Retirement: 8 Deferred Compensation and Stock Plans Flashcards
1
Q
Retirement 8-1 Nonqualified Deferred Comp
Employee taxation controls timing of your tax deduction
Lack of security for employees in an unfunded plan
Generally, more costly to employer than paying compensation currently
a. Advantages of NQDC plans
b. Disadvantages of NQDC plans
A
b. Disadvantages of NQDC plans
2
Q
Retirement 8-1 Nonqualified Deferred Comp
The American Jobs Creation Act (AJCA) was signed into law in 2004, and it created Internal Revenue Code (IRC) Section 409A, which was designed to create strict rules to govern deferred compensation. Unless an exception applies, the term “nonqualified deferred compensation plan” means any plan that provides for the deferral of compensation for any employee. A deferral of compensation generally occurs when a legally binding right to compensation arises in one taxable year and the compensation _____ be payable to employee in a subsequent taxable year.
a. May
b. Must
A
a. May
3
Q
Retirement 8-1 Nonqualified Deferred Comp
There are severe penalties for failure to meet the new Section 409A requirements including all amounts deferred under the arrangement becoming subject to immediate taxation, interest penalties, and a ____ additional tax on deferrals.
a. 10%
b. 20%
A
b. 20%
4
Q
Retirement 8-1 Nonqualified Deferred Comp
Much of what is covered under Section 409A is beyond the scope of this module, but here are some of the basics:
Elections to defer compensation must occur in the year prior to the tax year of the delivery of services. When employees first become eligible to participate in a nonqualified plan during the current year (because they were recently hired or a new plan was put into place), they have __ days after they first become eligible to participate to make a deferral election under the plan for the current year.
a. 30
b. 60
A
a. 30
5
Q
Retirement 8-1 Nonqualified Deferred Comp
Much of what is covered under Section 409A is beyond the scope of this module, but here are some of the basics:
Where compensation is performance-based (that is, under an incentive plan), the deferral election must be made no later than _ months prior to the end of the 12-month performance period.
a. 3
b. 6
A
b. 6
6
Q
Retirement 8-1 Nonqualified Deferred Comp
Example. Jim Hopkins, age 64 and 8 months, has participated in the nonqualified deferred compensation plan of his employer for the last 23 years. Under the plan, he originally elected to have benefits paid in a lump sum at age 66, the age at which he would begin his Social Security and planned to retire. He now has decided to work until age 71, but isn’t exactly sure how long he will work. He wants to make a subsequent deferral so the original payment will be payable on the later of attaining age 71 or separation from service.
Jim’s new election will be valid if he makes the election on or before his 65th birthday since it will be at least 12 months prior to the original payment date, and any payments to Jim under the new election must be deferred at least ___ years from the previous payment commencement date specified by the plan.
a. 3
b. 5
A
b. 5
7
Q
Retirement 8-1 Nonqualified Deferred Comp
Example. Lisa Littlehorn, age 63, participates in the Industrial Design Inc. nonqualified deferred compensation plan, and she has done so for over 15 years. Originally she elected to have her plan benefits paid in a lump sum at age 65. She is in excellent health and is concerned about outliving her retirement funds. She has decided to work until age 70, and wants her benefit to be paid over 25 years. She would like to make a subsequent deferral so the series of payments over 25 years will begin on the later of the date she attains age 70 or the date she decides to retire.
Lisa’s new election will be valid if she makes the election on or before her __th birthday since it will be at least 12 months prior to the original payment date and defers the new payment date at least five years. If Lisa terminated at age 67, her payments would begin at age 67, since she terminated.
a. 64
b. 65
A
a. 64
8
Q
Retirement 8-1 Nonqualified Deferred Comp
An employee (or beneficiary) may change a previously elected time or form of a payment, subject to certain limitations. A change in either the time or form of payment may not take effect for __ months and must provide for a new payment beginning date that is at least five years after the original beginning date. In addition, if the payment is made as an annuity or as installment payments, the election must be made 12 months before the date the first amount was scheduled to be paid.
a. 12
b. 24
A
a. 12
9
Q
Retirement 8-1 Nonqualified Deferred Comp
Qualified vs. Nonqualified Plans
_____ allow for significant tax deferral, but must meet the stringent requirements of the Internal Revenue Code (IRC), as well as those of the Employee Retirement Income Security Act of 1974 (ERISA). The plan must be nondiscriminatory if it is to qualify for the tax benefits associated with qualified employee benefit plans. These include the ability of the employer to take an immediate deduction for a plan contribution regardless of whether it is included in the employee’s current income, and the deferral of taxation on plan earnings until they are distributed to the participant.
a. Qualified
b. Non Qualified
A
a. Qualified
Additionally, special tax rules relating to forward averaging and the ability to move assets to another tax-deferred arrangement such as an IRA apply only to qualified plan assets.
10
Q
Retirement 8-1 Nonqualified Deferred Comp
Qualified vs. Nonqualified Plans
A ____ is a contractual agreement between an employer and employee that specifies when and how future compensation will be paid. The plan represents an unfunded and unsecured promise to pay benefits in the future. In the meantime, plan assets remain within the reach of corporate creditors and the employer may not take an income tax deduction on monies set aside to informally fund the plan.
a. Qualified
b. Non Qualified
A
b. Non Qualified
Nonqualified plans are ideal for individuals such as business owners and key employees, who want to provide compensatory benefits for themselves without having to provide similar benefits to rank-and-file employees. These key employees are also looking to avoid the contribution and participation limits that apply to qualified plans. The price for this freedom of plan design is that the employer cannot take a deduction for payments to a nonqualified deferred compensation plan until the employee reports the payments in income, which is often at retirement. Also, the earnings on plan assets are not tax-deferred; instead, earnings are taxed annually to the sponsor or to the participant.
11
Q
Retirement 8-1 Nonqualified Deferred Comp
Easier and less expensive to implement and maintain than a qualified benefit plan
Can be offered on a discriminatory basis
Can provide unlimited benefits
Allows employer to control timing and receipt of benefits
Enables employer to attract and retain key employees
a. Advantages of NQDC plans
b. Disadvantages of NQDC plans
A
a. Advantages of NQDC plans
12
Q
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: IRC Requirements
Discrimination: Plan may not discriminate
a. Qualified Plan
b. Nonqualified Plan
A
a. Qualified Plan
13
Q
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: IRC Requirements
Discrimination: Plan may discriminate
a. Qualified Plan
b. Nonqualified Plan
A
b. Nonqualified Plan
14
Q
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: IRC Requirements
Compensation limit: Compensation limit applies
a. Qualified Plan
b. Nonqualified Plan
A
a. Qualified Plan
15
Q
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: IRC Requirements
Compensation limit: Compensation limit does not apply
a. Qualified Plan
b. Nonqualified Plan
A
b. Nonqualified Plan
16
Q
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: IRC Requirements
Benefit limitations: Applies to both defined contribution and defined benefit plans
a. Qualified Plan
b. Nonqualified Plan
A
a. Qualified Plan
17
Q
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: IRC Requirements
Vesting: Vesting schedules are required
a. Qualified Plan
b. Nonqualified Plan
A
a. Qualified Plan
18
Q
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: IRC Requirements
Vesting: Vesting schedules are not required
a. Qualified Plan
b. Nonqualified Plan
A
b. Nonqualified Plan
19
Q
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: IRC Requirements
Penalties and excise taxes: Penalties and excise taxes apply
a. Qualified Plan
b. Nonqualified Plan
A
a. Qualified Plan
20
Q
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: IRC Requirements
Penalties and excise taxes: Penalties and excise taxes do not apply unless the plan violates AJCA (Section 409A)
a. Qualified Plan
b. Nonqualified Plan
A
b. Nonqualified Plan
21
Q
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: IRC Requirements
ERISA requirements: Must satisfy ERISA requirements
a. Qualified Plan
b. Nonqualified Plan
A
a. Qualified Plan
22
Q
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: IRC Requirements
ERISA requirements: Exempt from most ERISA requirements
a. Qualified Plan
b. Nonqualified Plan
A
b. Nonqualified Plan
23
Q
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: Tax Treatment
Employer’s deduction: Available in year of plan contribution
a. Qualified Plan
b. Nonqualified Plan
A
a. Qualified Plan
24
Q
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: Tax Treatment
Employer’s deduction: Available in year of plan contribution
a. Qualified Plan
b. Nonqualified Plan
A
a. Qualified Plan
25
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: Tax Treatment
Employer’s deduction: Available in year employee is taxed on benefits
a. Qualified Plan
b. Nonqualified Plan
b. Nonqualified Plan
26
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: Tax Treatment
Employee deferral: Tax deferred until plan distribution
a. Qualified Plan
b. Nonqualified Plan
a. Qualified Plan
27
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: Tax Treatment
Fund earnings: Accrue tax deferred until distribution
a. Qualified Plan
b. Nonqualified Plan
a. Qualified Plan
28
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: Tax Treatment
Fund earnings: Are currently taxable to the employer in most cases
a. Qualified Plan
b. Nonqualified Plan
b. Nonqualified Plan
29
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: Tax Treatment
Distributions: Ordinary income tax rates apply; capital gains rates for net unrealized appreciation on employer securities
a. Qualified Plan
b. Nonqualified Plan
a. Qualified Plan
30
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: Tax Treatment
Distributions: Ordinary income tax rates apply and benefits are taxed as wages
a. Qualified Plan
b. Nonqualified Plan
b. Nonqualified Plan
31
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: Tax Treatment
Distributions: Ordinary income tax rates apply and benefits are taxed as wages
a. Qualified Plan
b. Nonqualified Plan
b. Nonqualified Plan
32
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: Tax Treatment
Tax-free rollovers: Assets are fully portable and may be rolled over into an IRA or another qualified plan
a. Qualified Plan
b. Nonqualified Plan
a. Qualified Plan
33
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: Tax Treatment
Tax-free rollovers: Assets are not portable and rollovers are not permitted
a. Qualified Plan
b. Nonqualified Plan
b. Nonqualified Plan
34
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: Tax Treatment
Creditor protection: Benefits are protected from the claims of both the employee’s and the employer’s bankruptcy and nonbankruptcy third-party creditors
a. Qualified Plan
b. Nonqualified Plan
a. Qualified Plan
35
Retirement 8-1 Nonqualified Deferred Comp
Comparison of Nonqualified and Qualified Plans: Tax Treatment
Creditor protection: Generally, benefits are fully subject to the claims of the employer’s third-party creditors; benefits are subject to the claims of an employee’s third party creditors after they become payable or are nonforfeitable
a. Qualified Plan
b. Nonqualified Plan
b. Nonqualified Plan
36
Retirement 8-1 Nonqualified Deferred Comp
Generally the way that tax deferral occurs with nonqualified deferred compensation is not because of special tax laws, but because the individual has yet to receive anything on which to be taxed. There are two main ways this can occur. This first is that there has not been any money set aside exclusively for the individual, and it is just a promise to pay the employee, which may or may not happen. Typically this is because there are strings attached to the promise, such as having to complete three more years of service or any payment is forfeited. These so-called “strings” are referred to as a “_____” provision.
