This is the BIG Issue with all Non-Qualified Plans)

Payroll Tax

Answer

A

Deferred compensation is considered to be earned income at the time it is earned or at the time a substantial risk of forfeitures expires (for restricted stock) and, therefore, is subject to payroll taxes at that time even though the employee may not receive payment until sometime in the future.

When the income is later paid to the executive, it will be subject to income tax. The payments will not constitute “earned income” in the period received and, therefore, will not be subject to payroll taxes and will not qualify for the earned income test for IRAs and other qualified plans.

Question 15

Q

Income Tax Issues (This is the BIG Issue with all Non-Qualified Plans)

Employer Income Tax Deduction

Answer

A

In deferred compensation plans, the employer is entitled to receive an income tax deduction for contributions to the plan ONLY when the employee is required to include the payments as taxable income (Matching Principle).

Question 16

Q

Funding Arrangements and Types of Nonqualified Deferred Compensation Plans

Answer

A

A Non-Qualified Deferred Compensation (NQDC) plan

is a contractual arrangement between an employer and an executive whereby the employer promises to pay the executive a predetermined amount of money sometime in the future.

Question 17

Q

Funding Arrangements and Types of Nonqualified Deferred Compensation Plans

advantages of deferred compensation plans to the employer are:

Answer

A

(1) cash outflows are often deferred until the future,
(2) the employer will save on payroll taxes except for the 1.45 percent Medicare match (since the employee’s income is probably over the Social Security wage base), and
(3) the employer can discriminate and provide these benefits exclusively to a select group of key employees.

Question 18

Q

Funding Arrangements and Types of Nonqualified Deferred Compensation Plans

Unfunded Promise to Pay

Answer

A

This type of arrangement will meet the standards of a substantial risk of forfeiture and will, therefore, meet the objective of tax deferral.

The employee, however, is at some risk of not being paid.

Question 19

Q

Funding Arrangements and Types of Nonqualified Deferred Compensation Plans

Secular Trust

Answer

A

Secular trusts are irrevocable trusts designed to hold funds and assets for the purpose of paying benefits under a non-qualified deferred compensation arrangement.
Since a secular trust eliminates the substantial risk of forfeiture with regards to the assets being secure, the employee is at risk of immediate taxation to the employee. This tax consequence is the cost of eliminating the risk that the funds will not be paid in the future.
Assets placed into secular trusts are often subject to some other substantial risk of forfeiture, like a vesting schedule or term of employment requirement to prevent immediate taxation.

Question 20

Q

Funding Arrangements and Types of Nonqualified Deferred Compensation Plans

Rabbi Trust

Answer

A

Rabbi trusts strike a good balance between the risk of an unfunded promise to pay and the lack of that risk of forfeiture in a secular trust.

While the assets in a rabbi trust are for the sole purpose of providing benefits to employees and may not be accessed by the employer, they may be seized and used for the purpose of paying general creditors in the event of the liquidation of the company.

Even though assets are set aside in a trust, rabbi trusts are treated as unfunded (also can be informally funded) due to the presence of a substantial risk of forfeiture.

Question 21

Q

Exam QUestion - Rabbi Trusts

Which of the following statements concerning raboi trusts is (are) correct?

a) A rabbi trust is a trust established and sometimes funded by the employer that is subject to the claims of the employer’s creditors, but any funds in the trust cannot generally be
used by or revert back to the employer.

b) A rabbi trust calls for an irrevocable contribution from the employer to finance promises under a non-qualified plan, and funds held within the trust cannot be reached by
the employer’s creditors.

c) A rabbi trust can only be established by a religious organization.

d) All of the above are correct.

Answer

A

Answer: A

Only Option A is correct as it describes a rabbi trust. Option B describes a secular trust.

Option C is a false statement.

Question 22

Q

Funding Arrangements and Types of Nonqualified Deferred Compensation Plans

Chart of Characteristics of Alternative Deferred Compensation Arrangements

Exam Tip: Know Table

Question 23

Q

Funding Arrangements and Types of Nonqualified Deferred Compensation Plans

Funding with Insurance

Answer

A

For NQDC plans that have funds set aside to pay obligations under the plan, the employer will be responsible for paying income tax attributable to earnings on assets held in the plan.

As assets accumulate for executives and remain “at risk”, earnings will be subject to taxation by the employer.

Ultimately the employer will receive an income tax deduction when the funds are distributed to the executives, however, employers will often use insurance products because the surrender value is not taxed if payments are not made from the policy.

Question 24

Q

Funding Arrangements and Types of Nonqualified Deferred Compensation Plans

Phantom Stock Plans

Answer

A

A phantom stock plan is a non-qualitied deferred compensation arrangement where the **employer grants fictional shares of stock to a key employee that is initially valued at the time of the grant. **

The stock is later valued at some terminal point (usually at termination or retirement), and the executive is then paid the differential value of the stock in cash. (No stock actually changes hands.)

Question 25

Q

Funding Arrangements and Types of Nonqualified Deferred Compensation Plans

Types and Applications of NQDC Plans

Answer

A

There are several types of non-qualified deferred compensation plans that can be established to benefit key executives.

1) Salary reduction plans allow employees to elect to reduce their current salary and defer it until future years, generally until retirement or termination.

2) Salary continuation plans typically provide benefits after retirement on an ongoing basis or for a predetermined period of time.

Supplemental Executive Retirement Plans (generally referred to as SERPs) are non-qualified deferred compensation arrangements designed to provide additional benefits to an executive during retirement.

These plans are also referred to as top-hat plans because they are designed to benefit a select group of top management or key employees.
Excess-benetit plans are a type of SERP that is designed solely to provide benefits in excess of the benefits available in qualified plans.
Salary-reduction plans are common with professional athletes. A large signing bonus a part thereof, is frenuently transferred to an escrow agent to deter the receipt of taxable income until such time as the athlete is beyond his/her peak earning period, thereby helping to assure the athletes future financial security.

Question 26

Q

Funding Arrangements and Types of Nonqualified Deferred Compensation Plans

401(k) Wrap Plan

Answer

A

401(k) wrap plans are a form of salary reduction plan that enables executives who are subject to salary deferral limitations due to the nondiscrimination rules to contribute higher amounts than otherwise permitted under a 401(k) plan.

Question 27

Q

Funding Arrangements and Types of Nonqualified Deferred Compensation Plans

The following chart summarizes the concepts behind non-qualified deferred compensation.

Question 28

Q

Exam Question - Deferred Compensation

Which of the following statements concerning tax considerations of non-qualified retirement plans is (are) correct?

Under IRS regulations an amount becomes currently taxable to an executive even before it is actually received if it has been “constructively received.”
Distributions from non-qualified retirement plans are generally subject to payroll taxes.

a) 1 only.
b) 2 only.
c) 1 and 2.
d) Neither 1 nor 2.

Answer

A

Answer: A.

Statement 2 is incorrect because payroll taxes are due on deferred compensation at the time the compensation is earned and deferred, not at the date of distribution.

Question 29

Q

Employer Stock Options and Stock Plans

Stock Options

Answer

A

An employee stock option gives employee a right to buy stock at a specified price for a specified period of time.

Stock options are usually granted to select employees for the purchase of stock of the employer or a subsidiary.

The option agreement must be in writing, and
the option holder has no obligation to exercise
the option.
The terms of the option agreement must be stated (e.g., 10 years) in the agreement

Question 30

Q

Employer Stock Options and Stock Plans

Stock Options for Options Price

Answer

A

Generally, the option price (exercise price) is equal to the FMV at the grant date (the date or issuance).

If the option does not have a readily ascertainable FMV at the grant date, there is no taxable income to the option holder as of the grant date.

If values were available and the value was ascertainable, it would be taxable income to the recipient.

An option is a form of deferred compensation if the price of the stock increases.

