Module 9 Deferred Compensation and Stock Plans Flashcards
Which of these employee benefits give an employee the right to purchase a fixed number of shares of employer stock at a predetermined price over a stated period?
A)
Stock appreciation rights
B)
Elective deferral plan
C)
Phantom stock plan
D)
Stock option
d
Which of these circumstances constitute a substantial risk of forfeiture for restricted stock?
The employee does not remain with the employer for the specified period
The employee does not meet certain sales or performance goals
The employee goes to work for a competitor
The employee works for a corporation that is not controlled by immediate family members
A)
I, II, III, and IV
B)
I and II
C)
III and IV
D)
I, II, and III
a
A supplemental executive retirement plan (SERP)
A)
is designed to provide a specified percentage of retirement income to the executive without regard to the Section 415 benefit limit.
B)
is a qualified salary continuation plan.
C)
is funded entirely with employee dollars.
D)
must be formally funded.
a The answer is designed to provide a specified percentage of retirement income to the executive without regard to the Section 415 benefit limit. A SERP is a prototypical nonqualified salary continuation plan designed to provide a specified percentage of retirement income to the executive without regard to the Section 415 benefit limit. A SERP may be unfunded or informally funded. This plan can protect the executive from involuntary termination if the company changes ownership by awarding him increased benefits from the plan, and it is funded entirely with employer money.
LO 9.3.1
Which of these are the income tax ramifications of exercising an incentive stock option (ISO)?
There are no regular income tax consequences upon exercising an ISO.
The option exercise price becomes the employee’s taxable basis for the regular income tax.
There may be an alternative minimum tax (AMT) adjustment when the ISO is exercised.
The employer receives an income tax deduction when the employee exercises an ISO.
A)
I and II
B)
I, II, and III
C)
III and IV
D)
I, II, III, and IV
b The answer is I, II, and III. When the employee exercises the ISO, there is no regular taxable income. However, there is an AMT adjustment to the extent the fair market value (FMV) exceeds the option exercise price. (The excess of the FMV of the stock over the exercise price is sometimes referred to as the bargain element or spread.) The adjusted tax basis for the regular tax is the option exercise price. For AMT purposes, the basis equals the option price plus appreciation at the exercise date (equivalent to the FMV of the stock on the date of exercise). The employer does not receive an income tax deduction when an employee exercises an ISO. However, if the employee disposes of the ISO shares in a disqualifying disposition, the employee will generally have ordinary income, and the employer will receive a tax deduction.
LO 9.4.1
Which of these statements regarding nonqualified stock options (NQSOs) are CORRECT?
NQSO grants are inflexible.
There are no special IRC requirements for NQSOs.
The NQSOs can be gifted to a family member or a qualified charity before the options exercise date.
A)
I and II
B)
II and III
C)
I, II, and III
D)
I and III
b There are no special requirements under the IRC for NQSOs. A viable planning technique is for the employee/executive to gift the NQSO to either a family member or qualified charity before the option’s exercise date. NQSOs are very flexible, as employers may grant an employee an NQSO on any terms, exercisable over any period of years.
LO 9.4.1
The major advantage of a nonqualified plan is that it
A)
can be discriminatory.
B)
provides coverage for rank-and-file employees.
C)
provides employers with an immediate tax deduction.
D)
is subject to ERISA nondiscrimination rules.
a The major advantage of a nonqualified plan is that it does not have to comply with the general nondiscrimination rules that apply to qualified plans. In addition, nonqualified deferred compensation (NQDC) is not subject to all the reporting and disclosure rule requirements that pertain to qualified plans. Generally, nonqualified plans are used to benefit selected executives and exclude rank-and-file employees. Employers typically do not get an immediate tax deduction; rather, they get a deduction when the employee is in constructive receipt of the funds. Immediate constructive receipt is rare in nonqualified plans.
LO 9.1.1
Which of these nonqualified deferred compensation arrangements use a portion of the executive’s current compensation to fund the promised benefit?
A)
Corporate-owned continuation program
B)
Informal secular trust arrangement
C)
Salary reduction
D)
Salary continuation
c The answer is salary reduction. In a salary reduction, or pure deferred compensation arrangement, the plan uses a portion of the executive’s current compensation to fund the promised benefit, usually payable at the executive’s retirement date.
LO 9.3.1
Which of these are characteristics of an unfunded nonqualified deferred compensation (NQDC) plan?
An employer makes an unsecured promise to pay an executive.
Payment is typically made in the future.
The executive is always in constructive receipt of the deferred income.
The executive must pay current taxes on the deferred compensation.