a. high risk of forfeiture
b. substantial risk of forfeiture
b. substantial risk of forfeiture
37
Retirement 8-1 Nonqualified Deferred Comp
The other way that deferral of taxation can occur is that the money is “_____” and creditors may get to it before the employee does. Once the employee is vested, meaning the money is definitely theirs and cannot be taken away, then that is when they will be taxed.
a. risky
b. at risk
b. at risk
38
Retirement 8-1 Nonqualified Deferred Comp
A nonqualified deferred compensation plan is considered _____ if the employer has irrevocably and unconditionally set aside assets in a trust for the payment of plan benefits. Such assets are beyond the reach of the employer and their creditors. In exchange for this security, however, these plans offer limited tax deferral opportunity and may be subject to all of ERISA’s requirements including rules governing administrations, reporting, disclosure, participation, vesting, funding and fiduciary activities.
a. funded
b. unfunded
c. informally
a. funded
39
Retirement 8-1 Nonqualified Deferred Comp
In an ______ plan, the more popular plan, no funds are set aside by the employer. Employers favor this approach because cash is not tied up in plan investments, but remains available for ongoing business needs. In addition, these plans provide the benefit of tax deferral and avoid nearly all ERISA requirements (except minimal reporting and disclosure requirements). On the other hand however, this “pay-as-you-go” approach gives the employee little assurance that their promised payments will actually be received.
a. funded
b. unfunded
c. informally
b. unfunded
40
Retirement 8-1 Nonqualified Deferred Comp
With an ______ funded plan the employer sets aside assets which to be used to pay its promises under the plan. The plan will be considered unfunded if these assets remain available to the employer’s general creditors.
a. funded
b. unfunded
c. informally
c. informally
41
Retirement 8-1 Nonqualified Deferred Comp
As we have seen, individuals cannot defer more than $18,000 of annual compensation to a qualified 401(k) in 2016. Highly compensated individuals may wish to defer amount in excess of $18,000. A salary reduction plan, or pure deferred compensation plan, is a way to achieve this. These plans are funded with _____ money.
a. employee
b. employer
a. employee
The employee agrees to give up a specified portion of current compensation (salary, raise, or bonus); in turn, the employer can promise to pay a benefit in the future that is equal to the deferred amounts plus a predetermined rate of interest. The employer could also give the employee investment choices (oftentimes these can be the same as those offered in the company’s 401(k) plan) and credit the employee with whatever returns these investments may have. A salary reduction arrangement is sometimes called an “in lieu of” plan because the employee is receiving the employer’s promise to pay benefits in lieu of current income.
42
Retirement 8-1 Nonqualified Deferred Comp
Because of its nature (i.e., it continues where the qualified plan leaves off), a popular form of nonqualified plan is the excess benefit plan. This plan is linked indirectly by benefit to the qualified plan or plans in place. It provides for benefits in excess of the amount to which the employee would otherwise be entitled through the plan formula as modified by the above contribution or benefit limits in the qualified plan or plans.
a. excess benefit
b. additional benefit
a. excess benefit
That is, the contribution or benefit provided to a participant by an excess benefit plan is the contribution or benefit that would apply if the Section 415 limits did not exist minus the Section 415 limited contribution or benefit provided by the qualified plan. The payment is typically made upon an employee’s retirement and is usually paid in the same manner that benefits are paid under a qualified retirement plan. The plan may be either funded (i.e., specific property is set aside to secure the obligation accruing to the employee) or unfunded (i.e., a mere promise is made).
43
Retirement 8-1 Nonqualified Deferred Comp
If an excess benefit plan is _____, it is essentially exempt from all ERISA Title 1 requirements regarding funding, vesting, participation, and reporting requirements. Accordingly, for simplicity’s sake, these plans are often structured as unfunded and unsecured promises to pay an excess benefit at an employee’s normal retirement age.
a. funded
b. unfunded
b. unfunded
44
Retirement 8-1 Nonqualified Deferred Comp
A _____ excess benefit plan is subject to ERISA’s reporting and disclosure requirements, specifications regarding fiduciary responsibilities, and administrative and enforcement procedures. Like an unfunded plan, however, it need not comply with the participation, vesting, and funding requirements of ERISA.
a. funded
b. unfunded
a. funded
45
Retirement 8-1 Nonqualified Deferred Comp
In a supplemental executive retirement plan (SERP) the ______ makes a commitment to fund a specific deferred benefit.
a. employee
b. employer
b. employer
The employee does not forgo current compensation. This plan is sometimes referred to as a salary continuation plan. Such a plan might be considered an additional fringe benefit that the employer could offer to induce an executive to join or stay with the company. SERPs are often referred to as “golden handcuffs” because if the executive risks losing a substantial amount of retirement benefits by leaving the company, he may rethink a career move. As such, SERP that is designed with a delayed vesting schedule can be a very successful retention tool.
46
Retirement 8-1 Nonqualified Deferred Comp
An executive will not realize income under a nonqualified plan, even though he is vested, if the employer’s promise to pay future compensation is unsecured and unfunded.
Vested but unfunded SERP
Funded but not vested SERP
Vested but unfunded SERP
47
Retirement 8-1 Nonqualified Deferred Comp
An executive will not realize income, even if the plan is funded, if the executive’s right to receive the future benefit is not transferable and is subject to a substantial risk of forfeiture.
Vested but unfunded SERP
Funded but not vested SERP
Funded but not vested SERP
48
Retirement 8-1 Nonqualified Deferred Comp
The employer _____ permitted a current tax deduction for contributions to a SERP
a. is
b. is not
b. is not
Their deduction for contributions is deferred until these amounts are included in the executive’s income. When the benefit payments are included in the executive’s income, generally during the retirement years, then the employer may deduct the payments. In addition, earnings that accrue in a funded plan will be currently taxable to the employer.
49
Retirement 8-1 Nonqualified Deferred Comp
A ______ plan is a type of SERP established to provide unfunded deferred compensation benefits to a select group of management or highly compensated employees.
a. top hat
b. cowboy hat
a. top hat
Because a top hat plan is always unfunded it is not subject to ERISA’s fiduciary, participation, vesting, and funding rules. It is nevertheless subject to the reporting and disclosure requirements and to the enforcement and administration requirements of ERISA. These requirements, however, generally are not onerous and can usually be satisfied by a single filing of a brief informational statement with the Labor Department and by providing plan documents to the Labor Department if they are requested.
50
Retirement 8-1 Nonqualified Deferred Comp
Important Characteristics of Excess Benefit Plans, Top Hat Plans, and SERPs
Participation Restrictions: Plan may be established for any employee (plan typically is established for highly compensated employees)
a. Excess Benefit Plans
b. Top Hat Plans and SERPs
a. Excess Benefit Plans
51
Retirement 8-1 Nonqualified Deferred Comp
Important Characteristics of Excess Benefit Plans, Top Hat Plans, and SERPs
Source of Benefits: Benefits generally are paid by the employer out of general assets
a. Excess Benefit Plans
b. Top Hat Plans and SERPs
both a. and b.
52
Retirement 8-1 Nonqualified Deferred Comp
Important Characteristics of Excess Benefit Plans, Top Hat Plans, and SERPs
Type of Funding: May be funded or unfunded
a. Excess Benefit Plans
b. Top Hat Plans and SERPs
a. Excess Benefit Plans
53
Retirement 8-1 Nonqualified Deferred Comp
A ______ trust is technically an unfunded plan, although it is often considered to be informally funded. This trust is established by an employer to informally fund their obligation to provide employees with benefits under a nonqualified deferred compensation plan. Such an arrangement is meant to provide employees with assurance that payment of the deferred compensation will in fact be paid when due.
a. secular
b. Rabbi
b. Rabbi
The first irrevocable trust approved in this scenario was sponsored by a synagogue for its rabbi, hence the name.
54
Retirement 8-1 Nonqualified Deferred Comp
As grantor and owner of the Rabbi trust assets, the employer may use these assets only to satisfy the obligation owed the executive. Plan assets are protected against a change of control, such as a hostile takeover, but are not protected if the employer becomes bankrupt or declares insolvency. In that case, the trust assets must be available to satisfy the general obligations of the employer’s creditors. Thus, the contributions and earnings on investments used to fund the trust are considered to have “_____” and are not currently taxable income to the executive.
a. high risk of forfeiture
b. substantial risk of forfeiture
b. substantial risk of forfeiture
Additionally, as per the definition of a grantor trust, the trust earnings are currently taxable to the grantor (or employer), rather than taxable to the grantee (employee).
55
Retirement 8-1 Nonqualified Deferred Comp
A _____ trust is also an irrevocable trust established for the purpose of providing nonqualified plan benefits to an employee.
a. secular
b. Rabbi
a. secular
Secular trusts may be employer-funded or employee-funded. An employee-funded secular trust is a type of grantor trust that is established by an employee. (Income earned by a grantor trust is taxed to the grantor, the employee in this situation.)
56
Retirement 8-1 Nonqualified Deferred Comp
Unlike assets in a rabbi trust, employee-funded secular trust assets ____ subject to the claims of an employer’s creditors. The secular trust is designed to be the opposite of the rabbi trust.
a. are
b. are not
b. are not
The plan will not include a substantial risk of forfeiture provision, and the employee will be in constructive receipt of contributions made to the trust. Therefore, the employer’s contribution to the trust is immediately taxable to the employee and the employer receives an immediate deduction. Such contributions are considered wages and are subject to the normal withholding requirements, including FICA and FUTA. Often the employer will increase the participant’s compensation to offset the taxes on this imputed income.
57
Retirement 8-1 Nonqualified Deferred Comp
If properly structured, an employee-funded secular trust consists of a _____ arrangement on behalf of a named employee. Typically, assets in the trust are invested in tax-deferred assets such as permanent life insurance, tax-exempt securities, or other similar investments. Therefore, the increase in value of the tax-deferred assets usually will not be taxable to the employee-beneficiary until payments are made from the trust.
a. fully funded
b. unfunded
a. fully funded
One useful purpose of an employee-funded secular trust is to protect an employee-beneficiary from his or her employer’s failure to pay the promised benefits because of employer insolvency, employer bankruptcy, a change in ownership or control of the employer, or outright refusal by the employer to honor the agreement.
