18
Employee Compensation and Retirement Plans
Solutions to Tax Research Problems
18-36 There are several ways to approach this problem. Here is one: What is the present
value at the beginning of Year 11 (beginning of retirement) of each option
assuming the amounts of compensation, net of tax, are received at year-end?
Current compensation option: Sum of an annuity for 10 years, beginning
immediately, of $27,600 (after-tax compensation) at 6.9 percent after tax return
(“p-v” stands for present value factor):
$27,600 × 13.7514 p-v = $379,538
Deferred compensation option: Present value of a 10-year annuity beginning in 10
years of $34,500 (after-tax deferred compensation) at 6.9 percent after tax return:
$34,500 × 7.0562 p-v = $243,438
Given the comparative values of the two options at the beginning of retirement,
the current compensation option is superior!
18-37
1. The practitioner should consider advising the taxpayer to adopt an Employee
Stock Ownership Plan (ESOP). Setting up an ESOP can accomplish both of
the corporation’s objectives. The ESOP provides a vehicle for financing
working capital or expansion needs. It is also a unique benefit plan in that it
allows the employees to become owners of the corporation, thereby increasing
loyalty and productivity.
Providing stock to the employees through an ESOP would allow them to
participate in the company’s ownership, profits and future growth. This should
provide incentive for employees to remain with the company and increase their
productivity.
Using an ESOP to finance the purchase of needed capital improvements can
conserve working capital in one of two ways.
• Gills can borrow the $700,000 directly from a lender, repay the lender
directly, and make annual contributions to the ESOP in stock of a value equal
to the principal payments.
• The ESOP can borrow the $700,000 and buy newly issued stock valued at
$700,000 from Gills. The ESOP would then use annual contributions from
Gills to repay the loan with interest,
Assuming total interest of $325,000 and a corporate tax rate of 34%, the aftertax
cost of funding the capital improvements and ESOP under the two options would
be as follows:
Acme Borrows Funds Directly
Principal $ 700,000
Interest325,000
Tax benefit:
Interest expense ($325,000 × 34%) (110,500)
ESOP contribution ($700,000 × 34%) (238,000)
After-tax cost of funding capital improvements and ESOP $676,500
ESOP Borrows Funds and Purchases Stock from Gills
Contributions to ESOP (equal to debt service) $1,025,000
Tax benefit ($1,025,000 × 34%) (348,000)
After-tax cost of funding capital improvements and ESOP $ 676,500
In the case of a leveraged ESOP, the employer contributions used to pay ESOP
loan interest are fully deductible and the employer contributions used to repay
loan principal are deductible up to 25% of compensation of the participants under
§ 404(a)(9). [Under § 404(a)(3) the maximum deduction for a nonleveraged
ESOP is 15% of compensation of participants when the ESOP is not combined
with a pension plan.] Because Gills’ payroll is approximately $600,000,
contributions could be as much as $150,000 ($600,000 × 25%) plus the interest
payment.
2. In comparing an ESOP with a pension or profit-sharing plan, an ESOP will
produce more working capital because the contribution is made with employer
stock rather than cash. The corporation is entitled to a deduction for the
contribution and has no corresponding decrease in its cash flow. In this case, the
corporation has taxable income of $600,000 before making the $100,000
contribution to its retirement plan. The impact on working capital is shown as
follows.
ESOP Pension or Profit Sharing
Taxable income before contribution $ 600,000 $ 600,000
Contribution (100,000) (100,000)
Taxable income after contribution $ 500,000 $ 500,000
Tax (@ 34%) (136,000) (136,000)
Add back noncash contribution 100,000 0
Increase in working capital $ 364,000 $ 264,000
3. Before implementing an ESOP, a company should fully understand the
disadvantages that it may face. The following list includes some of the
disadvantages that must be considered.
a. Under § 401(a)(28)(C), the value of stock of a closely held corporation
contributed to an ESOP must be determined by an independent appraiser.
b. If the stock sold to an ESOP is overvalued, there is a potential for imposition
of the rules on prohibited transactions, loss of corporate deductions, and
imposition of excise tax for the contribution of nondeductible amounts.
c. Dilution of voting rights can be important in the case of a possible merger,
buy-out, or similar transaction. This dilution can reduce the attractiveness for
a purchase of the corporation by an outside buyer.
d. Liquidity of the corporation can be an important factor because the stock will
most likely have to be repurchased when distributions are made in the form of
corporate stock. Under §§ 4975(e)(7) and 409(h), the participant must be
given the right to require the employer to repurchase the shares of stock at
FMV.