If the stock price declines, the option holder will simply allow the option to lapse.

It is important to note that options granted at FMV are NOT subject to the rules under IRC Section 409A.

Options issued at a discount from FMV, however, are subject to IRC Section 409A and its harsh tax results.

Question 31

Q

Employer Stock Options and Stock Plans

Stock Options for Vesting

Answer

A

Generally, stock options vest over time, thus continuing to provide an incentive to the executive who is receiving the option to remain with the employer and to be productive.

Question 32

Q

Employer Stock Options and Stock Plans

Stock Options for Types of Options

Answer

A

There are two standard types of employer stock options:

Incentive Stock Options (ISOs) and
Non-Qualified Stock Options (NQSOs).

Question 33

Q

Employer Stock Options and Stock Plans

Incentive Stock Options (ISOs)

Answer

A

An incentive stock option (ISO) is a right given to an employee to purchase an employer’s common stock at a stated exercise price.

If the requirements of IRC Section 422 are met when the incentive stock option is granted (provided the exercise price is equal to the FMV of the stock), the employee will not recognize any taxable income at the date of grant.

Further, at the date of exercise, the employee will also not be subject to ordinary income tax on the difference between the FMV of the stock and the exercise price (bargain element).

HOWEVER, this difference (the bargain element) is a positive adjustment for the Alternative
Minimum Tax (AMT) calculation.

When the employee sells the stock subsequent to the exercise, the difference between the sales price of the stock and the original exercise price is considered long term capital gain (assuming the holding period requirements are met), and there is a negative adjustment for the alternative minimum tax calculation.

To obtain this preferred tax treatment the requirements below must be met:

In addition, a strict dual holding period must be met.
A qualified sale requires waiting until 2 years from the date stock was granted and 1 year from the date the stock was exercised.
Sales prior to either holding period being met
are disqualified dispositions and terminate most of the tax benefits.
it effectively triggers similar treatment as a NQSO.

Question 34

Q

Exam Tip

Answer

A

Must know the holding periods and retirements.

Question 35

Q

Employer Stock Options and Stock Plans

Requirements for Incentive Stock Options (ISO)

Exam Tip: Item #8 above it tested occasionally and item #9 above is tested often.

Question 36

Q

Employer Stock Options and Stock Plans

Following Graphic Illustrates how an ISO Works

On January 5, 20x0, Phil, vice president of ABC Corporation, is granted 10,000 ISOs at an exercise price of $10. On February 6, 20x1, he exercises all of the options when the price of XYZ
stock is $42. Phil subsequently sells the stock at $60 on February 14, 20x2. What are his tax consequences?

Answer

A

At the date of exercise, Phil has no W-2 income, or ordinary income, but does have an AMT adjustment of $320,000 ($420,000 - $100,000) which may cause Phil to pay AMT. For regular
tax, he has an adjustable basis of $100,000.

When he subsequently sells the stock for $600,000, he has a long-term capital gain of $500,000 subject to a capital gains rate of 15% and a negative AMT adjustment equal to $320,000.

Question 37

Q

Exam Question - ISOs

Tori receives ISOs with an exercise price equal to the FMV at the date of the grant of $22. Tori
exercises these options 3 years from the date of the grant when the FMV of the stock is $30. Tori
then sells the stock 3 years after exercising for $35. Which of the following statements is (are)
true?

At the date of grant, Tori will have ordinary income equal to $22.
At the date of exercise, Tori will have W-2 income of $8.
At the date of sale, Tori will have long-term capital gain of $13.
Tori’s employer will not have a tax deduction related to the grant, exercise or sale of this
ISO by Tori.

a) 3 only.
b) 3 and 4
c) 2, 3, and 4
d) 1, 2, and 4

Answer

A

Answer: B

Statements 3 and 4 are correct. Since Tori held the underlying security 2 years from grant and
one year from exercise before its sale, Tori will receive long-term capital gain treatment for the
appreciation, and her employer will not have a deductible expense related to the ISO.

Question 38

Q

Employer Stock Options and Stock Plans

Incentice Stock Options - Disqualifying Disposition

Answer

A

If stock acquired after exercising an ISO is disposed of before either two years from the date of the grant or one year from the date of exercise, the sale is known as a disqualifying disposition and some of the favorable tax treatment is lost (see above).

For such a sale, any gain on the sale of the stock attributable to the difference between the exercise price and the fair market value at the date of exercise will be considered ordinary
income, but it will not be subject to payroll tax or federal income tax withholding.

Any gain in excess of the difference between the exercise price and the FMV at the date of exercise will be short- or long-term capital gain considering the executive’s holding period.

Question 39

Q

Example of Disqualifying Disposition

Question 40

Q

Employer Stock Options and Stock Plans

Incentice Stock Options - Cashless Exercise (Disqualifying Disposition, too)

Answer

A

At the time of a cashless exercise, a third-party lender lends the executive the cash needed to exercise the option and the lender is immediately** repaid with the proceeds of the almost simultaneous sale of the stock.**

A cashless exercise of incentive stock options automatically triggers at least a partial disqualifying disposition since the holding period requirements will not be met.

Question 41

Q

Example Cashless Exercise (Disqualifying Disposition, too)

Answer

A

Jo, an executive, has 10,000 ISOs with a $8 exercise price. When the value of the stock
increases to $32, the stock has a total value of $320,000. If Jo exercised today, she would need
$80,000 to exercise the option (ignoring any potential AMT consequence) Like many individu-
als, Jo does not have the $80,000 cash available to exercise the option. Therefore, Jo makes a
cashless exercise of the option and receives $240,000 (the proceeds from the sale of the stock less the exercise price of $80,000 In reality, the proceeds Jo actually receives will be reduced
for withholding taxes.

Since the sale of the stock did not meet the holding period requirements of an ISO, $240,000
will be subjected to ordinary income tax

Question 42

Q

Exam Question - ISOs

On January 1, 20x0, Ralph was awarded 15,000 ISOs at an exercise price of $3 per share when
the fair market value of the stock was equal to $3. On April 17, 20x1, Ralph exercised all of his
ISOs when the fair market value of the stock was $5 per share. At the date of exercise, what are
the tax consequences to Ralph?

a) $0 W-2 income, $30,000 AMT adjustment.
b) $0 W-2 income, $75,000 AMT adjustment.
c) $30,000 ordinary income, $30,000 AMT adjustment.
d) $75,000 ordinary income, $0 AMT adjustment.

Answer

A

Answer A

When an ISO is exercised, the appreciation in excess of the exercise price is an AMT adjust-
ment. In this case, Ralph would have an AMT adjustment equal to $30,000 (15,000 x $2 appre-
ciation).

Regular Income Tax:
Recognition = $0
Exercise Price =$3
Adjusted Basis: $3

AMT:
Recognition: $8
Exercise Price: $3
Adjusted Basis: $5

AMT = (5-3) x 15,000

Question 43

Q

Employer Stock Options and Stock Plans

Non-Qualified Stock Options

Answer

A

An NQSO is an option that does not meet the requirements of an incentive stock option or is it explictly identified as non-qualified.

Basically it is a bonus program - additional compensation, nothing more.

As such, the exercise of NQSOs do not receive favorable capital gains treatment, but also are not subject to the holding period associated with ISOs.

From a risk perspective, the executive takes no risk in an NQSO. If the stock price falls below the exercise price l’ve exccutive simply does not exercise. If the stock appreciates, the executive may stock,

Question 44

Q

Employer Stock Options and Stock Plans

Non-Qualified Stock Options: Taxation - For Grant Date

Answer

A

The grant of an NQSO will not create a taxable effect assuming that there is no readily ascertainable value for the NQSO.

If, however, the option does have a readily ascertainable value at the date of grant, the
income will otherwise have W-2 income equal to the value and the employer will have a income tax deduction.