58
Retirement 8-1 Nonqualified Deferred Comp
Example. BordCom Inc. offers certain employees a funded nonqualified deferred compensation plan, and all ERISA-eligible employees are in the plan. The plan uses an employee-funded secular trust to hold plan assets, which consist of a variable life insurance contract for each participant. The plan does not contain substantial risk of forfeiture provisions. Therefore, the contributions to the plan (used to pay premiums) will be taxed ______ and are subject to normal withholding, including FICA and FUTA.
a. each year as they are made
b. at distribution
a. each year as they are made
For this reason, the plan should not be subject to IRC Section 409A since the deferrals are includible in gross income and are not “deferred compensation.” The increase in value of the insurance contract is subject to tax once the payments from the secular trust are made to the employee beneficiary. A ratable portion of each payment is taxed as income (again, subject to FICA and FUTA), based on the increase in value of the insurance contract over the total contributions (life insurance premiums in this case) already taxed to the employee.
59
Retirement 8-1 Nonqualified Deferred Comp
There are other ways to benefit executives other than deferred compensation that is merely a promise to pay, or is at risk.
The concept of ______ involves an arrangement between two or more persons, or between a person and a corporation or other entity, to share (1) premium payments on a life insurance policy and (2) proceeds of the life insurance policy. This insurance is meant to replace income lost due to premature death. The employer recovers its cost at the premature death of the executive or when the policy is surrendered by the executive.
a. Split Dollar Life Insurance Plans
b. Key Employee Life Insurance
c. Death-Benefit-Only Plans
a. Split Dollar Life Insurance Plans
The employer receives its share of the death benefit tax-free, as does the executive’s beneficiary. The premium is not deductible to the employer, and the executive must pay tax on the economic benefit of the policy, as determined in IRS Table 2001, less any premiums paid by the executive.
60
Retirement 8-1 Nonqualified Deferred Comp
There are other ways to benefit executives other than deferred compensation that is merely a promise to pay, or is at risk.
An employer’s purchase of a ______ represents protection for the company, not the employee. Such a policy would be prudent if the company were obligated to pay a benefit at the key employee’s death under a DBO plan or under the death benefit provisions of a deferred compensation plan. Other reasons for such a policy could center on a company’s need for liquidity for purchasing an executive’s stock or funding ongoing operations of the company.
a. Split Dollar Life Insurance Plans
b. Key Employee Life Insurance
c. Death-Benefit-Only
b. Key Employee Life Insurance
Since there are no benefits paid to the employee, there are no tax consequences to the employee from a key employee life insurance policy. Nor is the employer entitled to a deduction for premiums paid on the policy, since the employer is the beneficiary of the policy.
61
Retirement 8-1 Nonqualified Deferred Comp
There are other ways to benefit executives other than deferred compensation that is merely a promise to pay, or is at risk.
______ are just what the name implies: The only benefit they provide is a death benefit to the employee’s designated beneficiary. A death benefit-only plan (DBO plan) is a type of ERISA welfare plan often misclassified as a nonqualified deferred compensation plan. (A welfare plan is an employer sponsored plan that provides, among other things, death, disability, sickness, accident, or unemployment benefits for its participants.)
a. Split Dollar Life Insurance Plans
b. Key Employee Life Insurance
c. Death-Benefit-Only
c. Death-Benefit-Only
A DBO plan is not considered to be an ERISA employee pension benefit plan because it does not provide retirement benefits, nor does it provide for the deferral of income. Welfare plans are subject to ERISA’s reporting, disclosure, fiduciary, administration, and enforcement requirements; however, they are not subject to ERISA’s participation, vesting, and funding requirements. A death-benefit-only plan is a valuable tax planning tool for a highly compensated employee who has a large estate that may be subject to significant federal estate taxes, even after the unified credit and marital deduction are taken into account. It’s valuable because a properly designed death-benefit-only plan is excluded from federal estate tax for a highly compensated employee who owns 50% or less of a closely held corporation’s (i.e., the employer’s) stock. All payments are taxed as ordinary income to the beneficiary.
62
Retirement 8-1 Nonqualified Deferred Comp
Example of Death-Benefit-Only benefit
Chuck Baines owns 48% of BioFuels Inc. The company’s estimated value is $12 million. Ted Dryden owns 40% and Mark Rule, a former employee, owns the remaining 12%. Ted has decided he needs to provide liquidity to his estate for tax and other reasons. The company will provide this liquidity through a death-benefit-only plan. Ted is 42 and will be covered by a $5 million policy; with the _____ as beneficiary of this policy
a. Ted's designated beneficiary
b. the company
b. the company
63
Retirement 8–2: Taxation of NQDC Plans
Case law and IRS rulings hold that an employee may be taxed on cash or property that is “received” in exchange for services rendered. This requirement is known as the _____ doctrine. The constructive receipt issue isn’t whether the taxpayer has actually received the income, but whether he has access to it.
a. constructive receipt
b. economic benefit
a. constructive receipt
Technically speaking, the constructive receipt doctrine taxes “income not actually reduced to a taxpayer’s possession yet otherwise made available to him so that he could have drawn upon it at his discretion.” To avoid constructive receipt, agreements usually contain specific provisions establishing substantial risk of forfeiture (funded plans) or availability of funds to the company’s general creditors (unfunded plans).
64
Retirement 8–2: Taxation of NQDC Plans
The _____ doctrine states that if any economic or financial benefit is provided to an individual as compensation immediate taxation will result. In other words, when the employee’s benefit has become substantially vested or essentially equivalent to the receipt of cash, current income taxation will result.
a. constructive receipt
b. economic benefit
b. economic benefit
In other words, when the employee’s benefit has become substantially vested or essentially equivalent to the receipt of cash, current income taxation will result. Economic benefit goes beyond the income-related issue of constructive receipt because it concerns anything that an employer might give to an employee as a substitute for cash.
65
Retirement 8–2: Taxation of NQDC Plans
Because of the alternative minimum tax (AMT) provisions, a corporation may incur a tentative minimum tax liability on the buildup of cash value in corporate owned life insurance or on the proceeds received from a life insurance policy upon the death of an insured. For example, in certain situations it is possible for 75% of the life insurance proceeds received by a corporation to be subject to a tax based on the ___ AMT rate.
a. 15%
b. 20%
c. 25%
b. 20%
This results in an effective tax rate of 15% (the 20% AMT rate × 75%.)
66
Retirement 8–2: Taxation of NQDC Plans
The value of any death benefits payable to an employee’s beneficiary _____ includible in that employee’s gross estate for federal estate tax purposes.
a. are
b. are not
a. are
Accordingly, in some estates it will be important for the deferred compensation payments to qualify for the unlimited maximum marital deduction. The payments that qualify for this deduction are payments directly to the surviving spouse or payments directly to a marital deduction trust over which the spouse has a general power of appointment. Ultimately, the deferred compensation may have to be included in the gross estate of the surviving spouse, i.e., “the second to die.” It is the estate of the second to die that may have to pay all of the federal estate taxes attributable to the deferred compensation, unless the right to receive payments is non-transferable and expires after the death of the second to die. For example, single life annuity payments to a surviving spouse are not subject to estate tax.
67
Retirement 8–2: Taxation of NQDC Plans
Deferred compensation is taxable as ordinary income to a deceased participant’s beneficiary. This is known as _____ in respect of a decedent
a. benefits
b. income
b. income
(IRD). The beneficiary is entitled to some relief in the form of an income tax deduction based, in part, on the amount of estate tax, if any, that results from inclusion of retirement benefits in the deceased participant’s estate. The beneficiary must itemize to be able to claim this deduction.
68
Retirement 8–2: Taxation of NQDC Plans
Nonqualified deferred compensation defers wages, and “wages,” as defined in the Code, include all payments for services performed by an employee for his employer, including the cash value of all payments in property other than cash (including benefits). The general rule is that this “compensation” is subject to Social Security taxes as of the _____ of
1. the date on which services are performed or
2. when the deferred compensation is no longer subject to a substantial risk of forfeiture.
a. earlier
b. later
b. later
69
Retirement 8–2: Taxation of NQDC Plans
Deferred compensation arrangements in _____ generally are unsuccessful deferral vehicles due to their adverse tax consequences.
a. closely held corporations
b. partnerships
b. partnerships
The IRS considers contributions to a partnership’s deferred compensation plan as income (compensation) to the partnership and, therefore, as currently taxable. Even when the benefit payments are forfeitable, contributions to such a trust are currently taxable to the partners.
70
Retirement 8–2: Taxation of NQDC Plans
Problem Areas of Closely Held Corporations
During an audit, the IRS will carefully scrutinize a deferred compensation arrangement between a closely held corporation and its controlling shareholder.
a. Control issues
b. Unreasonable compensation
c. Accumulated earnings tax
a. Control issues
The IRS may argue that a controlling shareholder has complete power to accelerate or defer the income at will. Nevertheless, case law on this point generally supports the conclusion that such deferred compensation arrangements are valid. In particular, the courts have looked to determine whether the corporation involved is a valid legal entity. In general, a valid corporation will be recognized for tax purposes; however, a sham corporation or a corporation that has failed to comply with state corporation requirements and is essentially invalid will usually be disregarded for tax purposes.
