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Blake Christian
Cash and Non-Cash Compensation

Choices and tax issues abound.

July 14, 2008
by Blake Christian, CPA/MBT

With the current economic downturn, combined with inflationary pressures on operating costs — including energy, raw materials, wages and healthcare — business owners are looking for ways to optimize the value they derive from every expenditure.

Since compensation and employee benefit costs are often part of the largest drivers of profitability, and there are a variety of tax-efficient ways to design and pay these expenses, business owners must carefully evaluate all forms of employee compensation to ensure that their dollars are used in the most tax-efficient manner.

The following are examples of broad categories of compensation and benefits, along with the related tax issues facing both employers and employees.

Employee vs. Independent Contractor vs. Partner

Depending on the form of business, compensation may be reportable on a Form W-2 (W-2), a Form 1099MISC (1099MISC) and/or a Form K-1 (K-1). C Corps and S Corps will generally report owner and employee compensation on a W-2. Amounts paid to Independent Contractors will generally be reported on a 1099MISC form. Equity owners of partnerships, LLCs/LLPs or S Corps will generally have compensation-related items reported as "Guaranteed Payments" on line five of K-1. C Corps and S Corps will generally report owner and employee compensation on a W-2 as well as Form 1099 in the same year, or alternating years. Tax authorities will also routinely investigate the accounting of employee versus independent contractor reporting.

Misclassification can have numerous unintended consequences, including: penalties for under-withheld payroll taxes, impact on employee benefit eligibility, impact on incentive tax credits, and future impact on eligibility for unemployment or retirement benefits. The leading factors used by the IRS in determining the proper employee vs. independent contractor classification are contained in Rev. Rul. 56-694, Rev. Rul. 87-41 and Rev. Proc. 91-20.

S Corp shareholders must also make sure they are paying a fair market value salary, as the IRS is successfully challenging those S Corps paying only nominal salaries to shareholders in order to minimize FICA and Hospitalization taxes.

Another issue that arises is erroneous reporting by LLCs/Partnerships of their member/partner compensation on W-2s vs. on the K-1 form as ordinary income and/or Guaranteed Payment. This type of flawed reporting can create significant issues on audit, making it difficult to unwind and recover the W-2 and tax withholdings. It also makes it difficult for firms to restate each equity owner's K-1 income properly (often impacted over a number of years). The misclassification of W-2 employees as independent contractors or partners/LLC members as employees can also create a variety of employee benefit issues such as:
  • Ineligibility for healthcare or retirement benefits,
  • Multi-state reporting and allocation/apportionment issues and
  • Future workers' compensation/unemployment compensation issues for both the employers and employees.

Bonuses and Deferred Compensation

Accrued bonuses payable to a C Corp shareholder/employee owning 50 percent or less of the entity within two-and-one-half months of year-end are generally deductible in the year accrued (for accrual basis taxpayers) — and the employee/recipient defers the reportable income until the following year. In an S Corp context, accrued bonuses timely paid (within two-and-one-half months of year-end) to a nonshareholder employee are also deductible in the year accrued. However, an accrued bonus payable to any S Corp shareholder cannot be deducted until paid. Similarly, an LLC or partnership cannot deduct accrued expenses associated with members or partners owning more than five percent of the equity. Many S Corps and Partnerships/LLCs report taxable income on a cash basis, which will negate the ability to accrue and deduct salary or bonuses.

Very complex rules apply when employees receive bonuses related to the sale or merger of a business, or when they agree with their employer to defer portions of their salaries and bonuses to a future year. The "Golden Parachute Payment" rules applicable under IRC Section 4999 can impose excise tax penalties on the recipient and can deny tax deductions to the employer in cases where the payments are more than three times greater than the average compensation received by the recipient/employee.