Question 45

Q

Employer Stock Options and Stock Plans

Non-Qualified Stock Options: Taxation - Exercise of the NQSO

Answer

A

At the exercise date of the NQSO, the executive will deliver to the employer both the option and the exercise price per share.

The executive will recognize W-2 income for the appreciation of the fair market value of the stock over the exercise price (often referred to as the bargain element), income and payroll tax withholding will apply, and the employer will have an income tax deduction for the same amount.

The amount paid for the stock at exercise plus the bargain element included in the executive’s W-2 will form the basis for the stock.

Question 46

Q

Employer Stock Options and Stock Plans

Non-Qualified Stock Options: Taxation - Sale of the Stock from the NQSO Exercise

Answer

A

Stock acquired through the exercise of an NQSO does not have a specified holding period requirement.

When the stock is sold, the executive’s gain or loss will be considered capital gain or loss and will receive short or long-term capital gain treatment according to the elapsed time between the date of the sale and the exercise date.

Question 47

Q

Example of Sale of Stock From the NQSO Exercise

Answer

A

On January 2, 20x0 (the grant date), Scott, an executive with Amco Corporation, is issued one
non-qualified stock option from Amco with an exercise price of $10 (the current market price).

On January 3, 20x1, Scott exercises his option when the Amco stock price is $35. Scott brings
the option and $10 to Amco. Amco issues the stock and Scott recognizes $25 in W-2 income
from Amco. Scott’s new basis in the stock is $35.

He later sells the stock, on March 4, 20x1 for
$50, which creates a short-term capital gain of $15. If instead, Scott had sold the stock on or
after January 4, 20x2, the gain would be long term.

Regular Income Tax:
Recognition = $25
Exercise Price =$10
Adjusted Basis: $35

AMT:
Recognition: $45
Exercise Price: $10
Adjusted Basis: $35

Regular Income Tax:
Sales Price = $50
Adjusted Basis =$35
Gain(ST): $15

AMT:
Sales price: $50
Adjusted Basis: $35
Amount Gain: $15

Question 48

Q

Exam Question - NQSOs

Bailey received NQSOs with an exercise price equal to the FMV at the date of the grant of $22. Bailey exercises the options 3 years after the grant date when the FMV of the stock was $30. Bailey then sells the stock 3 years after exercising for $35. Which of the following statements is
(are) true?

At the date of the grant, Bailey will have ordinary income of $22.
At the date of exercise, Bailey will have W-2 income of $8.
At the date of sale, Bailey will have long-term capital gain of $5.
Bailey’s employer will have a deductible expense in relation to this option of $22.

a) 3 only.
b) 2 and 3.
C) 2, 3, and 4.
d) 1,2, 3, and 4.

Answer

A

Statements 2 and 3 are correct. Bailey would not have any taxable income at the date of grant
provided the exercise price is equal to the fair market value of the stock, Bailey’s employer
Would receive a tax deduction equal to the amount of W-2 income. (Option 4)

Bailey would be required to recognize $8 of W-2 income-at the date of exercise. Bailey’s long-term capital gain is $5, calculated as the sales price of $35 less the exercise price of $30.

Question 49

Q

Exam Question - NQSOs

Meredith was granted 100 NQSOs on January 12, 20x0. At the time of the option grant, the value of the underlying stock was $100, and the exercise price was equal to $100. If Meredith exercises the options on August 22, 20x4 when the stock is valued at $145, what are the tax consequences (per share) to Meredith?

a) $45 of W-2 income, $100 of short-term capital gain per share.

b) $100 of W-2 income, $45 of short-term capital gain per share.

C) $145 of W-2 income per share.

d) $45 of W-2 income per share.

Answer

A

Answer: D

At the exercise date of an NOSO, the individual will have to buy the stock at the exercise price
and will have W-2 income for the appreciation of the stock value in excess of the exercise price.
In this case, Meredith will have $45 ($145-$100) of W-2 income. There is no other gain or loss
at exercise.

Question 50

Q

Employer Stock Options and Stock Plans

Non-Qualified Stock Options: Gifting of ISOs and NQSOs:

Answer

A

Lifetime transfers of unexercised ISOs by the employee are not permitted.

The requirement to obtain long-term capital gain treatment for the stock received upon
exercise is that the stock must be transferred only after the holding period requirement.

An NQSO can be gifted** provided the NQSO plan permits transfer of ownership.** There are no immediate income tax consequences on the transfer.

Upon exercise of the NQSO by the donee, the employee will have W-2 income for the difference between the exercise price and the fair market value on the date of exercise. The donee’s basis after the exercise will be equal to the fair market value on the date of exercise (exercise price plus employee’s tax recognition).
If the employee also pays the exercise price, it is an additional gift to the donee. Any gift of a NQSO that is neither vested nor exercisable is an incomplete gift.

Question 51

Q

Employer Stock Options and Stock Plans

Non-Qualified Stock Options: The following chart summarizes the concepts related to ISOs and NQSOs.

EXAM TIP: Know this Chart! Almost Guanranteed to be Tested!

Question 52

Q

Employer Stock Options and Stock Plans

Stock Appreciation Rights:

Answer

A

Stock Appreciation Rights (SARs) are rights that grant to the holder cash in an amount equal to the excess of the FMV of the stock over the exercise price.

The SAR is essentially a way to achieve a “cashless exercise.”

Payments received for the stock appreciation rights are includable in gross income in the year the rights are exercised.

Generally, SARs are granted with NQSOs or ISOs and may be used to provide cash to the executive, which is necessary to exercise the NQSO or ISO. Usually, the number of NOSOs or ISOs is reduced by any exercised SARs.

Question 53

Q

Employer Stock Options and Stock Plans

Restricted Stock Plans:

Answer

A

The plan pays executives with shares of the employer’s stock. The executive does not pay any amount towards the allocation of the stock and is restricted by the employer from selling or transferring the stock.

The restriction most often gives the employer the ability to repurchase the stock during a set period of years or prohibits the executive from selling the stock during a set number of years or until a defined occurrence or event (e.g., the executive attains 10 years of service with the company).

At receipt of the restricted stock, the executive will generally not recognize any taxable income (see Section 83(b) discussion below) as the restrictions generally create a substantial risk of forfeiture. In addition, the employer will not have a deductible expense.

When this substantial risk of forfeiture is eliminated, however, the executive recognizes W-2 income equal to the value of the stock at that date, and the employer will have a tax deductible expense for an equal amount. The amount recognized by the executive becomes the **executive’s adjusted basis in the stock **for purposes of any subsequent gain or loss calculation.

Question 54

Q

Employer Stock Options and Stock Plans

Restricted Stock Plans: The Section 83(b) Election

Answer

A

If property is transferred in connection with the performance of services, the person performing
such services may elect to include in gross income under IRC Section 83(b) the excess (if any) of the fair market value of the property at the time of transfer over the amount (if any) paid for such property as compensation for services.

In computing the gain or loss from the subsequent sale or exchange of such property, its basis shall be the amount paid for the property increased by the amount included in gross income under
Section 83(b). Its holding period shall be determined based upon the date the value was included in
gross income.

If property for which a Section 83(b) election is in effect is forfeited while substantially nonvested, such forfeiture shall be treated as a sale or exchange upon which there is realized a loss equal to the excess (if any) of the amount paid (if any) for such property over the amount realized (if any) upon such forfeiture

Question 55

Q

Employer Stock Options and Stock Plans

Restricted Stock Plans: Employee Stock Purchase Plans (ESPP)

Answer

A

Intended to benefit all or a large portion of an employer’s employees (the plan cannot be discriminatory), an employee stock purchase plan (ESPP) gives employees an incentive to buy
employer stock by allowing the employees to purchase the stock at a discounted price and receive favorable tax treatment for any gains if the stock meets certain holding period requirements.

The employee is able to purchase the employer stock through the ESPP for a price equal to no less than 85% of a date-determined stock price or an average stock price.