A)
I, II, III, and IV
B)
I and II
C)
III and IV
D)
I, II, and III
b The answer is I and II. An unfunded NQDC plan involves an employer’s unsecured promise to pay an executive in the future. The executive is not in constructive receipt of the deferred income and is not required to pay taxes on the deferred compensation.
LO 9.2.1
Which of these statements regarding a Section 83(b) election on restricted stock is CORRECT?
A)
The Section 83(b) election must be made within six months of receiving the restricted stock.
B)
An employee who receives restricted stock may elect under Section 83(b) to immediately recognize compensation income.
C)
If the election is made, long-term capital gain income will be immediately recognized and ordinary income will be recognized when the restriction expires.
D)
If the election is made and the employee then forfeits the stock before the restriction expires, he is permitted an ordinary loss against income.
b The answer is an employee who receives restricted stock may elect under Section 83(b) to immediately recognize compensation income. An employee who receives restricted stock may elect under IRC Section 83(b) to recognize the discount element immediately as compensation (W-2) income. When the restriction expires, any subsequent appreciation on the stock is then eligible for capital gains tax treatment. The Section 83(b) election must be made within 30 days of receiving the restricted stock.
LO 9.3.2
Joe is an executive for XYZ Corporation, where he has worked for the past 25 years. His current salary is $500,000, and XYZ’s defined benefit plan promises all employees 70% of their salary at retirement. As a result, Joe would be entitled to a benefit of $350,000 per year under the plan. However, this amount is above the Section 415 benefit limitation. Which of the following types of nonqualified deferred compensation should his company install to fund the difference between his promised benefit and his limited benefit plans?
A)
Over-the-limit plan
B)
Section 83(b) plan
C)
Excess benefit plan
D)
Carve-out plan
c Explanation
The answer is excess benefit plan. An excess benefit plan provides executives with the difference between the amount payable under a qualified plan and the potential amount received if the Section 415 limitation did not exist.
LO 9.3.1
Joaquin was granted enough nonqualified stock options (NQSOs) to purchase 10,000 shares of Nova, Inc., stock at $10 per share two years ago. He is fully vested in the options. Which of the following are income tax consequences if Joaquin gifts the NQSOs to a qualified charity before the option’s exercise date?
Joaquin does not recognize any gain on the transfer.
Joaquin will receive a charitable income tax deduction in the year of the gift.
Joaquin will be taxed at ordinary income rates if the charity exercises the options while he is living.
A)
I, II, and III
B)
I and II
C)
I and III
D)
II and III
a Joaquin does not recognize gain on the transfer date. He will have ordinary income if he is living when the charity exercises the options. Joaquin will be allowed a charitable income tax deduction on the date of transfer because he is fully vested in the options.
LO 9.4.1
Which of these statements regarding secular trusts is CORRECT?
A)
Because the funds in a secular trust are subject to a substantial risk of forfeiture, the employee will not be taxed on any amounts until they are distributed from the trust.
B)
A secular trust is irrevocable.
C)
The employer receives an income tax deduction equal to the amount of trust earnings each year.
D)
Funds held in a secular trust can be accessed by the employer’s general creditors.
b A secular trust is irrevocable. Funds in a secular trust are not subject to a substantial risk of forfeiture, and therefore, the employee will be taxed when the employer makes a contribution to the trust. In addition, the employer receives a deduction for the trust contributions each year, not for the trust earnings.
LO 9.3.2
Lucy’s employer grants her 500 shares of restricted stock worth $5 per share at the time of the grant. The terms of the restriction require Lucy to remain employed by her company for three more years. After the three-year restriction has been met, the stock is trading at $32.50 per share. How much is Lucy required to report as compensation (W-2) income for the year?
A)
$2,500
B)
$13,750
C)
$0
D)
$16,250
d The answer is $16,250. When the stock is no longer subject to a substantial risk of forfeiture, the value of the stock is taxed as compensation (W-2) income to the employee; therefore, she must report $16,250 ($32.50 × 500) of income for the year.
LO 9.5.1
In which of these situations would an employer consider implementing a nonqualified plan?
A)
The employer wants to provide additional deferred compensation benefits to an executive who is already receiving the maximum benefits or contributions under the employer’s qualified retirement plan.
B)
The employer has had a particularly profitable year and wants to lower the current tax bill.
C)
The employer wants to provide a benefit package that benefits all employees equally.
D)
The employer wants to provide rank-and-file employees with tax-deferred compensation benefits.
a A nonqualified plan is most appropriate when an employer wants to provide high level employees, but not rank-and-file employees, with tax-deferred compensation benefits or wants to provide additional deferred compensation benefits to an executive who is already receiving the maximum benefits or contributions under the employer’s qualified retirement plan.