71
Retirement 8–2: Taxation of NQDC Plans
Problem Areas of Closely Held Corporations
If deferred compensation payments made to the majority stockholder of a closely held corporation exceed (along with previous compensation paid) “reasonable compensation” as determined by the IRS, the corporation’s deduction is denied. The IRS’s concern is that the payment may actually be a disguised dividend. This generally is only an issue with stockholder-employees in closely held, not publicly traded, corporations.
a. Control issues
b. Unreasonable compensation
c. Accumulated earnings tax
b. Unreasonable compensation
72
Retirement 8–2: Taxation of NQDC Plans
Problem Areas of Closely Held Corporations
The issue of whether a deferred compensation plan is, in fact, concealing dividends is central to the accumulated earnings tax issue of regular corporations. If the IRS determines that the deferred compensation plan is designed to avoid dividend distributions, then plan premiums and funding payments are subject to a penalty tax. The IRS’s decision regarding the plan will be based on whether earnings are, in fact, being accumulated in excess of “reasonable business needs.”
a. Control issues
b. Unreasonable compensation
c. Accumulated earnings tax
c. Accumulated earnings tax
73
Retirement 8–3: Informally Funded Plans
1. only vehicle that fully secures payments immediately
2. only asset that builds a reserve sufficient to fund a sizable death benefit, however early death occurs
3. waiver of premium available for disability protection
4. settlement options available to meet payouts
5. investment advantages: safety of principal, convenient units of purchase, guaranteed tax-free annual return, 100% collateral value, no investment management, asset diversification, possible large tax-free gain if the policy is held until the employee’s death
6. the employer pays the premium and the proceeds in life or at death go to the employer; the employer makes a payment to the employee, then deducts the payment; the employee is taxed on the payment
a. informal funding using employer-owned life insurance
b. informal funding using a split dollar insurance policy
c. informal funding using an annuity
d. informal funding using a phantom stock plan
e. informal funding using a deferred stock plan
f. informal funding using split or combination funding
a. informal funding using employer-owned life insurance
74
Retirement 8–3: Informally Funded Plans
_____ is under new regulations issued in September 2003. Except for grandfathered plans, it appears that its usefulness is very limited.
a. informal funding using employer-owned life insurance
b. informal funding using a split dollar insurance policy
c. informal funding using an annuity
d. informal funding using a phantom stock plan
e. informal funding using a deferred stock plan
f. informal funding using split or combination funding
b. informal funding using a split dollar insurance policy
75
Retirement 8–3: Informally Funded Plans
1. the noncorporate employer is the owner and beneficiary of the annuity; the employee is the annuitant
2. the employer pays out to the employee and deducts payments
3. the Tax Reform Act of 1986 provides that non-individual (e.g., corporate) owners of deferred annuities are to be currently taxed on the increase in the cash surrender value; this has reduced the appeal of this funding vehicle (unless transferred into the name of the employee)
a. informal funding using employer-owned life insurance
b. informal funding using a split dollar insurance policy
c. informal funding using an annuity
d. informal funding using a phantom stock plan
e. informal funding using a deferred stock plan
f. informal funding using split or combination funding
c. informal funding using an annuity
76
Retirement 8–3: Informally Funded Plans
1. benefits paid are measured by the value of shares in mutual fund or employer stock
2. if employer stock is used, the employer credits the employee’s account yearly with a number of units, depending on the current value of the stock
3. the employee does not actually receive or own any stock; the phantom stock is merely a measuring device
4. on retirement, the employee’s units are revalued, and the value of the stock plus dividends can be paid over a period of years; the payments are taxed at ordinary income rates and deducted by the employer (withholding, FICA, and FUTA apply)
5. frequently used in closely held corporations
a. informal funding using employer-owned life insurance
b. informal funding using a split dollar insurance policy
c. informal funding using an annuity
d. informal funding using a phantom stock plan
e. informal funding using a deferred stock plan
f. informal funding using split or combination funding
d. informal funding using a phantom stock plan
also known as a shadow stock plan
77
Retirement 8–3: Informally Funded Plans
1. involves payout under a phantom stock plan; payments made in measuring shares of stock instead of cash
2. the employee is taxed at distribution on the fair market value of the shares; the employer deducts the same amount
a. informal funding using employer-owned life insurance
b. informal funding using a split dollar insurance policy
c. informal funding using an annuity
d. informal funding using a phantom stock plan
e. informal funding using a deferred stock plan
f. informal funding using split or combination funding
e. informal funding using a deferred stock plan
78
Retirement 8–3: Informally Funded Plans
1. provides an immediate death benefit plus a retirement benefit that is responsive to market fluctuations through use of insurance and equities, such as mutual funds
2. insured benefits are lower than if the plan were fully insured at the same cost
3. the cash value of insurance can provide a guaranteed minimum retirement benefit
a. informal funding using employer-owned life insurance
b. informal funding using a split dollar insurance policy
c. informal funding using an annuity
d. informal funding using a phantom stock plan
e. informal funding using a deferred stock plan
f. informal funding using split or combination funding
f. informal funding using split or combination funding
79
Retirement 8–4: Restricted Stock Plans
The compensation package of an executive typically consists of several elements such as base salary, incentive pay, fringe benefits (including health insurance), retirement benefits, and cafeteria plan tax benefits. In addition, the executive’s compensation often includes long-term equity-based incentive plans involving stock, restricted stock, restricted stock units, or stock options. Such equity arrangements typically make up more than ___ of the executive’s compensation.
a. 20%
b. 30%
c. 40%
b. 30%
80
Retirement 8–4: Restricted Stock Plans
From the employer’s perspective, one of the most effective ways to compensate an executive is to align the interests of the executive with those of the company via incentive pay. Plans that tie together executive performance and company stock values are an effective means of creating this alignment of interests. These arrangements are collectively referred to as _____ compensation plans. In general, when a company is successful, the compensation paid to the executives will reflect that success.
a. equity-based
b. performance
a. equity-based
81
Retirement 8–4: Restricted Stock Plans
______ provide for the grant of company stock by the employer to certain employees in which the employee’s rights to the stock are restricted until the shares vest or otherwise lapse in restrictions. As such, these plans are meant to encourage the executive to remain with the company. These plans are attractive to employees because they are typically not required to pay anything for the stock and the grant is not taxable to the employee until it vests. The plans are attractive to employers because they require minimum cash outflow.
a. Incentive Stock plans
b. Restricted stock plans
b. Restricted stock plans
82
Retirement 8–5: ISOs and Nonqualified Stock Options
An _____ is a right granted by a corporation, or a parent or subsidiary of the corporation, to an employee (usually an executive) that allows the employee to purchase stock of the corporation in a tax favored manner.
a. incentive stock option
b. non qualified stock option
a. incentive stock option
Incentive stock options are also called statutory stock options and sometimes incorrectly called restricted stock options (abolished in 1964) or qualified stock options (abolished in 1976). Any employee, including the employees of a parent or subsidiary corporation of the granting corporation, may receive a grant of ISOs. However, ISOs may not be granted to owners of more than 10% of the voting power of all classes of stock of the granting corporation unless the exercise price is at least 110% of the fair market value of the underlying stock.
83
Retirement 8–5: ISOs and Nonqualified Stock Options
Any employee, including the employees of a parent or subsidiary corporation of the granting corporation, may receive a grant of _____. However, they may not be granted to owners of more than 10% of the voting power of all classes of stock of the granting corporation unless the exercise price is at least 110% of the fair market value of the underlying stock.
a. incentive stock option
b. RSUs
a. incentive stock option
84
Retirement 8–5: ISOs and Nonqualified Stock Options
The tax advantage of an incentive stock option plan to an employee is that no income is recognized on the grant or even on the exercise of the option. Recognition is triggered only by the sale of the shares, and assuming certain holding period requirements are met then any gain is taxed at ______.
a. ordinary income
b. the lower capital gains rates
b. lower capital gains rates
85
Retirement 8–5: ISOs and Nonqualified Stock Options
The employee recognizes an amount of income that is the difference between the amount realized from the _____ of the stock and the price paid for the option.
a. grant
b. sale
b. sale
86
Retirement 8–5: ISOs and Nonqualified Stock Options
When the ISO is _____, and the stock purchased by the employee, there are no regular income taxes due—this does not occur until the stock is actually sold.
a. exercised
b. granted
a. exercised
87
Retirement 8–5: ISOs and Nonqualified Stock Options
The employee-recipient may be subject to the individual alternative minimum tax (AMT) since the “bargain element” (the difference between the _____ price and the current fair market value of the stock) is considered to be an adjustment for alternative minimum tax purposes.
a. purchase
b. grant
a. purchase
88
Retirement 8–5: ISOs and Nonqualified Stock Options
An AMT adjustment occurs only if the stock is not actually sold during the ___ in which the option was exercised.
a. month
b. year
b. year
89
Retirement 8–5: ISOs and Nonqualified Stock Options
Incentive stock options are viable options for employees whom a company may wish to employ and retain, especially in _____ where competition for talented professionals is strong. Without expending any cash, the employer is able to give an employee a stake in the company, while simultaneously providing an incentive to remain with the company and produce the desired results.
a. high-tech businesses
b. well established companies
a. high-tech businesses
90
Retirement 8–5: ISOs and Nonqualified Stock Options
ISOs cannot be exercised after __ years from the date of the grant.
a. 10
b. 15
a. 10
91
Retirement 8–5: ISOs and Nonqualified Stock Options
The exercise price must be _____ the fair market value of the stock at the time the ISOs are granted.
a. less than
b. at least
b. at least
92
Retirement 8–5: ISOs and Nonqualified Stock Options
ISOs must be exercised within _ months from the date of retirement or termination in order to preserve favorable tax treatment (up to one year if the termination of employment is due to disability).
a. 3
b. 6
a. 3
93
Retirement 8–5: ISOs and Nonqualified Stock Options
After exercise, the acquired stock must be held for a period of _ years from the date of the grant and one year from the date of exercise, to preserve capital gain treatment.
a. 1
b. 2
b. 2
94
Retirement 8–5: ISOs and Nonqualified Stock Options
The aggregate fair market value of any ISO grants for the year must be no more than _____ per employee (if more than _____ then any amount over _____ will be treated as a nonqualified stock option).
a. $100,000
b. $1,000,000
a. $100,000
95
Retirement 8–5: ISOs and Nonqualified Stock Options
At the time of _____of the option there is no taxable income to the employee. Assuming the employee paid nothing for the _____ (which is typically the case), the basis in the option is zero.
a. Grant
b. Exercise
c. Dispositions
a. Grant
96
Retirement 8–5: ISOs and Nonqualified Stock Options
At the time of _____ there is no taxable income to the employee unless the _____ occurs more than three months after terminating employment.
a. Grant
b. Exercise
c. Dispositions
b. Exercise
1. Stock resulting from exercise of the ISO. The amount paid by the employee for the stock in exercising the option is the employee’s basis in the stock.
2. Alternative minimum tax (AMT). At the time of exercise the bargain purchase element of the ISO (the difference between option price and fair market value) is treated as a preference item for AMT income unless the stock is actually sold in the year of exercise. So even though the shares have not been sold, the act of exercising the option requires the employee to add back the gain on exercise to other AMT preference items, to determine whether the AMT applies.
97
Retirement 8–5: ISOs and Nonqualified Stock Options
The difference between the amount received on _____ and the employee’s basis will be treated as long-term capital gain if the holding period has been satisfied.
a. Grant
b. Exercise
c. Dispositions
c. Dispositions
In the case of a “qualified disposition” (one where the holding period has been met), the company cannot take a tax deduction. If, however, there is a “disqualifying disposition” due to the employee exercising and selling the shares before meeting the required holding periods, the spread is taxable to the employee and deductible by the employer. Any increase or decrease in the shares’ value between exercise and sale is taxed at capital gains rates.