Employee Dollar Limit:

An employee is statutorily limited to purchasing $25,000 of employer stock per year as determined based on the fair market value at the date of grant of the employer stock through the ESPP.

Qualifying Disposition:

If the employee holds the stock purchased through the ESPP for two years from the date of grant
and one year from the date of exercise, any subsequent sale is a qualifying disposition of the stock.
The employee’s gain on the sale of the stock will be ordinary income to the extent the gain is attributable to the discount at the date of purchase. Any gain in excess of the ordinary income portion will be long-term capital gain.

Disqualifying Disposition:

If an employee does not hold the stock purchased through the ESPP for at least two years from the date of grant and one year from the exercise date, any sale is a disqualifying disposition.
The primary difference as compared to a qualifying disposition is that the gain attributable to the
discount will be W-2 income rather than ordinary income.

Loss:

If the employee sells the stock purchased through the ESP at a price less than the exercise price, the employee will have a short-or long-term capital loss as determined based upon the holding period beginning at the date of exercise and the difference between the exercise price and the sals

Question 56

Q

Example 1

Answer

A

Scrubs Company has an ESPP and its stock traded on June 30, 20x0 for $30 and July 31, 20x0
for $25.

Christina had elected to defer after-tax income to the ESP and purchased 400 shares of the stock at 85% of the lower of the two values. Christina purchased 400 shares of the Scrubs Company stock for $8,500 ($21.25 x400 shares).

Six months later, Christina sold the 400 shares at $27 per share.

Since Christina did not hold the stock for the required holding period, Christina will have W-2 income at the date of sale of $1,500 ($25.00 - $21.25) x400] and a short-term capital gain of $800 [($27.00 - $25.00) x 4001.

Because you did not meet the holding requirements it is (21.25 x 400) and not 25 x 400.

Question 57

Q

Example 2

Answer

A

Because you met holding requirement it is (25/12) to get the how many shares.

Question 58

Q

Employee Benefits: Fringe Benefits!
(Hot Topic - “recognition” of rules crucial!)

Important Numbers 2023

Question 59

Q

Fringe Benefits Defined

Answer

A

A “fringe benefit” is a form of compensation where a benefit, other than customary taxable wages, is provided by the employer to the employee for the performance of services. Used effectively, it’s a way to increase employee total compensation without raising (or minimally raising) employee taxable income.

Broadly, fringe benefits include paid vacation, sick leave, family leave, health insurance, life insurance, pension plans, profit sharing plans, the use of recreational facilities, personal use of employer’s property, holidays, parking, prizes and awards, discounted products and services, and many others.

Question 60

Q

Fringe Benefits Defined

Taxation of Fringe Benefits

Answer

A

Under IRS Treasury Regulations, all fringe benefits provided to an employee are taxable as WAGES UNLESS a specific provision of the IRC excludes the benefit from taxation OR unless the employee pays fair value for the fringe benefit.

The value of a fringe benefit provided to an employee is deductible as compensation expense by the employer unless the fringe benefit is excludable from the employee’s taxable income.

The 2017 TCJA eliminated the ability to deduct costs associated with many fringe benefits.

Question 61

Q

Fringe Benefits Defined

Nondiscrimination of Fringe Benefits

Answer

A

Nondiscrimination is an issue with some fringe benefits. Ensuring that the employer does not discriminate against different classes of employees is vital.

If the fringe benefit is deemed discriminatory, then the exclusion may be lost. This will result in the** value of the fringe benefit being added to an employee’s income.**

As discussed below, some fringe benefits have nondiscrimination requirements while others do not.

Question 62

Q

Fringe Benefits Defined

2017 TCJA Changes:

Answer

A

No deduction is allowed with respect to:

An activity generally considered to be entertainment, amusement or recreation.
Membership dues to any club organized for business, pleasure, recreation, or other social purpose, or
A facility or portion there of used in connection with any of the above items.
Effective after 2017.

No ER deduction for any qualified transportation fringe. Except as necessary for ensuring the safety of an employee, no deduction for expenses for commuting between an employee’s residence and the placec of employment. Effective after 2017.

Taxpayers (Business owner / Employer) may still deduct 50% of food and beverage expenses associated with operating a trade or business (travel meals). The law expands the 50% limitation to meals provided for the convenience of the employer. These rules are effective after 2017 through 2025.

Taxpayer Certainty and Disaster Tax Relief Act of 2020 created an exception to the 50% deduction limit for food and beverage provided by a restaurant. Such meals will be fully deductible when paid or incurred after December 21, 2020 and before January 1, 2023. Other rules for deduction meals remain unchanged (no lavish or extravagant meals, etc.)

Question 63

Q

Fringe Benefits Defined

Summary of Available Fringe Benefits

Question 64

Q

Specific Fringe Benefits

Answer

A

Meals and Lodging Provided by the Employer to the Employee
Athletic Facilities Furnished by the Employer
Educational Assistance Programs
Dependent Care Assistance
“No-Additional-Cost Services”
Qualified Employee Discounts
Working Condition Fringe Benefits
“De Minimis” Fringe Benefits
Qualified Moving Expense Reimbursement
Qualified Transportation and Parking
Adoption Assitance Programs
Awards and Prizes
Qualified Tuition Reduction Plans

Answer 58

A

In general, an employee may exclude from gross income the value of all meals provided in-kind (not as cash reimbursement) to him, his spouse, or any of his dependents as long as the meals meet both of the following conditions:

The meals are furnished for the convenience of the employer, and
The meals are furnished on the employer’s business premises.

Meals for the convenience of the employer are now limited to a 50% deduction for years after 2017 through 2025 based on TCJA 2017. (See Taxpayer Certainty and Disaster Tax Relief Act above)

The Following CHART Gives examples of Meals deemed furnished for the convenience of the employer.

Answer 59

A

Exception! - The IRS also provides specific examples as to what is not considered “for the convenience of the employer.”

Answer 60

A

The IRC provides an exclusion from an employee’s gross income for the value of lodging furnished by an employer to an employee if ALL three of the following qualifications are met:

The lodging is furnished on the employer’s business premises;
The lodging is furnished for the convenience of the employer; and
The employee is required to accept the lodging as a condition of employment.

Includable Lodging - Exception!

If the lodging is not furnished on the business premises of the employer, or the lodging is not furnished for the convenience of the employer, or the employee is not required to accept the lodging as a condition of the employment, then the employee must include the value of the lodging in gross income irrespective of whether the value exceeds or is less than the amount charged.

Answer 61

A

The value of any “on premises athletic facility” provided by an employer to an employee is not included in the employee’s gross income. To be considered an “on premises athletic facility,” it MUST meet the requirements listed below and may include a gym or other athletic facility including a tennis court, pool, or golf course.

Operated by the employer;
Located on premises owned or leased by the employer; and
“Substantially all” of the use of the facility is by employees of the employer, their spouses or, their dependent children.

Answer 62

A

Jake works at XYZ Advertising in a high-rise building in downtown Topeka, Kansas. Adjacent
to the main office, XYZ rents out a gym from the building management. Under these circum stances, as long as the general public does not use the gym, the XYZ employees may exclude the
value of the use of the on-premises gym from their gross income.

However, if the high-rise building was a resort for residential use, then the value of the use of the athletic facility would need to be included in each employee’s gross income.

Answer 63

A

The value of an educational assistance program provided by an employer for the benefit of an employee is excluded from the employee’s gross income subject to certain limitations and requirements.

To be considered qualified, the plan must be a separately written document which provides employees with educational assistance. The program need** not be funded, nor must the employer apply to the IRS for a determination of whether the plan is qualified**.

The gross income exclusion for educational assistance is limited to the value of $5,250.