18
Employee Compensation and Retirement Plans
Test Bank
True or False
________ 1. Taxpayer A, a dentist, fills a cavity for Taxpayer B, an attorney, in
exchange for legal services. If the value of the dental services equals the
value of the legal services, neither A nor B has earned taxable income.
________ 2. As a general rule, any economic benefit granted an employee by his or
her employer and intended to compensate the employee for services
rendered represents gross income to the employee.
________ 3. If the value of a noncash fringe benefit is not specifically excluded from
gross income by statutory law, it must be included in the recipient’s gross
income.
________ 4. The value of an annual employer-sponsored Christmas party may be
excluded from an employee’s gross income because it is a de minimis
fringe benefit.
________ 5. During the current year, AC Corporation required a key employee,
Taxpayer X, to transfer from AC’s San Diego, California office to AC’s
Phoenix, Arizona office. AC agreed to pay the commission charged by
the real estate agent on the sale of X’s home in San Diego. Because the
payment represents a “working condition fringe benefit,” the amount of
the real estate commission paid is not included in X’s gross income for
the current year.
________ 6. In 2010, M corporation transferred 1000 shares of its common stock
worth $90,000 to Y, an employee, in connection with her performance of
services for the corporation. The shares, however, are subject to
substantial restriction: Y will have to forfeit the shares if she leaves M
corporation before 2013. Y makes a § 83(b) election to include the
$90,000 value of the shares in her 2010 income. In 2013 Y is still
working for M corporation and her 1,000 shares are worth $230,000. Y
realizes $140,000 of taxable income on her 2013 return.
________ 7. If a taxpayer makes a § 83(b) election to recognize current income on the
receipt of restricted property, the subsequent forfeiture of the property
will give rise to a tax deduction.
________ 8. Stock options are always taxed as income to the recipient on the day they
are granted.
________ 9. The employee who exercises an ISO creates a deduction for his
employer at that time equal to the difference between the option price
and the market price.
________ 10. B Inc. has an unfunded deferred compensation program for its
employees. In the current year, B employees earned $120,000 in
deferred compensation, none of which is taxable to any employee. If B
Inc. is an accrual basis taxpayer, the corporation may claim a $120,000
tax deduction in the current year because of its deferred compensation
liability.
________ 11. An accrual basis employer may take a deduction for deferred
compensation when the employer promises to pay the deferred
compensation, but does not set aside funds for that purpose.
________ 12. Employee Q has been a participant in his employer’s non-qualified
retirement plan for 25 years, during which period Q’s employer has made
regular annual contributions to the plan on Q’s behalf. Q’s right to his
retirement fund is fully vested. Upon retirement, any amounts withdrawn
from this plan will be fully taxable to Q.
________ 13. A taxpayer who is 60 years old on retirement in the current year may use
the special forward averaging method of computing his or her income
tax on a lump sum distribution from a qualified plan only once.
________ 14. Individuals who are not disabled and who make lump-sum withdrawals
from an Individual Retirement Account (IRA) prior to age 5972 years
must pay a 10 percent penalty tax.
________ 15. An employer with a qualified defined contribution (profit sharing) plan
is required to make an annual contribution to the plan.
________ 16. Only corporate employers may have qualified retirement plans for their
employees.
________ 17. The employee retirement plan adopted by BT Corporation provides that
the total amount of retirement benefits provided to a particular employee
under the plan can be reduced by the amount of any social security
benefits to which that employee is entitled. Because this provision of the
plan discriminates in favor of the highly compensated employees of BT,
the retirement plan cannot be “qualified” for Federal tax purposes.
________ 18. In order for a retirement plan to be “qualified,” retirement benefits must
vest immediately in participating employees.
________ 19. Qualified retirement plans may be funded or non-funded by the
employer.
________ 20. A self-employed taxpayer is limited only by the amount of his or her
earned income in determining the maximum annual contribution to a
defined contribution Keogh plan.
________ 21. A self-employed individual who establishes a qualified retirement plan
for his employees may be eligible for participation in the plan.
________ 22. In recent years Congress has passed legislation to systematically reduce
the retirement benefits available to self-employed individuals through
use of a Keogh plan.
________ 23. Lump sum distributions out of an Individual Retirement Account (IRA)
are not eligible for the forward averaging tax computation.