98
Retirement 8–5: ISOs and Nonqualified Stock Options
On January 1, 2007, Bill Ryan was granted 100 ISOs to purchase shares at $10 per share (the fair market value at that time).
On May 12, 2014, Bill exercised all of his shares when the market price was $16 per share. On December 31, 2014, he sold 50 ISO shares at $21 per share. He has ordinary income of $300 in 2014 (the bargain element (16 – 10) × 50). Bill also has a short-term gain (also taxed as ordinary income) of
a. $650
b. $550
b. $550
(21 – 10) × 50 = $550
99
Retirement 8–5: ISOs and Nonqualified Stock Options
On January 1, 2007, Bill Ryan was granted 100 ISOs to purchase shares at $10 per share (the fair market value at that time).
On February 2, 2015, Bill sold 30 shares at $13 per share. He still has not met the one-year holding period requirement from the date of exercise, so he must recognize as ordinary income in 2015 the difference between the $13 per share amount realized on the sale and $10—the basis in the stock at the exercise price times the number of shares. There _____ withholding, FICA, or FUTA assessed with these transactions.
a. is
b. is no
b. is no
100
Retirement 8–5: ISOs and Nonqualified Stock Options
On January 1, 2007, Bill Ryan was granted 100 ISOs to purchase shares at $10 per share (the fair market value at that time).
On June 1, 2015, Bill sold the remaining 20 shares at $17 per share. Since he has now met the holding period requirement, any gain above the $10 exercise price is a long-term capital gain. In this case, Bill would have a long-term capital gain of
a. $140
b. $240
a. $140
$17 – $10 = $7
$7 x 20 = $140
101
Retirement 8–5: ISOs and Nonqualified Stock Options
An employee stock purchase plan is a right (option) that is granted by the employee’s corporation enabling employees to purchase shares in the company stock at fixed intervals (_____).
a. offering periods
b. holding periods
a. offering periods
102
Retirement 8–5: ISOs and Nonqualified Stock Options
Oftentimes this is accomplished through taxable payroll deductions. At the end of the offering period, employees’ accumulated funds are used to buy company stock, usually at a specified discount (up to __%) from the market value.
a. 10%
b. 15%
b. 15%
103
Retirement 8–5: ISOs and Nonqualified Stock Options
When the ESPP stock is sold, the _____ the employee received when buying the stock is taxed as ordinary income.
a. original share price
b. discount
b. discount
104
Retirement 8–5: ISOs and Nonqualified Stock Options
As with ISOs, ESPPs have a _____ year holding period to qualify for special tax treatment. If the holding period is met, the employee pays ordinary income tax on the amount attributable to the discount and any additional gains would be taxed as long-term capital gains.
a. one/two
b. two/three
a. one/two
105
Retirement 8–5: ISOs and Nonqualified Stock Options
Seth purchased stock in his ESPP on March 23, 2014. The stock closed at $11.16 on the offering date of January 1st and $18.65 on the purchase date of June 30th. The plan gives him a 15% discount, thus giving him an actual purchase price of:
a. $8.49
b. $9.49
b. $9.49
(85% of $11.16 via the lookback provision).
106
Retirement 8–5: ISOs and Nonqualified Stock Options
Seth purchased stock in his ESPP on March 23, 2014. The stock closed at $11.16 on the offering date of January 1st and $18.65 on the purchase date of June 30th.
Seth will have to hold his stock at least until ______, in order for this to be a qualifying disposition.
a. March 23, 2016
b. March 24, 2016
b. March 24, 2016
107
Retirement 8–5: ISOs and Nonqualified Stock Options
Seth purchased stock in his ESPP on March 23, 2014. The stock closed at $11.16 on the offering date of January 1st and $18.65 on the purchase date of June 30th.
Seth will have to hold his stock at least until March 24, 2016, in order for this to be a qualifying disposition. If he does this and sells the stock in April of 2016 for $22.71, then only the discounted amount of $1.67 per share ($11.16 x 15%) will be reported as ordinary income. The difference between the actual undiscounted market price and the sale price will be counted as a long-term gain or loss. Seth will therefore have a long-term gain of _____ per share
a. $11.55
b. $12.55
a. $11.55
($22.71 – $11.16).
108
Retirement 8–5: ISOs and Nonqualified Stock Options
If the holding period is not met, there would be a “______ disposition,” and the difference between the discounted grant price (exercise price) and the market value on the exercise date (purchase price) would be taxed as ordinary income. Additional profit earned between the date of purchase and the date of sale would be treated as a capital gain
a. improper
b. disqualifying
b. disqualifying
109
Retirement 8–5: ISOs and Nonqualified Stock Options
If Seth were to sell the stock before the holding period expired, he would recognize $9.16 as ordinary income ($18.65 – the discounted purchase price of $9.49). The market price on the day of purchase ($18.65), then becomes the cost basis for the sale. In this case, the remaining $4.06 of sale proceeds (sale price of $22.71 – the market price on day purchase of $18.65) will then be taxed as a _____, depending upon the length of his holding period.
a. ordinary income
b. long- or short term capital gain
b. long- or short term capital gain
110
Retirement 8–5: ISOs and Nonqualified Stock Options
Unlike ISOs, which have a $100,000 annual limit, the annual limit for ESPPs is _____. If an employee defers more than allowed, any excess would be returned.
a. $25,000
b. $50,000
a. $25,000
111
Retirement 8–5: ISOs and Nonqualified Stock Options
Just as with ISOs, after exercise the acquired stock must be held for a period of _____ years from the date of the grant and one year from the date of exercise, to preserve favorable tax treatment.
a. three
b. two
b. two
112
Retirement 8–5: ISOs and Nonqualified Stock Options
If an employee is able to purchase company stock at a discount, any discounted amount will be taxed as ordinary income, even if the holding period requirement is met. For example, Alexis has participated in her company’s employee stock purchase plan, which allows employees to purchase stock at a 10% discount. Alexis purchases 10 shares at $90 per share when the stock’s fair market value is $100. Alexis holds the stock for more than two years from the grant date and more than one year from the exercise date, and sells the stock for $130. She has met the holding period requirement and has a qualifying disposition.
$_____ per share will be taxed as ordinary income.
a. $5
b. $10
b. $10 ($100 on 10 shares)
This is the amount of the discount Alexis received when she was granted the option (the difference between her $90 per share grant price and the $100 per share fair market value at the time).
113
Retirement 8–5: ISOs and Nonqualified Stock Options
If an employee is able to purchase company stock at a discount, any discounted amount will be taxed as ordinary income, even if the holding period requirement is met. For example, Alexis has participated in her company’s employee stock purchase plan, which allows employees to purchase stock at a 10% discount. Alexis purchases 10 shares at $90 per share when the stock’s fair market value is $100. Alexis holds the stock for more than two years from the grant date and more than one year from the exercise date, and sells the stock for $130. She has met the holding period requirement and has a qualifying disposition.
$__ per share ($300 on 10 shares) will be taxed as long-term capital gain since she met the holding period requirement.
a. $30
b. $40
a. $30 ($300 on 10 shares)
If the employee sells at a loss (sells at a price less than the exercise price), then the employee will have a short-term or long-term capital loss depending upon the holding period beginning at the date of exercise.
114
Retirement 8–6: Nonqualified Stock Options (NSOs)
A nonqualified stock option (NSO) is a right granted by a corporation, its parent, or one of its subsidiaries to one or more of its employees on a _____ basis to acquire shares of the corporation’s stock. More specifically, a nonqualified stock option is the right to purchase a specified number of shares of employer stock at a given time and at a given price. Since the term nonqualified stock option is not defined in the Internal Revenue Code, it is also sometimes referred to as a nonstatutory option.
a. discriminatory
b. non discriminatory
a. discriminatory
115
Retirement 8–6: Nonqualified Stock Options (NSOs)
Nonqualified stock options are nonstatutory, and there are essentially no legal requirements other than those resulting from state law and securities law for nonqualified stock options. For example, the price may be equal to the fair market value at the date of grant, or it may be substantially _____ the value at the date of grant, although if this is the case the employee will be taxed and penalized immediately on any difference between the grant price and current fair market value (the bargain element) on the grant date.
a. above
b. below
b. below
116
Retirement 8–6: Nonqualified Stock Options (NSOs)
if one received a grant to purchase 1,000 shares at $30 per share, and the stock is at $35 per share, the employee would be taxed on the $5 per share discount, which in the case with 1,000 shares would be immediate taxable income of $5,000. This amount will also be subject to the underpayment interest rate plus 1% dating from the time it was not taxed and should have been. Finally, an additional tax of ___ is assessed.
a. 20%
b. 25%
a. 20%
117
Retirement 8–6: Nonqualified Stock Options (NSOs)
The price of the option generally is fixed—usually at the fair market value of the stock on the date of the option’s grant—and may be exercised only for a specified time period, typically _____ years or less. Although nonqualified stock options are not legally restricted by the duration and holding requirements found in ISO plans, most plans do require some holding period.
a. 5
b. 10
b. 10
118
Retirement 8–6: Nonqualified Stock Options (NSOs)
There are three distinct transactions with possible tax ramifications in the life of an option. These transactions are
1. the grant of the option (if there is a readily determinable market value, which is rare);
2. the exercise of the option to purchase the underlying stock; and
3. finally, the _____ of the stock.
a. sale
b. purchase
a. sale
119
Retirement 8–6: Nonqualified Stock Options (NSOs)
Code Section 83 contains the rules that govern the taxation of nonqualified stock options (in addition to covering restricted stock which we covered earlier). Section 83 applies to the grant of the options only if the option has a readily determinable market value at the time of grant. If this is the case, the value will be taxed as compensation to the employee in the year of the grant and the employer will receive a deduction in the same amount. Typically, the employee _____ recognize taxable income at the time the option is granted
a. will
b. will not
b. will not
because there is no “readily ascertainable fair market value” at the date of its grant. The general rule is that the value of nonstatutory options is almost never ascertainable. One exception to this rule can occur when the options are publicly traded, however nonstatutory options are almost never publicly traded.
120
Retirement 8–6: Nonqualified Stock Options (NSOs)
If the exercise price is less than the fair market value at the time of the grant, Section 409A will cause the bargain element to be immediately taxable and subject to the __% penalty, plus interest.
a. 20%
b. 25%
a. 20%
121
Retirement 8–6: Nonqualified Stock Options (NSOs)
Section 83 applies to the exercise of the option if the option did not have a readily determinable market value at the time of grant, which is almost always the case. The appreciation of the stock between the date of the grant and the exercise date will be taxed to the holder of the grant as compensation income and the employer will receive a deduction in the same amount. Social Security and Medicare (FICA) taxes _____ with nonqualified stock options.
a. apply
b. do not apply
a. apply
Generally speaking, any compensation or remuneration paid by the employer to an employee for services constitutes wages for withholding, FICA, and FUTA purposes unless otherwise exempt. As discussed before, FICA and FUTA do not apply to ISOs, but they do apply to NSOs. Also, since nonqualified stock options are taxed upon exercise, there is no potential AMT consequence with nonqualified stock options as there is with ISOs.