LO 9.1.1
Which of these objectives would NOT be met by an employer’s use of a nonqualified deferred compensation plan?
A)
The employer desires a plan in which benefits may legally discriminate in favor of highly paid employees.
B)
The employer needs to bring executive retirement benefits up to desired levels by adding a second tier of benefits on top of the qualified plan.
C)
Employers want to boost morale for all workers.
D)
The employer desires an alternative to the qualified plan because of the complexity of legislative changes.
c Deferred comp plans are designed to boost the morale and commitment of selected employees, not all workers. The other answers are true concerning nonqualified deferred compensation plans.
LO 9.1.1
Conway Enterprises, Inc., wishes to set up an equity-based compensation plan that offers these benefits to employees:
Tax advantages
Immediate sale of the stock is possible after vesting
Voting rights when the stock is awarded
Shares granted to an employee at no cost or at a bargain price
Which of the following would be the best choice for the company?
A)
Junior class shares
B)
Severance pay plan
C)
Restricted stock plan
D)
Stock appreciation rights
c The answer is restricted stock plan. A restricted stock plan would offer all the features that Conway is seeking in an equity-based compensation plan.
LO 9.5.2
All of these are characteristics of restricted stock EXCEPT
A)
The restricted period is called the vesting period
B)
If the stock is not sold until after one year from vesting, the difference between the stock price on the grant date and the sale date will be taxed at long-term capital gains rates.
C)
It is employer stock that is forfeited by the employee if their work performance is unsatisfactory or if they terminate employment before a certain period.
D)
There is a current taxable event upon grant
d There is no taxable event upon grant for restricted stock. The restricted period is called the vesting period. Restricted stock is employer stock that is forfeited by the employee if their work performance is unsatisfactory or if they terminate employment before a certain period. If the stock is not sold until after one year from vesting, the difference between the stock price on the grant date and the sale date will be taxed at long-term capital gains rates.
LO 9.5.1
Malone’s employer recently offered him stock appreciation rights (SARs) with respect to 10,000 shares of the company’s stock. The terms of the SARs entitle Malone to be paid the difference between the fair market value (FMV) of the stock at the time of exercise and the FMV of the stock at the time of the grant. If the FMV of the stock was $5 on the date of the grant and $9 when Malone exercised the SARs, what is the amount of the award Malone will receive?
A)
$50,000
B)
$40,000
C)
$90,000
D)
$0
b The answer is $40,000. Malone is entitled to receive an award of $4 per share, or $40,000 (10,000 shares × $4 difference between value at grant and value at exercise).
LO 9.5.2
A cashless exercise of stock options
provides the employee with cash only.
provides the employee with stock only.
involves no cash outlay by the employee.
works best for employees with insufficient cash to exercise the option.
A)
III and IV
B)
I, II, and III
C)
I and II
D)
I, II, III, and IV
a he answer is III and IV. The employee receives the net amount of the stock (the stock remaining after the sale of shares) or all cash. When an option is exercised, the employee has to pay to buy the shares. If the employee does not have enough cash to exercise the options, then a cashless option becomes a viable choice. The option is exercised, after which sufficient stock is immediately sold for the fair market value to realize the cash needed to pay for the exercise and any costs and taxes associated with the sale. The employee receives the net amount of the stock in either stock or cash.
LO 9.4.1
All of these statements regarding an informally funded nonqualified plan are correct EXCEPT
A)
the underlying assets funding the plan are not subject to the claims of the employer’s general creditors.
B)
the plan may defer taxation on the executive’s current compensation.
C)
the most popular type of an informally funded nonqualified plan is the rabbi trust.
D)
the underlying assets funding the plan are owned by the employer.
a The answer is the underlying assets funding the plan are not subject to the claims of the employer’s general creditors. The underlying assets funding a nonqualified plan are subject to the claims of the employer’s general creditors.
LO 9.3.1
Which of these may create a current income tax liability of any kind upon exercise?
A)
Neither a nonqualified stock option nor an incentive stock option
B)
Nonqualified stock option
C)
Incentive stock option
D)
Both a nonqualified stock option (NQSO) and an incentive stock option (ISO)
d The answer is both a nonqualified stock option (NQSO) and an incentive stock option (ISO). Both ISOs and NQSOs may create a current income tax liability. The exercise of an NQSO creates additional W-2 compensation or ordinary taxable income that is subject to FICA or payroll taxes. The exercise of an ISO creates an individual alternative minimum tax (AMT) adjustment item. This item, if large enough, may result in current AMT liability.