Multiple Choice
________ 24. K Airlines provides its employees free air travel if space on the flight is
available at departure time. Under § 132, this fringe benefit
a. Represents income to the employee in the amount of the seat’s lowest
rate
b. Does not represent gross income to the employee
c. Is a no-additional-cost service
d. Both b. and c.
________ 25. Which of the following fringe benefits may be taxable to the recipient?
a. Employer-provided parking
b. Employer-provided on-premises health club or athletic facility
privileges
c. Employer-provided interior decorating for a new personal residence
d. Employer-provided child and dependent care services
________ 26. Which of the following represents an excludable working condition
fringe benefit under § 132?
a. Business magazine subscriptions paid for by an employer in the
names of various employees
b. Parking provided near its business by an employer for its employees
c. On-premises athletic facilities provided by an employer to its
employees
d. All of the above
e. Both a. and b.
________ 27. A restaurant chain offers the following benefits to its employees. Which
represents an excludable de minimis fringe benefit under § 132?
a. Annual employee picnic
b. Employer-provided coffee and doughnuts
c. Meal discount at any restaurant in the chain
d. Both a. and b.
e. All of the above
________ 28. Under § 83, property received for services is restricted property if it is
a. Subject to substantial risk of forfeiture
b. Immediately transferable by the recipient but held outside the United
States
c. Not immediately transferable by its recipient
d. Both a. and c.
e. Both a. and b.
________ 29. In 2011, employee E receives 10 shares of the common stock of his
employer, Beta Corporation, as compensation. However, E will have to
return the shares if he leaves his position with Beta before 2012. If E
does not make a § 83(b) election with regard to the shares
a. He will recognize no income in 2011 because of the receipt of the
stock.
b. He will never recognize income on the stock.
c. He will recognize 2011 income equal to the current value of the
shares.
d. He will recognize income only when he leaves his position with Beta
and forfeits his shares.
________ 30. In 2011, Corporation M transferred 1,000 shares of its common stock to
employee Y as a year-end bonus. However, Y will forfeit the shares if he
leaves his position with the corporation before 2013. Y makes a § 83(b)
election to include the $90,000 current value of the shares in his 2011
income. In 2013, Y is still working for Corporation M and his 1,000
shares are worth $230,000. Based on these facts
a. Corporation M may take no deduction for the transfer of its own
shares to Y.
b. Corporation M may take a $90,000 deduction in 2011.
c. Corporation M may take a $90,000 deduction in 2013.
d. Corporation M may take a $230,000 deduction in 2013.
________ 31. In 2011, P receives stock worth $15,000 from Q Corporation as payment
for services rendered. The stock is subject to substantial risk of
forfeiture, i.e., if P leaves Q Corporation before 2013, she must forfeit
the stock. P chooses to make a § 83(b) election and include the $15,000
value of the stock in her 2011 gross income. In 2013 the risk of
forfeiture lapses, the property is worth $38,000.
a. P must include $23,000 gross income attributable to the property in
2013.
b. P has no gross income attributable to the property in 2013.
c. P cannot recognize the gross income from the property in 2011.
d. None of the above is correct.
________ 32. During the current year, Corporation J granted a non-qualified stock
option to Employee E. The option allowed E to buy 1,000 shares of J
stock for $100 per share at any time during the next four years. At the
date of the grant, the market price of E stock was $110 per share, and
thus, the option’s value was $10,000. Two years after the option was
granted, E exercised the option when the market price of E stock was
$160 per share. Based on these facts, E should report
a. No income until he sells the 1,000 shares of E stock
b. $10,000 of ordinary income in the current year, but no income in the
year the option is exercised
c. $10,000 of ordinary income in the current year, and $50,000 of
ordinary income in the year the option is exercised
d. No income in the current year and $60,000 of ordinary income in the
year the option is exercised
________ 33. In 2009, Corporation D granted a non-qualified stock option to employee
Z, which entitled Z to purchase 500 shares of D stock at $100 per share
at any time until 2014. Upon date of the option grant, D stock was
selling at $90 per share. In 2012, when the market price of D stock had
increased to $145 per share, Z exercised his option. Based on these facts,
Z must recognize
a. $50,000 ordinary income in 2009
b. $50,000 ordinary income in 2012
c. $22,500 ordinary income in 2012
d. No ordinary income until the stock is sold by Z
________ 34. In 2009, Z received non-qualified stock options as part of her
compensation from U Corporation. When granted, the options had no
ascertainable value. In 2012, Z exercised the options and purchased
1,000 shares of U stock, market value $100 per share, for the option
price of $70 per share. Accordingly,
a. In 2012, Z must recognize $100,000 in ordinary income.
b. In 2012, Z must recognize $70,000 in ordinary income.
c. In 2012, Z must recognize $30,000 in ordinary income.
d. None of the above is correct.