122
Retirement 8–6: Nonqualified Stock Options (NSOs)
When stock acquired through the exercise of the NSO is later sold, the gain on the sale in excess of the exercise cost is treated as _____.
a. capital gain
b. ordinary income
a. capital gain
123
Retirement 8–6: Nonqualified Stock Options (NSOs)
Example. Nova Industries Inc. grants a nonqualified stock option to Ed Douglas,to purchase 1,000 shares of Nova Industries stock at $10 per share after five years of employment. The value was not ascertainable at the time of the grant. The fair market value of the stock is $50 per share at the end of five years. The option is exercised at this time at a price of $10 per share. Ed’s marginal tax rate is 28%. The federal tax due upon the exercise of the option by Ed is
a. $10,200
b. $11,200
b. $11,200
$40 gain
* 1,000 shares
= $40,000
$40,000
* 28%
= $11,200
This amount will also be subject to withholding, FICA, and FUTA.
124
Retirement 8–6: Nonqualified Stock Options (NSOs)
Example. Nova Industries Inc. grants a nonqualified stock option to Ed Douglas,to purchase 1,000 shares of Nova Industries stock at $10 per share after five years of employment. The value was not ascertainable at the time of the grant. The fair market value of the stock is $50 per share at the end of five years. The option is exercised at this time at a price of $10 per share.
Three years later, the stock is worth $80 per share, and Ed decides to sell his holdings. He has a long-term capital gain of $30,000 ($80,000 – the $50,000 basis of the stock purchased three years ago under the option). If Ed were to have sold the stock for $55 per share just four months after exercise, then he would have a short-term capital gain of $_____.
a. $5,000
b. $10,000
a. $5,000
125
Retirement 8–6: Nonqualified Stock Options (NSOs)
One of the problems of a nonqualified stock option plan is the requirement that the executive have cash available to pay income tax upon exercise of the option. A way around this is to do what is called “______.” In this case, the executive would sell the shares represented by the NSO, and then use the proceeds from the sale to both pay for the stock and pay taxes. Any amount left over would then be the employee’s.
a. non taxable
b. cashless exercise
b. cashless exercise
126
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
Options are granted
These options are granted to certain employees under a plan specifying the number of shares to be offered and the employees to be included. Certain requirements must be complied with, such as shareholder approval and a limit of $100,000 worth of options that may be granted annually and receive _____ treatment.
a. ISOs
b. NQSOs
a. ISOs
127
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
Options are granted
These options are granted typically to executives and management, with virtually no IRS-imposed restrictions regarding the dollar amount, length of the exercise period, the exercise price, or the length of the holding period before sale (these options are also known as “nonstatutory stock options”).
a. ISOs
b. NQSOs
b. NQSOs
128
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
Options are granted
When the option is exercised, no tax is paid, even on the bargain element (the difference between the exercise price and the stock’s value at the time of exercise) if holding period requirements are met the subsequent sale of the stock by the employee results in capital gain.
a. ISOs
b. NQSOs
a. ISOs
129
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
Options are granted
When the option is granted, no tax is paid, provided the option does not have an ascertainable fair market value (typically true except in the rare case of publicly traded options). When the option is exercised, the spread between the option price and market value at the time of exercise, is taxed as wages, subject to FICA and FUTA (the company also gets a deduction at that time).
a. ISOs
b. NQSOs
b. NQSOs
130
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
Options are granted
Grant price must be greater than or equal to fair market value to avoid 409A.
a. ISOs
b. NQSOs
b. NQSOs
131
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
Options are granted
Grant price must be fair market value.
a. ISOs
b. NQSOs
a. ISOs
132
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
Options are granted
Taxed at grant if value of grant is ascertainable. If not, taxed at exercise. Bargain element is taxed as wages.
a. ISOs
b. NQSOs
b. NQSOs
133
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
Options are granted
There is no tax to the recipient at the time of the grant and no tax at the time of exercise. There is an AMT adjustment at the time of exercise for the bargain element. Disqualifying dispositions will be taxed as ordinary income with no FICA/FUTA.
a. ISOs
b. NQSOs
a. ISOs
134
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
At time of grant: With ascertainable value
Bargain element if > 0 violates 409A
1. taxed as wages + 20% additional tax and interest assessed from the time of grant
2. withholding
3. FICA and FUTA apply Bargain element = 0
4. no tax; no 409A problem
a. ISOs
b. NQSOs
b. NQSOs
135
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
At time of grant: With ascertainable value
No tax
a. ISOs
b. NQSOs
a. ISOs
136
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
Options are exercised (value not ascertainable at grant)
No tax if taxed at time of grant
```
If not taxed at grant (which is usually the case):
Bargain element taxed at exercise
1. taxed as wages
2. federal withholding (25%)
3. FICA and FUTA apply
```
a. ISOs
b. NQSOs
b. NQSOs
137
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
Options are exercised (value not ascertainable at grant)
No tax. Bargain element becomes an AMT adjustment
a. ISOs
b. NQSOs
a. ISOs
138
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
Sale of option stock
Cap gain treatment—the basis is fair market value at exercise (since taxed at exercise)
a. ISOs
b. NQSOs
b. NQSOs
139
Retirement 8–6: Nonqualified Stock Options (NSOs)
A Comparison of Incentive (ISOs) and Nonqualified Stock Options (NQSOs)
Sale of option stock
If disqualifying disposition then would be taxed as ordinary income, no FICA or FUTA, company gets a deduction Cap gain treatment if qualifying disposition.
a. ISOs
b. NQSOs
a. ISOs
140
Retirement 8–6: Nonqualified Stock Options (NSOs)
A _____ is nothing more than an imaginary unit that is tracks the value of the common stock of an employer. They provide a method for an employee to obtain the benefit of a stock option plan without having to make the necessary capital outlay required to purchase the stock.
a. stock appreciation right
b. phantom stock plan
a. stock appreciation right (SAR)
In other words, SARs entitle the employee to a payment in cash or shares equal to the appreciation in the company’s stock over a designated time period. Generally, their exercise price is based on the fair market value of employer stock, and can be exercised at any time once vested (up until the expiration date if one exists). The amount of compensation paid to an employee upon exercise will be measured by the performance of the employer’s stock—the difference between the grant price and the fair market value of the company stock on the date of exercise. As the stock increases in value, the SAR increases in value. As the stock decreases in value, the SAR decreases in value, but not below the value or formula price at the date of grant of the SAR.
141
Retirement 8–6: Nonqualified Stock Options (NSOs)
Income is recognized and taxable as ______ when the SAR is exercised. The taxable amount equates to the spread between the exercise price and the fair market value, or the gain. At the same time, the employer recognizes a deduction for the payment to the employee. SARs are attractive to employers because they are cashless and do not dilute ownership
a. long term capital gains
b. ordinary income
b. ordinary income
142
Retirement 8–6: Nonqualified Stock Options (NSOs)
A _____ is a cashless method of providing deferred compensation through an unfunded and unsecured promise of the employer either the value of company shares or the increase in that value over a period of time. As an example, a company could promise its employee that it will pay her a cash bonus every five years tied either equal to the increase in the equity value of the firm, or as a fixed number of shares
a. stock appreciation right
b. phantom stock plan
b. phantom stock plan
Such a plan tracks the performance of the “phantom” stock of the company, which is used as an incentive to spur the performance of the executive-employee. A phantom stock plan is typically initiated with a book entry made to the accounting records of the company. This entry reflects the amount of phantom stock granted to the employee based upon the compensation agreement.
143
Retirement 8–6: Nonqualified Stock Options (NSOs)
______ provide awards contingent upon attainment of an earnings goal measured over a long period of time, typically a number of years. Such a program is generally contractual because payment is measured by the attainment of these goals. Such a program commonly provides for payment only when the average annual compound growth rate in the earnings per share of the common stock during the specified period equals or exceeds those goals.
a. Performance unit or performance share programs
b. Junior stock plans
a. Performance unit or performance share programs
Performance programs are generally structured as unfunded and unsecured promises to pay cash or stock to a select group of highly compensated employees or management personnel, with the plans almost always limited to senior executives. Performance programs exist primarily in publicly held corporations, although there is no reason why they cannot be used in closely held businesses as well.
144
Retirement 8–6: Nonqualified Stock Options (NSOs)
______ provide a significant performance incentive to the recipient and are effective in deferring taxation. The company establishes the plan by creating a new class of common stock with diminished rights and hence, diminished value.
a. Performance unit or performance share programs
b. Junior stock plans
b. Junior stock plans
For example, the junior stock may be entitled to only a small fraction of the voting, dividend, and liquidation value of the regular common stock, such as it may receive one-tenth or one-twentieth of the dividends or voting rights of the common and maybe only $1 per share at liquidation. These limited rights make the value of the stock much less, maybe one-tenth or one twentieth the value of the common stock.