“Educational assistance” includes:

Expenses incurred by an employee for education including books, or
the employer’s provision of education to an employee.
Education loan repayments made by the employer to employee (or lender).
CARES Act 2019 allows employee exclusion from income subject to the $5,250 limit. Taxpayer Certainty and Disaster Relief Act of 2020 extended the loan repayment exclusion made before January 1, 2026.

Answer 64

A

the employer’s payment for tools or supplies, other than textbooks, that the employee may retain;
the employer’s payment for meals, lodging, or transportation; or
the employer’s payment for education involving sports, games, or hobbies, unless the education involves the employer’s business or is a required part of a degree program.

Nondiscrimination requirements apply - The IRC prohibits discrimination in the provision of the
educational assistance program. If the program discriminates in favor of officers, shareholders, self-employed, or highly compensated employees, then the exclusion from gross income is lost.

Answer 65

A

The IRC allows an employee to exclude the value of dependent care assistance (as defined below) provided by an employer from the employee’s gross income. (This is not an FSA item!)

Dependent care assistance applies to household and dependent care services paid for or provided by the employer to an employee under a dependent care assistance program.

The services must be provided under the following conditions:

dependent children under 13 years of age;
dependent children who are physically or mentally incapable of caring for themselves; or
an employee’s spouse if the spouse is physically or mentally incapable of caring for herself.

The services must also allow an employee to work.

An employee may exclude up to the lesser of:

$5,000 annually ($2,500 for married couples filing separate returns) in benefits received
through a dependent care assistance program from her gross income, OR
the earned income of the employee or her spouse.

The plan must provide beneficiaries with advance notice of the program to permit them to make informed decisions about dependent care.

Non-discrimination requirements apply to the dependent care assistance exclusion!!

Answer 66

A

The exclusion for “no-additional-cost services” applies to ANY service provided by an employer to an employee that does not cause the employer to incur any substantial additional cost or lose revenue.

The service provided must be offered to customers in the ordinary course of business in which the employee performs substantial services.

Examples: of no-additional-cost services include providing free airline, bus, or train tickets, and hotel accommodations or telephone services either tree or at reduced prices to employees working in those lines of business.

Caution: Foregone revenue or substantial costs associated with providing these services could deem them taxable. For example, whether the no-additional-cost exclusion would be available to for an airline employee may depend on whether they fly “stand-by’ or reserve. If the airline had to forego revenue to provide the fringe benefit it will not be excludable.

Nondiscrimination requirements apply!

Employers may not exclude the value of the services to highly compensated employees if the value of the no-additional-cost service is not available, on the same terms, to most emplovees

Answer 67

A

The value of “qualified employee discounts” on property or services offered to an employer’s customers in the ordinary course of the employer’s business may be excluded from an employee’s income (subject to certain limits).

The exclusion for an employee discount is limited to the lesser of:

20% of the price at which the SERVICE is offered to non-employee customers, or
for MERCHANDISE or other property, the employer’s gross profit percentage multiplied by the price the employer charges non-employee customers for the property.

Nondiscrimination rules apply to the exclusion for qualified employee discounts.

Answer 68

A

Eric’s Parts Depot sells radiators for $100 to its customers. The radiator cost Eric’s $80. If Eric’s
allows its employees to purchase the radiator for $90, the employee can exclude the $10 discount from his gross income. If, however, Eric’s sold the radiator to the employee at $75 then
the employee would be required to include $5 in his gross income. The maximum excludable
discount in this situation is $20 (20% x$100).

Gross Profit Percentage:
($100 - $80) = $20 / $100 = 20%

20% x $100 = $20

Answer 69

A

The value of “working condition fringe benefits” provided by an employer are excluded from an employee’s gross income.

Working condition fringes are defined as any property or service provided to an employee that enables the employee to perform his work and, if paid for by the employee, would be deductible as a trade or business expense.

It may even include cash reimbursement for such items purchased by the employee.

Not subject to nondiscrimination rules!

Example: A common working condition fringe benefit is the provision of a company car. If the employee utilizes the car for both personal and business purposes, the portion used for business is considered the value of the working condition fringe benefit, whereas the personal use value of the car will be included in the employee’s gross income.

Answer 70

A

If an employee is provided a vehicle that is deemed to be a qualified non-personal use vehicle, the value of the provision will be excluded from his gross income. Qualified non-personal use vehicles may include:

Clearly marked police and fire vehicles;
Unmarked vehicles utilized by law enforcement individuals if the use is officially authorized;
An ambulance or hearse;
Any vehicle designed to carry cargo with a loaded gross weight over 14,000 pounds;
Delivery trucks with seating for the driver only or the driver with a folding jump seat;
A passenger bus with the capacity of at least 20 passengers;
School buses; and
Tractors or other farm-type vehicles.

Answer 71

A

The term “de minimis” fringe benefit is any property or service provided by an employer to an employee that is so small in value that it makes accounting for it unreasonable or administratively impracticable.

Examples of some de minimis fringe benefits:

Occasional typing of personal letters by a secretary hired by an employer;
Occasional personal use of an employer’s copying machine, providing that the employer exercises sufficient control and imposes significant restrictions on the personal use of the machine so that at least 85% of the use of the machine is for business purposes;
Traditional birthday or holiday gifts or property (not cash) with a low FMV;
Coffee, donuts, or soft drinks;
Local telephone calls; and
Flowers, fruit, or books, or similar property provided to employees under special circumstances (i.e., on account of illness, outstanding performance or family crisis).

Exceptions - Items that do NOT qualify as “de minimis”

Season tickets for sporting or theatrical events;
The commuting use of an employer-provided automobile more than one day a month;
Membership in a private country club or athletic facility;
Employer-provided group term life insurance on the life of the spouse or child of an employee; and
Use of employer-owned or leased facilities (such as an apartment, hunting lodge, boat, etc.) for a
weekend, unless required for work

Benefits Exceeding Value and Frequency Limits - All or Nothing

If a benefit is provided to an employee that is not deemed de minimis due to excess value or excess frequency, then NO amount is considered a de minimis fringe.

Answer 72

A

The 2017 TCJA suspends the deduction for moving for taxable years 2018 through 2025.

However, the provision is retained for active duty members of the military that move pursuant to a military order and incident to a permanent change of station. Employers may continue to reimburse such moves but the reimbursement will be taxable income.

Qualifying Move:

The move must be due to a relocation while on active duty.

**Deductible Moving Expenses:*

Deductible moving expenses are confined to reasonable expenses for the following:

Traveling and associated lodging DURING the move from the former home to the new home.

Any portion or amount of reimbursement for expenses that could have been deductible, will be excluded from income for US Armed Forces members.

Nondiscrimination rules do not apply.

ONLY FOR ARMED FORCES

Answer 73

A

Prior to 2018, the regulations provided for an exclusion of the value of qualified transportation benefits from an employee’s gross income. This exclusion for transportation benefits was subject to limitations.

If the value of a benefit was more than the limit, then any excess amount above the limit, less any amount the employee paid, was included in the employees income. The excess could not qualify as a deminimis benefit.

The 2017 TCJA disallows the ER a deduction for expenses associated with providing any qualified transportation fringe to employees

except for ensuring safety of an employee.

However, there is no requirement to treat the benefit as taxable income to EE’s unless the ER wants the deduction. Effective after 2017.

Answer 74

A

Answer: A

No deduction for expenses associated with providing any qualified transportation fringe to
employees is permitted after 2017, Emily can exclude the $265 from income.

Answer 75

A

An employee may exclude from gross income amounts paid for, or expenses incurred, by the employer for qualified adoption expenses concerning the adoption of a child by an employee if these amounts are furnished according to a written adoption assistance program.

An employer may establish a written adoption assistance program that will pay expenses related to an adoption not exceeding $15,950 for 2023 to an employee.