________ 35. In the current year, employee F is given an incentive stock option (ISO)
entitling him to purchase 100 shares of his employer Sigma
Corporation’s stock for $50 per share. He exercises the option in the
following year when the shares are selling for $80 per share. If F sells
these 100 shares four years later for $200 per share, he will recognize
a. A long-term capital gain of $120 per share
b. A long-term capital gain of $150 per share
c. Ordinary income of $30 per share and a long-term capital gain of
$120 per share
d. No income upon sale
________ 36. For § 421 (a) to apply so that the exercise of an ISO will not result in
income recognition to the owner, the stock purchased must not be
disposed of
a. Within two years from the date of granting
b. Within one year from the date of exercise
c. Within one year from the date of granting
d. Both a. and b.
________ 37. During the current year, Corporation P granted an incentive stock option
(ISO) to Employee A. The option entitled A to purchase 500 shares of P
stock for $150 per share. On the date the option was granted, P stock had
a market value of $130 per share. Three years after the grant, A
exercised the option when P stock had a market value of $190 per share.
Eight months after A acquired the 500 shares, he sold them for $200 per
share. Based on these facts, A should report a gain on sale of
a. $20,000 ordinary income and $5,000 capital gain
b. $25,000 capital gain
c. $25,000 ordinary income
d. $5,000 capital gain
________ 38. Section 422A(b) sets forth a number of statutory requirements for an
employee stock option to qualify as an incentive stock option (ISO).
Primary requirements are that
a. The option must be granted within 10 years of the date of adoption or
the date of shareholder approval, whichever is earlier.
b. The option price must be less than the market value of the stock at
date of grant.
c. The option must be exercised within 10 years of date of grant.
d. Both a. and c. be done.
e. All of the above are true.
________ 39. In 2009, J Corporation granted employee B an ISO to purchase 2,000
shares of J stock with a current aggregate value of $100,000. In 2012, J
Corporation granted B a second ISO to purchase 500 shares of J stock
with a current aggregate value of $150,000. If B decides to exercise any
of his ISOs in 2012, he may
a. Purchase 1,000 shares through exercise of his 2009 option
b. Purchase 333 shares through exercise of his 2012 option
c. Purchase 500 shares through exercise of his 2012 option
d. Do both a. and b.
e. Do none of the above
________ 40. Which of the following is true regarding incentive stock options (ISOs)?
a. The value of stock with respect to which ISOs are exercisable shall
not exceed $100,000 per calendar year per employee, the value of the
stock being determined at the date of exercise.
b. ISOs may be exercised only in the order in which received.
c. The value of stock with respect to which ISOs are exercisable shall
not exceed $100,000 per calendar year per employee, the value of the
stock being determined at the date of grant.
d. Both a. and b.
________ 41. If contributions are made to an employer-sponsored (i.e., not a Federal
retirement program), qualified retirement plan,
a. The employer’s contributions on behalf of the employee are not
includible in the employee’s gross income.
b. The employer is entitled to a current deduction for contributions to
such plans.
c. The employee includes the retirement benefits in his or her gross
income in the tax year of receipt.
d. All of the above are true.
________ 42. If an employer’s contributions are made to a non-qualified retirement
plan in which employees are fully vested,
a. The employer’s contributions on behalf of the employee are
includible in the employee’s gross income.
b. The employer is not entitled to a current deduction for contributions
to such plans.
c. The employee is allowed a deduction for current contributions, but
must include retirement benefits in his or her gross income in the tax
year of receipt.
d. All of the above are true.
________ 43. In the current year, ZT Inc., an accrual basis taxpayer, declares a
$75,000 year-end bonus to its president, Mr. Z. Upon Z’s request, ZT
agrees to defer payment of the bonus for 10 years, at which time Z is
anticipating retirement. The deferred compensation arrangement is
unfunded, so that Z becomes an unsecured creditor of T. Based on these
facts, which of the following is accurate?
a. Although Mr. Z does not receive a cash payment of the bonus, he is
in “constructive receipt,” and therefore, must include the $75,000 in
current year income.
b. Although T does not pay the bonus, the liability incurred entitles ZT
Inc. to deduct the bonus in the current year.
c. Because the deferred compensation arrangement is not a qualified
retirement plan, Mr. Z must include $75,000 in current-year income.
d. Mr. Z has no tax liability on the $75,000 until the deferred
compensation is actually paid.