LO 9.1.2
Which of these are nonqualified deferred compensation plans?
Salary reduction arrangement
Pure deferred compensation arrangement
Salary continuation arrangement
A)
I, II, and III
B)
I and II
C)
II and III
D)
I and III
a There are two broad ways to structure a nonqualified plan. The first is as a salary reduction or pure deferred compensation arrangement. With this approach, the plan uses some portion of the executive’s current compensation to fund the promised compensation benefit, usually payable at the executive’s retirement date. Alternatively, the plan may be structured with a salary continuation approach. To implement this arrangement, the plan is funded with money that the employer has set aside from current earnings to benefit the executive. The salary continuation approach is preferred by most executives because they are not sacrificing any of their own compensation to fund the benefit.
LO 9.3.1
Which of these are characteristics of a supplemental executive retirement plan (SERP)?
A)
It rewards an executive’s early separation from service.
B)
It provides benefits to executives below those available from a qualified plan.
C)
It may be established to protect the executive from involuntary termination if the company changes ownership by providing increased benefits from the plan.
D)
It must be informally funded.
c A SERP provides benefits to executives over and above the benefits available from a qualified plan and is funded entirely with employer funds. The plan can be either completely unfunded (like an excess benefit plan) or informally funded. The plan rewards an executive’s continued employment or encourages the early retirement of the executive. A SERP also may be established to protect the executive from involuntary termination, if the company changes ownership, by awarding them increased benefits from the plan. A rabbi trust can also protect the executive from a change of control at the employer.
LO 9.3.1
All of these are characteristics of an informally funded nonqualified deferred compensation plan EXCEPT
A)
if the agreement provides for the employee to elect to defer income after the associated services are performed, substantial risk of forfeiture conditions are necessary to avoid current taxation.
B)
the plan may discriminate in favor of selected employees.
C)
fund earnings, if taxable, are taxed to the employer.
D)
the employer’s deduction is available when the deferred amounts are includible in the employee’s income.
a With an informally funded plan, fund earnings, if taxable, would be taxable to the employer in most cases. The employee must make the deferral election before the services are performed. The other choices are true of informally funded nonqualified deferred compensation plans.
LO 9.3.2
Incentive stock option (ISO) requirements include which of these?
A)
The shares received through the exercise of ISOs cannot be sold within one year from the date of grant and two years from the date of exercise in order to maintain favorable tax treatment.
B)
ISOs must be part of a written plan approved by the stockholders.
C)
The expiration date cannot exceed five years from the date of grant.
D)
The exercise price of the ISO must be at least 25% less than the market price of stock at the time of the grant.
b ISOs must be part of a written plan approved by the stockholders, and the expiration date cannot exceed 10 years from the date of grant. The exercise price of the option cannot be less than the market price of the stock at the date of the grant. The shares received as a result of exercising the ISOs cannot be sold within two years from the date of grant and one year from the date of exercise, otherwise the favorable tax treatment will be lost.
LO 9.4.1
Two years ago, Jonathan was granted enough nonqualified stock options (NQSOs) to purchase 10,000 shares of Capital, Inc. stock at $10 per share. He exercised the options this year when Capital, Inc. stock was $25 per share. Three years later, Jonathan sells the 10,000 shares for $100 per share. Which of the following statements regarding the tax consequences of Jonathan’s transactions are CORRECT?
Capital gains tax is due the year the options are granted to Jonathan.
Jonathan’s cost to exercise all of the NQSOs is $150,000.
Jonathan will have a $750,000 capital gain when he sells the stock at $100 per share.
Jonathan will have an additional $150,000 included in his W-2 compensation income in the year of exercise, which is a type of ordinary income, subject to payroll taxes this year.
A)
III and IV
B)
III only
C)
I, III, and IV
D)
I, II, and IV
a onathan will have a $750,000 capital gain when he sells the stock at $100 per share. His adjusted tax basis is $25 per share. Unlike ISOs, when NQSOs are exercised, the bargain element is taxable as ordinary income. Thus $150,000 will be deemed W-2 compensation.
LO 9.4.1
Which of these statements regarding junior class shares of stock is CORRECT?
They are a separate class of common stock.
They are usually convertible into preferred shares.
They allow employees to purchase company stock below fair market value.
The rights of junior class shares are subordinate to regular common stock shares.
A)
III and IV
B)
II, III, and IV
C)
I and II
D)
I, III, and IV
d Junior class shares are a separate class of common stock. The voting, liquidation, and dividend rights of junior class shares are subordinate to regular common stock shares. Junior class shares are generally convertible into common shares of stock upon specified requirements, such as achieving certain years of service or performance goals. Conversion can be automatic or at the employee’s discretion.