The amount paid is excluded from the employee’s income, but it is subject to an income phaseout starting at $239,230 of adjusted gross income (AGI) for 2023 through $279,230. If the employee’s AGI is greater than or equal to $279,230 for 2023, then the exclusion is eliminated.

Must adopt a child under the age of 18 to receive the credit.

Nondiscrimination requirements apply.

As of the time of printing, the phaseouts have not been finalized. We will issue a supplement once the phaseouts are determined.

Answer 76

A

Certain prizes and awards given to employees by the employer may be excluded from the employee’s gross income.

Limits on Value of Awards:

An employee is allowed to exclude from gross income the value of any employee achievement
awards insofar as the cost of the award does not exceed the following limitations:
$400 for all non-qualified plan awards when added to the employer’s cost for all other
employee achievement awards made to such employee during the taxable year that are not qualified plan awards, and
$1,600 for all qualified plan awards when added to the employer’s cost for all other employee achievement awards made to such employee during the taxable year (including employee achievement awards that are not qualified plan awards).

Qualified Plan Award

A “qualified plan award” is defined as an employee achievement award bestowed as part of an established written plan of the taxpayer that does not discriminate in favor of highly compensated employees.
However, there are limitations on this exclusion. If the “average cost” of all employee achievement awards provided by the employer during the year exceeds $400, then such employee achievement award shall not be treated as a qualified plan award for any taxable year.

The 2017 TCJA added a definition for tangible personal property, which shall not include:

cash, cash equivalents, gift cards, vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, or other similar items. Therefore, any award must now comply with the definition for tangible personal property. Effective after 2017.

Answer 77

A

An employee may exclude from gross income any amount representing a qualified tuition reduction.

Qualified tuition reduction is defined in the IRC as the amount of any reduction in tuition provided to an employee of an educational organization for education below the graduate level of:

current employees;
former employees who retired or left on disability;
widow(er)s of a person who died while employed;
widow(er)s of former employees who retired or left on disability; or
dependent children or spouses of any of the above.

Although this exclusion normally does not apply to the graduate level, exceptions for individuals who are graduate students teaching or performing research activities for an educational organization may be eligible.

The educational organization must normally maintain a regular faculty and curriculum and
have a regularly enrolled body of students in attendance at the place where its educational activities are carried out in the normal course of business. This educational organization can be elementary, secondary, a college, or university.

Nondiscrimination rules apply.

Answer 78

A

Answer: D

Peter must include $600 of the reimbursement in his gross income, as moving expenses are not
excludible after 2017, except for active duty military.

Answer 79

A

General Valuation Rule
Cents-Per-Mile Rule
Commuting Rule (Specialized Issue!)
Lease Value Rule
Unsafe Conditions Commuting Rule (Specialized Issue)

Answer 80

A

Most fringe benefits are valued under the general valuation rule.

Basically, the FMV should be the value assigned to a fringe benefit.

Answer 81

A

Valuation under the cents-per-mile rule requires multiplying the standard mileage rate by the total miles the employee drives the vehicle for **PERSONAL PURPOSES. **

The standard mileage rate is $0.655 per mile for 2023

Answer 82

A

The value of this fringe benefit is determined by multiplying each one-way commute from home to work or from work to home by $1.50. This value applies to more than one employee irrespective of whether one or more employees ride in the vehicle during the commute. The commuting rule is allowed
if all of the following requirements are satisfied:

The employer provides the employee the vehicle for use in the employer’s business and the employer requires the employee to commute in the vehicle for bona fide noncompensatory business reasons.
A written policy is established and implemented whereby the employer does not permit the employee to use a vehicle for personal use other than for commuting or minimal personal use.
Other than de minimis personal use and commuting, the employee does not use the vehicle for personal use
If the vehicle used is an automobile, the employee who uses the automobile for commuting must not be a control employee. Rather than using the definition of a control employee, an employer may
choose to define a control employee as a highly compensated employee

Answer 83

A

According to the lease value rule, the value of an employer-provided automobile is determined by using the automobile’s annual lease value.

The annual lease value of an automobile is determined by first ascertaining the automobile’s FMV on the first day it is available to any employee for personal use.

Personal use of a leased luxury car, provided by your employer, may increase the amount of income that will be included in your W-2 due to the lease value rule.

Answer 84

A

The unsafe conditions commuting rule determines the value of commuting transportation provided by an employer to a qualified employee solely because of unsafe conditions as $1.50 for a one-way
commute.

The unsafe conditions commuting rule requires that a “qualified employee” be provided with the subject commuting transportation.

For the unsafe conditions commuting rule to apply, the employee must ordinarily walk or use public transportation; the employer must have a written policy against transportation for personal purposes other than commuting because of unsafe conditions; and the employee does not use the transportation for personal reasons beyond commuting due to unsafe conditions.

Finally, whether other “unsafe conditions” exist is determined based on the facts and circumstances of each individual situation.

Answer 85

A

Introduction

Medical Plans

Group Term Life Insurance

Cafeteria Plans

Flexible Spending Accounts

Tax Year 2020 and 2021 Changes to FSA Health Care Spending Arrangements

Other Employee Benefits
Employer/Employee Insurance Arrangements

Answer 86

A

The federal government, in the case of some fringe benefits and insurance plans, promotes employer insurance arrangements by allowing the employer to pay the premiums for the employees and immediately deduct the cost
for income tax purposes without requiring the participant employee to include the premium cost in their taxable income.

Any group insurance premium amounts paid by the employer are generally deductible by the employer or included in the employee’s gross income.

Answer 87

A

There are a number of ways that an employer can provide an employee with benefits for medical expenses due to personal injury or sickness. Many employers use these types of group health insurance plans as a part of the overall compensation package provided to their employees.

Included in these health insurance plans are both private insurance plans and self-insurance plans.

Any payments made to these plans are deductible for income taxes by the employer and

excluded from the employee’s gross income.

Answer 88

A

The premiums paid by the employer for health insurance are not includable in the employee’s taxable income but are a deductible business expense for the employer under IRC Section 162.

Group medical insurance includes:

hospitalization coverage,
major medical,
indemnity coverage,
health maintenance organization,
preferred provider organizations,
point of service plans, and
dental and vision plans.

Answer 89

A

The employer can generally exclude the value of accident or health benefits provided to an employee from the employee’s gross income.

Premiums paid by the employer for accident, health, and disability insurance policies are deductible by the employer and excluded from the employee’s income.

When the insurance benefits are paid, they are includable in the employee’s income with the exception of:
- payments received for medical care of the employee, spouse, and dependents;
- and payments for permanent loss or the loss of the use of a member or function of the body or permanent disfigurement of the employee, spouse, or dependent.

Answer 90

A

Under the Combined Omnibus Budget Reconciliation Act of 1986 (COBRA), an employer that maintains a group health plan and employs 20 or more people onmmore than 50% of the calendar days in a year is required to:

continue to provide coverage under the plan to covered employees and qualified beneficiaries following the occurrence of a statutorily defined qualifying event. This is depicted in the following exhibit.

Answer 91

A

The employer may pay for the COBRA coverage either

directly or
by reimbursing the employee, or
the employer may shift the burden of paying for the benefit to the beneficiaries.

During the statutory COBRA period, the premium cannot exceed 102% of the cost to the plan for similarly situated individuals who have not incurred a qualifying event.

If a qualified beneficiary receives the 11-month disability extension of coverage, the premium for the additional 11 months may be increased to 150% of the plan’s total cost of coverage.

COBRA premiums may be increased if the costs to the plan increase, but generally must be fixed in advance of each 12-month premium cycle

Answer 92

A

Amounts paid by the employer for group term life insurance also receive favorable tax treatment.

The employer can deduct the amounts paid for the insurance, and the employee can exclude a portion, if not all, of the value from his income.

To receive such favorable treatment, the** life insurance must provide a general death benefit to a group of employees**, and the coverage must provide an amount of insurance to each emplovee based on a formula that prevents individual selection. This formula must use factors such as the employee’s age, years of service, pay, or
position.