________ 44. During the current year, Taxpayer Q quits her job. As a participant in her
employer’s qualified retirement plan, Q is entitled to a payment of
$100,000. Q never made any contributions of her own to this plan. Based
on these facts, which of the following statements is incorrect?
a. If Q decides to take her $100,000 in the form of a yearly annuity for
life, the full amount of the annual payment received must be included
in her gross income.
b. If Q is age 61 in the current year and decides to take her $100,000 in
the form of a lump sum distribution, she may elect to pay the tax on
the distribution over a five-year period.
c. If Q decides to take her $100,000 in the form of a lump sum
distribution, she may roll the amount over into an IRA and avoid
paying any current tax on the distribution.
d. If Q is age 40 in the current year, she will pay a 10 percent penalty
tax on any amount of the distribution included in her gross income
for the year.
________ 45. Which plans are included under defined contribution plans?
a. § 401(k) salary-reduction plans
b. Profit-sharing plans
c. Employee Stock Ownership Plans
d. Money purchase pension plans
e. All of the above
________ 46. Under § 401, contributions made as part of a qualified retirement plan
must be paid into a trust
a. Administered by the employer
b. Established by the employees
c. That may be used by the corporation as a source of emergency funds
d. None of the above is correct.
________ 47. Under § 401, which of the following is true regarding a qualified
retirement plan?
a. Any employee who has reached 18 years of age must be eligible to
participate after completing one year of service for the employer.
b. The plan may not exclude an employee from participation because of
a maximum age.
c. The plan may exclude an employee who is a union member.
d. The plan will provide sufficient coverage if it benefits at least two-
thirds of all employees not considered highly compensated.
________ 48. Under a defined benefit plan for 2011,
a. The highest annual retirement benefit payable may not exceed
$195,000.
b. The highest annual retirement benefit payable may not exceed 100
percent of the employee’s average earnings in his or her three highest
compensation years.
c. No minimum current contribution is required.
d. None of the above is correct.
________ 49. Which of the following is not a benefit of a qualified employer
retirement plan?
a. Earnings on amounts contributed to the plan are tax-exempt.
b. There is no limitation on the annual amount an employer may
contribute to the plan for the benefit of each employee.
c. Benefits paid from a plan in a lump sum distribution may be taxed
using a beneficial five-year forward averaging method.
d. Participant employees are not taxed on employer contributions until
such contributions are withdrawn from the plan.
________ 50. Mr. M has earned income of $125,000 in the current year and is a
participant in his employer’s qualified retirement plan. Mrs. M is a
housewife and has no earned income. During 2011, the Ms may make
total deductible contributions to their IRAs of
a. $0
b. $4,000
c. $5,000
d. $10,000
________ 51. Mr. T, an architect, had current year earned income of $25,000 in 2011.
Mrs. T earned $1,800 during the year by typing for university students.
The maximum amount the Ts may collectively contribute to their
Individual Retirement Accounts is
a. $4,000
b. $5,000
c. $5,800
d. $8,000
e. $10,000
________ 52. Which of the following rules apply to an Individual Retirement
Account?
a. The entire annual contribution to the IRA may be deductible for a
single taxpayer who is not an active participant in a qualified
retirement plan.
b. The entire annual contribution to the IRA may be deductible for a
single taxpayer who is an active participant in a qualified retirement
plan.
c. The entire annual contribution to the IRA may be deductible for a
taxpayer who is an active participant in a qualified retirement plan
but has A.G.I, over the applicable dollar amount (i.e., $89,000 for
MFJ in 2011, and $55,000 for single taxpayers in 2011).
d. Either a or b.
________ 53. Which of the following is accurate concerning annual contributions by
an employer to a Simplified Employee Pension?
a. They are made directly into a qualified trust.
b. They are excludable from an employee’s gross income.
c. They are limited to the lesser of $30,000 or 15 percent of employee
compensation.
d. Both b. and c.
18
Employee Compensation and Retirement Plans
Solutions to Test Bank
True or False
Multiple Choice