There are two types of nonqualified deferred compensation:
  • Funded deferred compensation plans involve the advanced funding for services previously rendered by an employee, but payable in the future. The employee is taxed at the time employer contributions are made to a trust or when premiums are paid for an annuity contract to the extent that the employee's interest in the benefits are substantially vested. The benefits are substantially vested at the point in time that the amounts are: transferable or not subject to a substantial risk of forfeiture (IRC Section 402(b)(1) and related Treas. Regs. 1.402(b)-1). The employer generally is entitled to claim a related tax deduction in the year that the employee includes the benefits in income (IRC Section 404(a)(5)). Similar rules apply to IRC Section 83 transfers discussed below.
  • Unfunded deferred compensation arrangements generally defer the employee's taxable income, and the related employer's tax deduction, until such time that the employee vests in all or a portion of the deferred compensation amounts (IRC Section 402(b)(2) and 404(a)).

IRC Section 409A applies special rules to any non-qualified arrangement involving amounts deferred after December 31, 2004. Special rules also apply to plans involving pre-2005 deferrals, to the extent the employer or employee makes a "material modification" to an existing deferred compensation plan. These rules place detailed limitations on when the deferred amounts can be paid out upon: disability, date of separation from service, death, a change in ownership, a fixed date of distribution, or the occurrence of an unforeseen emergency. Violation of these and other administrative rules can cause retroactive "constructive receipt" of the deferred amounts back to the point in time the amounts were originally deferred. In addition to the tax hit in a prior year, additional interest at one percent above the statutory late payment rate, plus up to 20 percent in penalties can apply to any deferred compensation violations.

Options, Stock Sales and Other Non-Cash Awards

Statutory or "Qualified" stock options and "Nonqualified" stock options can offer employees significant upside in their compensation packages. These options also offer tax planning opportunities that can allow the employees to realize ordinary and/or capital gain income, with some level of control as to the timing and type of income they ultimately recognize. The employee's timing and nature of the reportable income will also generally control the timing and level of the employee's tax deduction.

For example, if an employee is awarded 1,000 nonqualified stock options to acquire common shares of BioTech, Inc. for one dollar per share, and the stock appreciates to three dollars per share at the time the employee exercises the options, both the employee's reportable income and employer's tax deduction, generally equal to $2,000 — the spread between the one dollar "strike price" and the fair market value per share on the date of the option holder's exercise (IRC Section 421(a)(3)).

However, if the options meet the requirements of IRC Section 422(a) to qualify as Qualified/Incentive Stock Options (ISO), and the employee does not exercise the options until after one year of issuance, and the employee does not dispose of the underlying shares until at least two years from the date the options were issued, then the employee has no reportable "regular" taxable income until the shares are actually sold.

Employee stock purchase plans, meeting the IRC Section 423(b) requirements that allow companies to issue shares to employees at up to a 15 percent discount, can also offer an additional tax advantaged employee benefit.

Stock options and employee stock purchase plans can be very effective tax planning tools for both employees and employers when the stock is appreciating before it is sold. Unfortunately, when the stock falls in value between the date of issuance and the time it is sold, the employee can be left with a situation in which he or she may have a limited or nondeductible capital loss. Therefore, careful planning and thorough modeling of various scenarios are necessary to minimize the possibility of reporting ordinary or AMT income in early years when options are exercised, and then reporting capital losses in the year the acquired stock is ultimately sold.

Employees in certain companies may hold both nonqualified options and ISOs, which can offer additional planning opportunities to maximize the after-tax results. Regardless of the types of options held, employees with "in-the-money" options should work with their investment advisors to develop a long-term strategy to diversify their holdings so they're not overly concentrated in their employer's stock — particularly if employer stock is also held in the employee's retirement plan.

Conclusion

Employers can maximize their after-tax profits by fully evaluating the numerous ways to provide cash and noncash benefits to their employees in the most cost-effective matter. The rules can occasionally be complex, but ignorance always has the biggest price tag.

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Blake Christian, CPA/MBT, is a Tax Partner in the Long Beach Office of Holthouse, Carlin & Van Trigt, LLP and is Co-Founder of National Tax Credit Group, LLC.