Generally, Iife insurance provided by the employer is not considered group term lilfe insurance

unless the employer provides it to at least 10 full-time employees at some time during the year.

If the employer does not meet the general 10-employee rule, the employer may still be eligible to recognize the benefits of the group term life insurance coverage if the employers provision of the coverage meets the
following three requirements:

The employer provides coverage under the plan to all of its full-time employees who provide evidence of insurability.
The coverage provided under the plan must be based on either a uniform percentage of pay or a set amount of coverage depending upon age, years of service, compensation, or position.
The required evidence of insurability must be limited to a medical questionnaire (completed by the employee) that does not require a physician.

Group term life insurance premiums paid by the employer on the first $50,000 of death benefit are deductible by the employer and are excludable from an employee’s gross income.

The cost, as determined under the Uniform Premium Table provided by the IRS, of any death benefit coverage in excess of $50,000 is taxable to the employee.

Answer 93

A

The employee can always receive the first $50,000 of death benefit coverage tax free. Thus, if an employee’s death benefit under the employer-provided term life insurance is $90,000, the employee will be taxed (as determined above) on $40,000 ($90,000 - $50,000) of the coverage.

Nondiscrimination rules apply - To be considered nondiscriminatory, the plan must cover either:

70% or more of all eligible employees, or
85% of the non-key employees.

Answer 94

A

Disability insurance provides benefits in the form of periodic payments to a person who is unable to work due to sickness or accidental injury.

The cost of disability insurance varies depending on occupation, age, and sex of insured, as well as the benefit term, coverage, and the length of the waiting period (elimination period) provided under the policy.

Disability insurance can be provided under a group or individual plan and as either short-term (up to two years) or long-term coverage (over two years).

In any case. the premiums paid by the employer are deductible by the employer and are not included in the employee’s gross income.

HOWEVER, when the employer pays the premium and the value is excluded from the employee’s gross income, any disability income benefit received by the employee is taxable to the employee.

If the employee pays the entire premium with after-tax income or the employer pays the premium and the employee includes the premium payment in income, any benefits received will be considered tax exempt.

Answer 95

A

Answer: B

Elisa can exclude the cost of up to $50,000 of group term life insurance coverage. In this case,
the cost of $50,000 of coverage is $450 [50 ($50,000 ÷ $1,000) × 0.75 x12 months].

Answer 96

A

A cafeteria plan is a written plan under which the employee may choose to receive cash as compensation or tax-free fringe benefits.

Provided the cafeteria plan meets the requirements defined below, the value of the fringe benefit, if chosen by the employee, will be a deductible expense for the employer and will not be included in the employee’s gross income.

The following chart summarizes benefits that are allowed and benefits that are not allowed.

In the case where the plan provides a benefit that is not allowed,

the value of the benefit will be included in the employee’s gross income.

Discrimination in favor of either highly compensated or providing more than 25% of the benefit to the key employees

will result in the value of the nontaxable benefits chosen by the key employees or highly compensated being included in their gross income.

Answer 97

A

A flexible spending account (FSA) is a cafeteria plan that is funded by employee deferrals rather than employer contributions. Because of the consequences of** forfeiture of unused benefits,** these are often referred to as “Use It or Lose It” accounts.

However, after 2012, the IRS permits FSA funds to be used in the “grace period,” which must not extend beyond the 15th day of the third calendar month after year-end.

Since the ACA 2010, FSAs have an annual limit that is indexed. The limit for 2023 is $3,050.

EXAMPLE: Joe, who is getting a bit older, plans to have eye surgery in 2023. For the 2023 plan year, Joe timely elects salary reduction of $3,050 for a health FSA. During the 2023 plan year, Joe learns that he cannot have the
eye surgery performed, but incurs other medical expenses totaling $1,300. As of December 31, 2023, he has $1,450 of unused benefits and contributions in the health FSA. Consistent with the use-it-or-lose-it rules he would forfeit the $1,450 if it is not used by March 15, 2024.

The FSA approach minimizes employee outlay since the FSA converts what would have been** after-tax employee expenditures for the benefits selected to pretax expenditures.**

Since FSAs are funded entirely through employee salary reductions, the employer only bears the administrative costs.
Salary reductions elected by employees to fund the nontaxable benefits available under the plan are not subject to income taxes or payroll taxes. There are many nontaxable benefits available from a FSA, which include many benefits that employers might not otherwise provide to their employees such as dependent care, dental, etc.
An FSA must meet the same nondiscrimination requirements as cafeteria plans.

Answer 98

A

Changes from Tax Payer Certainty and Disaster Tax Relief Act of 2020.

2020 plan year end unused balances can carry over to 2021 without limit. 2021 plan year end unused balance can carry over to 2022 without limit. Carryovers are limited to $610 in the 2023 plan year.

Employees who ceased participation in calendar year 2020 or 2021 can receive

reimbursement from unused benefits in the year the employee ceased participation.

Year end grace period is extended from 2.5 months to 12 months for plan years ending in 2020 and 2021.

NOTE: CARES Act permanently expanded the definition of eligible expenses for HSA, HRA and Health Care FSA funds to include over-the-counter drugs for expenses incurred after December 31, 2019.

Answer 99

A

The Health Insurance Portability and Accountability Act (HIPAA) established a tax favored savings account for medical expenses called an Archer Medical Savings Account (MSA).

The MAs could be established after 1996 and before 2006 for employers with 50 or fewer employees and self-employed individuals. Employees could not establish the MSA but could contribute (subject to the limitations discussed below) to the account if their employer established an MSA on their behalf.

After 2005, MSAs were replaced by the Health Savings Account (HSA). However, the MSAs that were established prior to 2006 are still in existence, may still be maintained, and retain their tax-favored status.

Contributions can be made to the MSA by the employee or the employer.

Employee contributions are deductible from the employee’s gross income. In addition, employer contributions are tax deductible by the employer, not subject to payroll taxes, and not taxable income to the employee.
The aggregate contributions to the plan by the employee and the employer cannot exceed 65% of the deductible for individual coverage and 75% of the deductible for family coverage.

The earnings on the assets within an MSA are tax deferred until a distribution is taken from the account.

If a distribution is for qualified medical expenses, the distribution, including any earnings, is not taxable.
If the distribution is not for qualified medical expenses, the entire distribution is taxable as ordinary income.
In addition, if the distribution is taken before the owner of the account is age 65, the distribution is subject to an additional 20% excise penalty tax.

Answer 100

A

Health Savings Accounts The Medicare Act of 2003 created Health Savings Accounts (HSAs), which are very similar to MSAs but less restrictive.

HSAs can be established by anyone with a high deductible health insurance plan,
allow a higher contribution amount, and
reduce the penalty for non-medical distributions.

To qualify for an HSA, the individual’s health insurance plan’s deductible must be at least $1,500 for single coverage and the annual out-of-pocket costs cannot exceed $7,500 for 2023.

For family coverage under an HSA, the health insurance plan deductible must be at least $3,000, and the annual out-of- pocket costs cannot exceed $15,000 for 2023.

Contributions to the HSA can be made by the individual or by the individual’s employer. In either case, the aggregate contributions cannot exceed the health insurance plan deductible subject to a maximum contribution of $3,850 for individuals and $7,750 for families for 2023.

Individuals between 55 years old and 64 years old, however, can make additional catch-up contributions of $1,000 over these limits
for 2023.

Earnings within the HSA are not taxable, and amounts **distributed from an HSA are also not taxable **provided the distributions are used to pay for qualified medical expenses.

If a distribution is **not for qualified medical expenses, the entire distribution is taxable as ordinary income. **

If the distribution is taken before the owner of the account is 65, the distribution is subject to an additional 20% excise penalty tax.