145
Retirement 8–6: Nonqualified Stock Options (NSOs)
A right granted by the employer to purchase stock at a stipulated price during a specified period of time in accordance with Section 422 of the Internal Revenue Code.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
a. Incentive stock options
146
Retirement 8–6: Nonqualified Stock Options (NSOs)
A right granted by employer to purchase stock at a stipulated price over a specified period of time.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
b. Nonqualified stock options
147
Retirement 8–6: Nonqualified Stock Options (NSOs)
Employee realizes appreciation in the value of a specified number of shares. No employee investment is required.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
c. Stock appreciation rights (SARs)
148
Retirement 8–6: Nonqualified Stock Options (NSOs)
Awards are “granted” at the beginning of a specified period and then earned through attaining performance goals.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
d. Performance share/unit plans
149
Retirement 8–6: Nonqualified Stock Options (NSOs)
Shares of stock are granted to employee without costs or at a bargain price, subject to the restriction that they are not sold or disposed of for a specified period of time.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
e. Restricted stock plans
150
Retirement 8–6: Nonqualified Stock Options (NSOs)
Employee is awarded units, not representing an ownership interest, that correspond to a specific number of shares of stock. When performance goals are met or a specified time elapses, employee receives cash based on the current price of stock.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
f. Phantom stock plans
151
Retirement 8–6: Nonqualified Stock Options (NSOs)
Option price is not less than the fair market value on the date of grant.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
a. Incentive stock options
152
Retirement 8–6: Nonqualified Stock Options (NSOs)
May be granted at a price below fair market value. Previously acquired company stock may be used as payment for exercise.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
b. Nonqualified stock options
153
Retirement 8–6: Nonqualified Stock Options (NSOs)
May be granted alone or in tandem with stock options. Distribution may be made in stock, in an amount equal to the growth in value of the underlying stock.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
c. Stock appreciation rights (SARs)
154
Retirement 8–6: Nonqualified Stock Options (NSOs)
Payments are made in cash, stock, or a combination.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
d. Performance share/unit plans
155
Retirement 8–6: Nonqualified Stock Options (NSOs)
Shares become available to employees only after a specified time elapses, but stock can be voted when awarded. Dividend equivalents can be paid or credited to the owner’s account.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
e. Restricted stock plans
156
Retirement 8–6: Nonqualified Stock Options (NSOs)
Award may be equal to the value of the shares of phantom stock or just the appreciation portion. Dividend equivalents may be credited to account or paid currently.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
f. Phantom stock plans
157
Retirement 8–6: Nonqualified Stock Options (NSOs)
No taxes due upon
grant or exercise. Any appreciation is long-term capital gain income (taxable at a maximum rate of 20%) if the stock is held for at least one year from the date of exercise of the option.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
a. Incentive stock options
158
Retirement 8–6: Nonqualified Stock Options (NSOs)
The excess of the stock’s fair market value over its option price is taxable as ordinary income no later than the date of exercise of the option.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
b. Nonqualified stock options
159
Retirement 8–6: Nonqualified Stock Options (NSOs)
Upon exercise, the amount received is taxable as ordinary income.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
c. Stock appreciation rights (SARs)
160
Retirement 8–6: Nonqualified Stock Options (NSOs)
Taxable ordinary income is recognized on the date the payments are made.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
d. Performance share/unit plans
161
Retirement 8–6: Nonqualified Stock Options (NSOs)
Excess of fair market value of stock over employee cost is taxable as ordinary income after period of restriction lapses. Any dividends received during period of restriction are taxed as ordinary income.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
e. Restricted stock plans
162
Retirement 8–6: Nonqualified Stock Options (NSOs)
The value of the award paid and any dividend equivalents are taxable as ordinary income.
a. Incentive stock options
b. Nonqualified stock options
c. Stock appreciation rights (SARs)
d. Performance share/unit plans
e. Restricted stock plans
f. Phantom stock plans
f. Phantom stock plans
163
Retirement 8–6: Nonqualified Stock Options (NSOs)
Types of Severance Plans
A _____ is an agreement between an executive and his or her company requiring the company to pay certain benefits in the event of a change in control of the company. The agreement, therefore, provides a guarantee of financial security to the executive in the event of a takeover. Since such an agreement typically provides a substantial amount of severance pay, a financial adviser may find his or her services are being requested regarding an appropriate investment of such a large lump sum.
a. Golden parachutes
b. Tin parachutes
c. VSRPs: corporate downsizing
a. Golden parachutes
Payments take the form of cash, stock, compensation, extra pension benefits, medical and life insurance, other fringe benefits, and various combinations of all of these benefits. In each situation, the “parachute” opens when there is an employment termination or transfer upon a change in corporate control. The agreement protects the executive’s financial position in the event of a takeover and is justified from the company’s standpoint as assisting in the retention and recruiting of valuable top management.
164
Retirement 8–6: Nonqualified Stock Options (NSOs)
Types of Severance Plans
______ apply to middle-management employees, as opposed to the golden parachutes applicable to upper-management executives. While tin parachutes carry the same potential tax disadvantages as golden parachutes, these rules are much more rarely invoked. Obviously, this is because middle-management employees are generally not considered valuable enough to warrant extensive severance packages.
a. Golden parachutes
b. Tin parachutes
c. VSRPs: corporate downsizing
b. Tin parachutes
Tin parachutes are employed on a basis similar to that of golden parachutes, only on a much smaller scale.
165
Retirement 8–6: Nonqualified Stock Options (NSOs)
Types of Severance Plans
_____ are a popular tool used by companies not only to reward long-term employees, but also to reduce the companies’ compensation costs in the long run. These plans, which allow employees to retire early, have become popular in recent years as a means of transitioning older employees of the company into retirement. The opportunity of an attractive severance benefit package provides considerable incentive for an employee to retire early and still receive an adequate income stream.
a. Golden parachutes
b. Tin parachutes
c. VSRPs: corporate downsizing
c. VSRPs: corporate downsizing
From the employer’s standpoint, the cost of the employee has been fixed at this point. Thus, no raises or promotions need to be considered in the future. In addition, employer costs relating to payroll, insurance coverage, and other employee benefits are no longer incurred, which often makes these plans a viable alternative for the company.
166
Retirement 8–6: Nonqualified Stock Options (NSOs)
The law limits a publicly held corporation’s deduction for compensation paid to certain “______” to $1 million per year. A person is a covered employee if the employee is the chief executive officer of the corporation (or an individual acting in such capacity) as of the close of the taxable year, or the employee’s total compensation is required to be reported for the taxable year under the Securities Exchange Act of 1934 because the employee is one of the four highest-compensated officers for the taxable year (other than the chief executive officer).
a. key employees
b. covered employees
b. covered employees
167
(LO 8-1)
Question 1 of 30
Which one of the following is an important reason for establishing an unfunded nonqualified excess benefit plan?
to reduce the employer's current tax liability
to provide additional retirement benefits for highly compensated employees
to provide benefits for key employees in the event their employer becomes bankrupt
to provide additional retirement benefits for highly compensated employees
An important reason for establishing a nonqualified plan is to provide additional retirement benefits for highly compensated employees.
168
(LO 8-1)
Question 2 of 30
Which one of the following situations would most likely benefit from a supplemental executive retirement plan?
W Corporation has $50,000 it would like to set aside as a severance benefit for a key employee.
X Corporation would like to establish an unfunded plan that will provide benefits for a vice president in excess of those provided by the company's qualified plan.
Y Corporation has a president to whom it would like to pay a bonus.
X Corporation would like to establish an unfunded plan that will provide benefits for a vice president in excess of those provided by the company's qualified plan.
A supplemental executive retirement plan is a funded or an unfunded plan providing benefits for select employees in excess of those provided by the employer's qualified retirement plan.
169
(LO 8-1)
Module Exam
Question 3 of 30
Which one of the following is a correct statement about top hat plans?
A top hat plan is a type of salary deferral plan.
Top hat plans are subject to ERISA's reporting and disclosure requirements.
Top hat plans must be funded.
Top hat plans are subject to ERISA's reporting and disclosure requirements.
Top hat plans are subject to ERISA's reporting and disclosure requirements, although not to other ERISA requirements.
170
(LO 8-2)
Module Exam
Question 4 of 30
Which one of the following is a correct statement about a funded nonqualified deferred compensation plan that funds future benefits with real estate and is not currently taxable to plan participants?
It will provide tax deferral for an employer.
The benefit is subject to the claims of the employer's creditors.
It must be subject to a substantial risk of forfeiture.
It must be subject to a substantial risk of forfeiture.
To avoid immediate taxation to the participant, a funded nonqualified deferred compensation plan must be nontransferable and subject to a substantial risk of forfeiture.
171
(LO 8-2)
Module Exam
Question 5 of 30
Which one of the following is a correct statement about the constructive receipt doctrine?
It may tax income that is made available but is not yet received by a taxpayer.
It taxes payments made in the future that are based on a company's earnings.
It prevents a deferred compensation agreement from being informally funded.
It may tax income that is made available but is not yet received by a taxpayer.
The constructive receipt doctrine taxes income that is made available, even though the income is not actually received.
172
(LO 8-5)
Module Exam
Question 6 of 30
Which one of the following statements is correct about employee stock purchase plans (ESPPs)?
There is a $100,000 annual grant limit on ESPPs.
ESPPs require management, but not shareholder, approval.
The holding period requirement in order to receive preferential capital gains treatment is two years from the grant date, and one year from the date of exercise.
The holding period requirement in order to receive preferential capital gains treatment is two years from the grant date, and one year from the date of exercise.
This is the holding period requirement in order to receive capital gains treatment.
173
(LO 8-5)
Module Exam
Question 7 of 30
Which one of the following is a requirement for incentive stock options (ISOs)?
ISOs, with limited exceptions, must be made available to all employees.
ISOs, when granted, can be issued at a discount to the current fair market value of the company stock.
ISOs must be exercised within three months of retirement in order to preserve favorable tax treatment.
ISOs must be exercised within three months of retirement in order to preserve favorable tax treatment.
This is a correct statement. ISOs are typically granted to select employees only, and they must be granted at fair market value, or higher for certain owners.
174
(LO 8-2)
Module Exam
Question 8 of 30
A closely held corporation that receives the proceeds from a life insurance policy upon the death of an insured employee may be subject to which one of the following taxes?
ordinary income tax
federal estate tax
alternative minimum tax
alternative minimum tax
Because corporate-owned life insurance is subject to the alternative minimum tax provisions, a corporation may incur a tentative minimum tax liability on proceeds received upon the death of an insured employee.
175
(LO 8-2)
Module Exam
Question 9 of 30
A beneficiary who receives the survivor benefits from a nonqualified deferred compensation plan is subject to which one of the following taxes?
Social Security tax
accumulated earnings tax
ordinary income tax
ordinary income tax
Nonqualified deferred compensation death benefits payable to a surviving beneficiary are subject to ordinary income tax as income in respect of a decedent.
176
(LO 8-2)
Module Exam
Question 10 of 30
John Thomas is the majority shareholder of a corporation. John's compensation and deferred compensation income exceed "reasonable compensation" as determined by the IRS. How will the IRS characterize the corporation's deferred compensation payments to John?
as capital gain
as a dividend
as an unreasonable bonus
as a dividend
The IRS treats unreasonable compensation payments to a majority shareholder as a dividend. A corporation is not permitted to deduct the payment of a dividend to a shareholder. However, compensation payments by a corporation are deductible.
177
(LO 8-2)
Module Exam
Question 11 of 30
Unreasonable compensation can be an issue for which one of the following legal entities?
publicly traded corporations.
partnerships
closely held corporations
closely held corporations
Unreasonable compensation generally is an issue only with stockholder-employees in closely held corporations.
