2013 cch basic principles ch14

Chapter 14
Deferred Compensation
and Education Savings
Plans
©2012 CCH. All Rights Reserved.
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Chapter 14 Exhibits

1. Investing for the Future: The Grocery Store Analogy
2. Employer-Sponsored Plans: Qualified v. Nonqualified
3. Distributions from Qualified Plans (QPs): Basic Concepts
4. Comparison of Defined Contribution and Defined Benefit Plans
5. Calculating RMDs Using the Uniform Lifetime Table
6. Portability Chart
7. Common Retirement Plans for Large Employers—Eligible Employers
8. Common Retirement Plans for Large Employers—Basic Features
9. Common Retirement Plans for Large Employers— Contribution Limits
10. 401(k) Plans—Lecture Problem on Tax Consequences
11. Common Retirement Plans for Small Businesses—Basic Features

Chapter 14, Exhibit Contents A CCH Federal Taxation Basic Principles 2 of 61

Chapter 14 Exhibits
12. Common Retirement Plans for Small Businesses—Contribution and
Deduction Limits
13. Personal Retirement Plans for Working Individuals
14. Applying the Two Qualifying Tests to Roth Distributions
15. Employee Stock Purchase Plans—Qualifying Distributions
16. Employee Stock Purchase Plans—Disqualifying Distributions
17. Incentive Stock Options—Qualifying Distributions
18. Incentive Stock Options—Disqualifying Distributions
19. Nonqualified Stock Options (NSOs)—Value Known at Grant Date
20. Nonqualified Stock Options (NSOs)—Value Unknown at Grant Date
21. Restricted Stock Plans—With and Without Section 83(b) Election
22. Savings Plans for Education

Chapter 14, Exhibit Contents B CCH Federal Taxation Basic Principles 3 of 61

Investing for the Future: The Grocery Store Analogy
 Fruit: Vegetables: Cereal: Coffee: Soup: Bread:
Identify the
• Apples • Carrots • Fiber • Freeze-dried • Vegetable • Rye
food to buy
• Oranges, etc. • Celery, etc. • Frosted, etc. • Instant, etc. • Tomato, etc. • Wheat, etc.

 Highly Liquid
Treasury Corporate
Identify the Stocks: Real Estate: Commodities: Cash
Securities: Bonds:
investments to Equivalents:
buy (this is a
mere glimpse • S&P 500 • T-Bills • Risk Specific • Equity REITS • Foreign • Interest-Bearing
• Russell 3000 • T-Notes • Term Specific • Mortgage Currencies Time Deposits
into the
thousands of • Industry-specific • T-Bonds • etc. REITS • Natural • Interest-Bearing
(e.g., consumer • Hybrid REITS Resources Demand Deposits
possibilities) • I-Bonds
staples, utilities) • Industrial • etc.
• EE- Bonds
• Geographic-specific Metals
• TIPS
(e.g., Pacific rim, • Precious
Latin America) • etc. Metals
• Risk specific (e.g., • Grains
aggressive growth • etc.
stocks, “blue chips”)
• Dividend specific
(e.g., high yield
stocks)
• Market-size
specific (e.g.,
emerging markets),
etc.

Select the grocery store  Kroger Whole Foods Costco Farmers Market Walmart 7-Eleven

Select the financial institution  Fidelity Bank of America Vanguard 1st Federal S&L E-Trade Prudential

Chapter 14, Exhibit 1a CCH Federal Taxation Basic Principles 4 of 61

Investing for the Future: The Grocery Store Analogy
Choose the type of food packaging  Cans Plastic Cartons Jugs Jars Rubber
wrappers bands

Choose the type of investment “packaging”  Mutual Exchange- Money market Bank certificates Savings Annuity
funds traded funds funds of deposit accounts contracts


Choose the best Paper Plastic Box
food carrier

 Tax-free
Tax Deferred Accounts Accounts Taxable Accounts
Choose the best
investment
• Roth IRA Any account maintained
“carrier” Employer-Sponsored Educational at a financial institution
• Roth 401(k) plan
Plans: Savings Plans: that generates:
• Interest
• 401(k) plan • 529 plans • Traditional
IRA • Dividend income
• 403(b) plan • Coverdell and/or
• Employee stock ownership savings account
• Capital gains
plan (ESOP)
• Solo 401(k) plan (for self-
employed taxpayers or that is CURRENTLY
single-employee entities) TAXABLE
• Keogh plan
• Simplified employee
pension (SEP) IRA
• Savings incentive match
plan (SIMPLE)
• DB/K plan
• Nonqualified employer-
sponsored plans

Chapter 14, Exhibit 1b CCH Federal Taxation Basic Principles 5 of 61

Employer-Sponsored Plans:
Qualified v. Nonqualified
Examples of Qualified and Nonqualified Plans:
Qualified Plans Nonqualified Plans
 401(k) plans (corporate-styled profit  Rabbi Trusts,
sharing or stock bonus plans),  Employee stock purchase plans,
 Roth 401(k) plans (effective January 1,
2006 for amended 401(k) plans),  Incentive stock options,
 403(b) plans (i.e., tax-sheltered annuity  Nonqualified stock options,
arrangements),  Variable annuity contracts,
 Employee stock ownership plans  Restricted stock,
(ESOPs),
 Solo 401(k) plans (for self-employed
 Informal short-term arrangements.
taxpayers or single-employee entities)
 Keogh plans,
 Simplified employee pension plans
(SEP IRAs),
 Savings incentive match plans for
employees (SIMPLE IRAs)


Tax Advantages (“+”) and Disadvantages (“-”)
+ Flexible Rules Governing Tax Deferral of Employer - Restrictive Rules Governing Deferral of
Contributions. Contributions by employers and Employer Contributions. Employee tax
employees are tax deferred (tax free for deferral on employer contributions can
employee contributions to Roth 401(k) plans). be achieved only under either of two
Taxation generally occurs when the amounts conditions: (a) the employer’s obligation
contributed are eventually distributed to to pay the benefits remains merely an
participants. Thus, the rules for tax deferral are unfunded and unsecured promise to pay
more flexible for QPs than for NPs. A QP can (i.e., no “economic benefit”); or (b) the
achieve tax deferral even if the employer employer’s obligation is funded or
contribution has been funded or secured and the secured but the employee must bear a
employee’s right to that compensation is not substantial risk of forfeiture (i.e., no
subject to a substantial risk of forfeiture. constructive receipt”).