Answer 101

A

A Voluntary Employees Beneficiary Association (VEBA) is a welfare benefit plan into which
employers deposit funds that will be used to provide specified employee benefits in the future.

Technically, the VEBA is either a trust or a corporation set up by an employer to hold funds used to pay benefits under an employer benefit plan.

The payments made to the VEBA are deductible by the employer and the income of the VEBA is tax exempt.

VEBAs can provide:

life insurance before and after retirement.
fitness and accident benefits (health).
severance benefits paid through a severance pay plan.
unemployment and job training benefits.
disaster benefits.
legal service payments for credits.

VEBAs cannot provide:

savings.
retirement.
deferred compensation.
commuting expenses.
accident or home owners insurance (property and causality).

Answer 102

A

The premium payments for qualified group long-term care insurance are tax deductible if paid by the employer and tax free to the employee (see the information below for a discussion of self-employed individuals).

To be a qualified long-term care insurance plan, the plan must meet the provisions of the IRC. Specifically the plan must:

Only provide long-term care insurance coverage;
Not duplicate benefits paid by Medicare;
The plan must be guaranteed renewable; and
Only pay benefits when the employee or beneficiary of the plan is certified by a licensed health care practitioner as chronically ill.

Long-term care premiums cannot be paid for within a cafeteria plan or flexible spending account

Nor can the premium payment be made with pretax employee salary deferral.

If, however, the employee pays the premiums with after-tax dollars,

the employee may deduct, as an itemized medical expense deduction, the costs on his income tax return for the year.

Answer 103

A

An employer may exclude from an employee’s gross income the value of any retirement planning advice or information he provides to the employee or his or her spouse if the employer maintains a qualified retirement plan.

In addition to employer plan advice and information, the services provided may include general advice and information on retirement.

The exclusion does not, however, apply to:

the value of services for tax preparation,
accounting,
legal, or
brokerage services.

Answer 104

A

Disability overhead insurance is designed to cover the expenses that are usual and necessary expenses in the operation of a business should the owner become disabled.

Premiums are deductible as a business expense, and benefits payable from the plan are taxable income to the entity.

Disability buyout policies:

are policies to cover the value of an individual’s interest in the business should they become disabled.

Answer 105

A

Key employee life insurance is NOT an employee benefit.

The company/employer purchases life insurance on a key employee, making nondeductible premium payments and receiving a **tax-free death benefit. **

If the employee is greater than a 50% owner, he/she is assumed to have incidents of ownership making the **proceeds taxable in his/her estate. **

The proceeds may also be indirectly taxable in the decedent’s estate to the extent his/her stock value in the company is increased due to the proceeds.

Lastly, life insurance death proceeds are not taxable to a corporation

for regular tax purposes but they are for AMT.

Answer 106

A

Split-dollar life insurance is an arrangement where an employee and employer generally share the premium costs and cash value or death benefit of a life insurance policy

covering the life of the employee.

The purpose of the split benefit is to reimburse the employer’s share of the premium cost of
the policy.

This is typically done with the death benefit reimbursement

in the amount of the premiums paid or,
if the policy is surrendered, the amount of the premiums paid or the entire cash value.

There are several ways to structure the premium split that are Listed Below:

Answer 107

A

Standard split-dollar plan:

the employer pays the portion of the premium that equals the increase in the cash value.

Advantages:

Simple in design and easy to explain and the employer’s “investment” is fully secured.

Disadvantages:

High premium payments required by the employee early on.

Answer 108

A

Level premium plan:

the employee’s share of the premium cost is level over a specified period of
time (e.g. 5 or 10 years)

Advantages:

Does not require the high premium payments by the employee.

Disadvantages:

If terminated early, the employer’s reimbursement, if limited to cash value, is
not fully recognized

Answer 109

A

Employer pay all plan:

the employer pays the entire premium.

Advantages:

The employee does not have to come out of pocket yet receives life insurance protection.

Disadvantages:

The employee must recognize taxable income based on the Table 2001 rates. If terminated early, the employer’s reimbursement, if limited to cash value, is not fully recognized.

Answer 110

A

Offset plan:

the employee pays the Table 2001 cost, if applicable, and the employer pays the remainder.
This effectively “zeros out” the employee’s income tax cost for the plan.

Advantages:

The employee’s cost is minimal and this offers the potential that the employer provides a special “bonus” in the amount owed by the employee.
Although the premiums paid are not tax-deductible, the bonus amount is tax deductible.

Disadvantages:

If terminated early, the employer’s reimbursement, if limited to cash value, is
not fully recognized.

Answer 111

A

There are also several methods to structure the cash value or death benefit split:

The amount of the premiums paid;
The cash value; or
The greater of the cash value or premiums paid.

Answer 112

A

Answer:

$15,000; the greater of premiums paid ($3,000 x5) or cash value ($6,000).

Answer 113

A

Endorsement method:

The employer owns the policy and is primarily responsible for making the premium payments.
The employee may elect a beneficiary but the employer is paid a portion of the death benefit equal to the death benefit split that is in the agreement.

Advantages:

The plan is easy and simple to create and administer,
the employer exercises greater control, and it avoids being considered a loan for purposes of laws and regulations

Answer 114

A

Collateral assignment:

The employee owns the policy and is primarily responsible for making the premium payments.
The employer makes interest-free loans to the employee in the amount of the premium the employer is responsible for.
Once again, the employee may elect a beneficiary but the employer is paid a portion of the death proceeds.

Advantages:

The plan provides more protection for the employee and emplovee’s beneficiary and
can be implemented easier with existing life insurance owned by the employee.

Answer 115

A

The employeR owns the policy if it is endoRsement method

Answer 116

A

If Julio’s employer creates a split-dollar agreement with him under the endorsement method the employer owns the policy, the employer and employee share in the premium payments (actual split depends on the agreement), and cash value, if surrendered, or death benefit is first used to reimburse the employer for premiums paid and the remainder goes to the employee/ beneficiary.

Answer 117

A

If Julio’s employer instead uses the collateral assignment method, the employee owns the policy, the employer and employee share in the premium payments (actual split depends on the agreement), and cash value, if surrendered, or death benefit is first used to reimburse the employer for premiums paid and the remainder goes to the employee/beneficiary.

Answer 118

A

Taxation depends primarily on the method chosen. For all methods, the employer does not receive a deduction for premiums paid and the death proceeds are tax-free.

The endorsement method and non-equity-type collateral assignment plans require that the employee recognize income in the amount of the pure death benefit under Table 2001 less any amount contributed to the plan by the employee. The employee is also taxed on any cash value that the employee gains access to during the year.
For equity-type collateral assignment plans the premium amounts “loaned’ to the employee are deemed “demand loans” if there is no stated interest rate. The tax treatment is additional compensation income to the employee in the amount of the assumed interest payable based on the applicable federal rate (AR). The employer gets a deduction for the assumed income paid and the employee must report the income on his/her tax return. Then the employee pays the employer the assumed interest, providing interest income to the employer and an interest deduction, subject to standard limitations, to the employee.

Answer 119

A

Answer: The total premium is $2,830 = ($500,000 ÷ $1,000 x 5.66).

Since he only pays $2,000 the recognizable income is $830. = ($2,830 - $2,000)

Answer 120

A

Answer: The interest piece is $100 = ($2,000 x0.05). The employer gets a deduction for compensation income paid in the amount of $100, Paul must recognize $100 of ordinary compensation income, the company must recognize $100 of interest income, and Paul may be able to deduct the $100 of interest.

Answer 121

A

This type of insurance provides coverage for business expenses, not including the owner’s wages, in the event the business owner becomes totally disabled.

The policy may have varying lengths, but 1 or 2 years is typical.

Policy premiums are deductible business expenses and the income is generally taxable.

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Lesson 5 of Retirement Benefits: Deferred Compensation and Employee Benefits Flashcards

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