LO 9.5.2
George has recently joined ABC Company, a closely held corporation, and as part of his compensation program, he was offered stock appreciation rights (SARs) for 5,000 shares of the company’s stock. The terms of the SARs entitle George to be paid the difference between the fair market value (FMV) of the stock at the time of exercise and the FMV of the stock at the time the SARs were granted. If the FMV of the stock is $2 on the date of the grant and $5 upon exercise, what is the amount of award George will receive from ABC?
A)
$5,000
B)
$10,000
C)
$15,000
D)
$30,000
c The answer is $15,000. George is entitled to receive an award of $3 per share, or $15,000 (5,000 shares × $3 difference).
LO 9.5.2
Which of these are requirements of an employee stock purchase plan (ESPP)?
The plan must be in writing and approved by the corporate shareholders.
The option price must be at least 75% of the fair market value (FMV) of the stock at the time of grant.
Acquired shares must be held by the employee for at least one year from the option grant date and two years after the exercise date.
A)
I and III
B)
I, II, and III
C)
II and III
D)
I only
d The option price must be at least 85% of the FMV of the stock at the time of grant. Employees owning more than 5% of the corporation cannot participate in the plan. The acquired shares must be held by the employee for at least two years from the option grant date and one year after the date of exercise.
LO 9.4.1
Which of these statements falsely describes a concept related to nonqualified deferred compensation?
A)
Substantial risk of forfeiture exists when the employee’s receipt of deferred compensation benefits is contingent upon performance of substantial services in the future.
B)
The employee’s receipt of anything that can be assigned a cash value results in economic benefit and taxation.
C)
An example of substantial risk of forfeiture provisions would be the employee’s loss of rights to the plan benefits because of disability or premature death.
D)
The availability of deferred compensation plan funds to the employee, without substantial restriction, generally results in constructive receipt.
c Disability or premature death does not create a substantial risk of forfeiture.
LO 9.3.2
A phantom stock plan
is a type of unfunded deferred compensation plan.
pays benefits in cash.
is based on the value and transactions of an imaginary stock that mirrors the value and transaction of the employer’s stock.
has an exercise date that is controlled by the employee.
A)
I, II, and III
B)
III and IV
C)
II, III, and IV
D)
I and II
Phantom stock plans have exercise dates that are controlled by the employer. All of the other statements are correct.
LO 9.5.2
A secular trust
can be used to defer taxation to an employee for an employer contribution made on her behalf under a nonqualified plan.
differs from a rabbi trust, in that the employer’s creditors cannot attach the funds in the secular trust.
provides security to the employee.
is a revocable trust for the exclusive benefit of the employee.
A)
I and II
B)
II and III
C)
II, III, and IV
D)
III and IV
b A secular trust causes immediate or accelerated taxation to the employee for employer contributions to a nonqualified plan. Funds in a secular trust cannot be reached by the employer’s creditors, thus providing security for executives. A secular trust is irrevocable.
LO 9.2.1
Four years ago, Latarsha was granted enough nonqualified stock options (NQSOs) to purchase 500 shares of her employer’s stock at $20 per share. She would like to obtain as many shares of the stock as she can but does not want any cash outlay when exercising the options. Assuming Latarsha exercises all of the NQSOs when the fair market value (FMV) of the stock is $30 per share and her marginal income tax rate at the time is 24%, how many shares of employer stock can she receive?
A)
373
B)
500
C)
0
D)
127
d The answer is 127. Latarsha will receive a net amount of 127 shares of stock calculated as follows:
The exercise cost of the NQSO is $10,000 (500 shares × $20 per share). She will have to pay ordinary income taxes of $1,200 on the bargain element [($30 FMV − $20 exercise price) × 500 shares × 0.24]. Therefore, Latarsha’s total cost of exercising the option is $11,200.
In order to cover the cost of the option, 373 shares of the stock must be sold ($11,200 ÷ $30 FMV). This leaves a net amount of 127 shares (500 − 373) that Latarsha will receive.
LO 9.4.1
Which of these statements regarding stock appreciation rights (SARs) are CORRECT?
A)
When the payout is made, the value of the award is not taxed to the employee.
B)
SARs allow the executive flexibility regarding when to exercise the right to share in the stock appreciation.
C)
SARs award the full value of the stock.
D)
SARs have a delay between the payment and the employer’s ability to take a deduction for the award.
b SARs only award the appreciation of the stock. When the payout is made, the value of the award is taxed to the employee and is tax deductible by the employer.
LO 9.5.1