178
(LO 8-2)
Module Exam
Question 12 of 30
Historically, which one of the following investment vehicles has been the most tax-favored means to informally fund a nonqualified deferred compensation plan?
corporate-owned life insurance
corporate-owned mutual funds
Treasury bonds
corporate-owned life insurance
Historically, corporate-owned life insurance has been the most tax-favored means to informally fund a nonqualified deferred compensation plan.
179
(LO 8-1)
Module Exam
Question 13 of 30
Assume that an employer has experienced cash flow problems in the past. Which one of the following types of life insurance should this employer use to informally fund a nonqualified deferred compensation agreement?
whole life insurance
universal life insurance
variable life insurance
universal life insurance
Universal life insurance is the best choice because the premium payment is more flexible than whole life insurance or variable life insurance.
180
(LO 8-2)
Module Exam
Question 14 of 30
Assume that an employer plans to use corporate-owned life insurance to informally fund a nonqualified deferred compensation agreement and would like to have the flexibility to invest in a number of different asset categories. Which one of the following types of life insurance should this employer choose?
term insurance
whole life insurance
variable life insurance
variable life insurance
Variable life insurance permits the cash value of the policy to be invested in a number of different accounts of the insurer, such as indexed equities, blue chip growth, growth and income, international, bonds, and so forth.
181
(LO 8-1)
Module Exam
Question 15 of 30
Which one of the following statements correctly describes an employee-funded grantor secular trust?
It is subject to current taxation.
It consists of a revocable trust.
The assets are subject to the claims of the company's general creditors.
It is subject to current taxation.
Earnings of an employee-funded grantor secular trust are currently taxable to the trust's employee-beneficiary.
182
(LO 8-5)
Module Exam
Question 16 of 30
Which one of the following factors is a disadvantage of an incentive stock option (ISO) plan for an executive?
Ordinary income must be recognized when the option is granted.
Exercise of the option may trigger the alternative minimum tax.
Ordinary income must be recognized when the option is exercised.
Exercise of the option may trigger the alternative minimum tax.
An employee-recipient may be subject to the alternative minimum tax, since the bargain element of the option is considered to be an adjustment for purposes of the alternative minimum tax.
183
(LO 8-5)
Module Exam
Question 17 of 30
Which one of the following factors is an advantage of an incentive stock option (ISO) plan for an executive?
It may be exercised at any time within 12 years.
It is subject to the protective provisions of ERISA.
It is taxed at capital gains rates if a holding period requirement is met.
It is taxed at capital gains rates if a holding period requirement is met.
The current maximum 15% capital gains tax rate makes incentive stock options appealing to executives who are in the 35% and lower tax brackets. For executives who are in the 39.6% marginal income tax bracket, the current maximum 20% capital gains tax rate may make incentive stock options appealing to these executives as well.
184
(LO 8-4)
Module Exam
Question 18 of 30
Which one of the following factors is an advantage of an equity-based form of compensation for a closely held company?
The company does not have to expend any cash to compensate the employee.
The company is able to reward employees without diluting company ownership.
The fair market value of the equity compensation is easily determined.
The company does not have to expend any cash to compensate the employee.
One benefit of an equity-based form of compensation is the fact that the employer does not have to expend any cash while compensating the employee.
185
(LO 8-6)
Module Exam
Question 19 of 30
Which one of the following is a correct statement about a disadvantage of a phantom stock plan?
Plan benefit payments must be made in cash.
The value of the company's stock may be affected by noneconomic factors.
This type of plan upsets stock ownership.
The value of the company's stock may be affected by noneconomic factors.
The value of privately held stock can be impacted by considerations not applicable to publicly held companies, such as family problems or the death of a key person.
186
(LO 8-4)
Module Exam
Question 20 of 30
Which one of the following is a correct statement about the taxation of stock option plans?
An ISO is taxed as wages at the time of grant or exercise.
An NSO is not ever taxed as wages.
An NSO is subject to federal withholding, FICA, and FUTA at some point.
An NSO is subject to federal withholding, FICA, and FUTA at some point.
An NSO is taxed as wages and subject to federal withholding, FICA, and FUTA at the time of the grant if the value is ascertainable (Section 83(b) election), or at the time of exercise.
187
(LO 8-5 & 8-6)
Module Exam
Question 21 of 30
Which statement does not correctly describe a concept related to nonqualified deferred compensation or stock plans?
ESPPs can be offered at a discount, unlike ISOs.
If an employee makes a Section 83 election upon the grant of restricted stock, he or she will not be taxed when the restricted stock becomes vested.
A disqualifying disposition with an ISO will result in ordinary income taxes, as well as FICA and FUTA taxes.
A disqualifying disposition with an ISO will result in ordinary income taxes, as well as FICA and FUTA taxes.
Incentive stock options, when there is a disqualifying disposition, are subject to ordinary taxes, but they are not subject to FICA or FUTA taxes.
188
(LO 8-2)
Module Exam
Question 22 of 30
Richard LaFata works as an executive in charge of The Binder Box Company's production department. As part of Richard's employment contract, Binder contributes 10% of his salary each year to a separate account for Richard's benefit. The terms of this nonqualified plan state that the contribution of these amounts will cease and Richard will have no rights to the income if he fails to complete 10 years of substantial service with Binder Box Co. Otherwise, Richard is entitled to receive the deferred cash amounts upon completing 10 years of substantial service with Binder Box Co. This nonqualified deferred compensation plan segregates property for the benefit of Richard. Which one of the following is an income tax implication of this plan Richard, and why?
The employer contributions to the plan are tax-exempt for Richard because they were made after August 1, 1969.
The employer contributions to the plan are not currently taxable to Richard because they are subject to substantial risk of forfeiture.
The employer contributions to the plan are taxable to Richard currently because a separate account was established for his benefit, and the plan segregates property for the benefit of Richard.
The employer contributions to the plan are not currently taxable to Richard because they are subject to substantial risk of forfeiture.
The plan has established substantial risk of forfeiture conditions—Richard will receive the deferred amounts when he completes 10 years of substantial service with his employer. Separate accounts can be created for each employee as long as those accounts are held as a general asset of the employer subject to the claims of creditors.
189
(LO 8-1)
Module Exam
Question 23 of 30
All of the following describe contrasting characteristics of qualified and nonqualified plans except
the timing of the tax deductibility of the employer's contributions to the plan.
the availability of rollover provisions to preserve tax deferral after a distribution.
the requirement that the plan must benefit a specific percentage of nonhighly compensated employees.
the ability to defer the employee's tax liability until actual receipt of the funds at retirement.
the ability to defer the employee's tax liability until actual receipt of the funds at retirement.
Both qualified and nonqualified plans can enable the employee to defer taxation on the plan funds until retirement.
190
(LO 8-1)
Module Exam
Question 24 of 30
Which one of the following is a characteristic of unfunded nonqualified deferred compensation plans?
The employee has secured rights in the benefits to be paid.
These plans are often referred to as top hat plans because they are provided to top executives of the company.
The plan is subject to most of the ERISA nontax requirements.
These plans are often referred to as top hat plans because they are provided to top executives of the company.
Unfunded nonqualified deferred compensation plans, also known as top hat plans, provide no security to the employee. The employee has nothing more than the employer's promise to pay future benefits. These plans are generally subject only to the reporting and disclosure requirements of ERISA.
191
(LO 8-4)
Module Exam
Question 25 of 30
Which one of the following statements is incorrect regarding characteristics of using life insurance for the informal funding of a nonqualified deferred compensation plan?
It represents an asset that may be purchased to fund the employer's unsecured promise to pay deferred amounts to the employee.
It offers the advantage of simplified administration since death proceeds are paid directly to an employee's surviving spouse or other beneficiary.
It offers the advantage of various settlement options.
It offers the advantage of being able to fund a death benefit immediately.
It offers the advantage of simplified administration since death proceeds are paid directly to an employee's surviving spouse or other beneficiary.
Life insurance is used to informally fund a nonqualified deferred compensation plan (NQDC) because it can immediately fund a death benefit and offers several settlement options. An NQDC plan's death benefits are payable to the employer, the owner of the policy.
192
(LO 8-5)
Module Exam
Question 26 of 30
Five years ago, Katie Lynn was granted 2,000 incentive stock options (ISOs) with the exercise price of $30. The stock price was $30 on that date. On February 2nd of this year, she exercised all 2,000 options at $67. Katie has decided to dispose of the stock she acquired through the exercise of her ISOs early next year. What is the tax impact of this transaction?
Katie will have an AMT income adjustment of $74,000.
Katie will have an AMT income adjustment of $134,000.
Katie will not have any AMT income adjustment.
Katie will have an AMT income adjustment of $74,000.
The bargain element, $67 - $30 = $37, will be an AMT adjustment.
193
(LO 8-6)
Module Exam
Question 27 of 30
Nonqualified stock options are taxable upon
exercise of the stock.
sale of the stock.
exercise or sale of the stock.
exercise of the stock.
Nonqualified stock options are taxable upon exercise; there is no choice, it is mandatory.
194
(LO 8-1)
Module Exam
Question 28 of 30
Potential beneficiaries of a rabbi trust include
only the participating employees of the company.
the participating employees of the company and the company.
the employee and the creditors of the company.
the participating employees, the creditors of the company, and the company.
the employee and the creditors of the company.
There are only two potential beneficiaries of a rabbi trust: the employee and the creditors of the company. The fact that creditors may get to the money rather than the employee enables the employee to defer taxation, but the trust is irrevocable to protect against a change of control, such as a hostile takeover, that might void the plan.
195
(LO 8-6)
Module Exam
Question 29 of 30
Which one of the following statements best describes characteristics of a golden parachute plan?
A golden parachute plan is an arrangement that provides an employee with retirement benefits in addition to those provided by the employer's profit sharing plan.
A golden parachute plan is an arrangement that provides a severance benefit to a valued employee conditioned on the sale or substantial change in ownership of the company and the subsequent termination of the employee.
The parachute payment is always subject to a 20% penalty.
A golden parachute plan is an arrangement that provides a severance benefit to a valued employee conditioned on the sale or substantial change in ownership of the company and the subsequent termination of the employee.
A golden parachute plan is an arrangement that provides a severance benefit to a valued employee conditioned on the sale or substantial change in ownership of the company and the subsequent termination of the employee. The 20% penalty would only apply if there is an excess parachute payment.
196
(LO 8-5)
Module Exam
Question 30 of 30
In order to receive preferential capital gains treatment, an ISO must be held for at least
one year from the grant date, and two years from the exercise date.
two years from the grant date, and one year from the exercise date.
five years from the grant date, and three years from the exercise date.
two years from the grant date, and one year from the exercise date.
In order to receive preferential capital gains treatment, an ISO must be held for at least two years from the grant date, and one year from the exercise date.