+ Deduction immediately available to employers. - No immediate employer tax deduction. An
Corporate employers, self-employed taxpayers, employer is not entitled to a tax deduction
or individuals (for IRAs) may deduct until such time as the benefits are actually
contributions even though income tax is paid to the employee.
deferred. For all plans except IRA’s, the
contribution may create an NOL.


+ Accumulated income tax deferred. Interest, dividends & - Income is taxable to the employer (unless
other income can accumulate tax free until benefits invested in tax-exempt securities).
are paid. (With Roth 401(k) plans, accumulated
income is intended to be tax-free.)

+ Future payouts with lower tax rates. Tax benefits are + Same advantage.
typically paid out after retirement when the
employee’s effective tax rate is often lower.

+ Payroll tax exemption. Employer contributions (but not - No payroll tax exemption. Employer
employee contributions!) are exempt from FICA contributions are generally subject
and FUTA taxes when paid into and out of a QP. to Social Security and Medicare
taxes when services are performed
or, if later, when a person’s right to
receive the compensation no longer
is subject to a substantial risk of
forfeiture. Sec. 3121(v).

Chapter 14, Exhibit 2c CCH Federal Taxation Basic Principles 8 of 61

+ Portability. Tax-free transfers between two QPs and - No Portability.
from one QP to a traditional IRAs are permitted,
thereby extending tax deferral.
- Credit to small employers for startup costs. Small - No employer tax credit available.
employers may be entitled to receive a credit for
some of the costs of establishing new QPs see
CCH ¶9045).

- Credit to employees for contributions. Employees may - No employee tax credit available.
be entitled to receive a saver’s credit for elective
contributions to a QP (see CCH ¶9033).

Chapter 14, Exhibit 2d CCH Federal Taxation Basic Principles 9 of 61

Nontax Advantages (“+”) and Disadvantages (“-”)

+ Bankruptcy protection. Plan assets are protected from the - No bankruptcy protection.
employer, employer creditors, and employee
creditors. (O.J. Simpson receives $25,000 monthly
from his pension plan despite losing a $36 million
judgment to the Goldman family.)

+ Employment incentive. QPs can be used to attract and + Same advantage.
retain employees.

+ Loan option available to employees. Participants may be - No loan option.
permitted to borrow up to $50,000 from their QPs.

Chapter 14, Exhibit 2e CCH Federal Taxation Basic Principles 10 of 61

- Nondiscrimination. The plan cannot discriminate in + More flexibility in choosing who participates.
favor of highly compensated employees. Code NPs are not subject to the same
Sec. 401(a)(4). minimum coverage and
nondiscrimination requirements as QPs.
Therefore, an NP can be designed to
cover a limited group of employees.

- Distribution restrictions. Distributions made too soon + No statutory restrictions on distributions.
may be subject to a 10% penalty. If made too late
and/or too little in amount, a 50% penalty may be
imposed on the recipient.

- Limitation on annual employee compensation. For + Unlimited benefits. An NP can provide
most employer-sponsored retirement plans, benefits in excess of those permitted
compensation subject to employer and employee under QP limits.
contribution percentages is limited to $250,000 in
2012.

Chapter 14, Exhibit 2f CCH Federal Taxation Basic Principles 11 of 61

- Limitation on contributions. Specified limits apply to how + No limitation on contributions.
much employees and employers can contribute to a QP.
Code Sec. 415.
- Independence of trustee. For most employer-sponsored + No independent trustee
retirement plans, retirement funds must be held in requirement.
trust managed by an independent trustee. Exceptions
include Keogh plans for self-employed taxpayers.

- Participation and coverage. Employees meeting certain + No participation and coverage
minimum age and service requirements must be requirements..
eligible to participate in an employer-sponsored
retirement plan. In addition, the plan must generally
cover at least 70% of eligible employees on a
nondiscriminatory bases. Sec. 410. Exceptions include
SIMPLE IRA plans.

Chapter 14, Exhibit 2g CCH Federal Taxation Basic Principles 12 of 61


- Written and continuous plan. The plan must be in writing and + The NP need not be written and
constitute a continuous program. continuous.

- Vesting. An employee’s nonforfeitable right to receive future + No vesting rules imposed on
benefits must take effect within a prescribed time frame. employer.
Sec. 411.

- Exclusive benefit of employees. The plan must be created and + No “exclusive benefit of
operated for the exclusive benefit of the employees” requirement.
employee/participants and isolated from potential
misfortunes of the employer.

Chapter 14, Exhibit 2h CCH Federal Taxation Basic Principles 13 of 61

Distributions from Qualified Plans (QPs):
Basic Concepts
“Before-Tax” v. “After-Tax Contributions. Grasping the distinction
between “before-tax” and “after-tax” contributions is essential to
understanding the distribution rules governing qualified deferred
compensation plans. Here’s the distinction: If contributions made to
qualified plans such as traditional IRAs or 401(k) plans are
deductible, the subsequent withdrawal of these contributions is
taxable. Conversely, if the contributions are not deductible, the
subsequent withdrawal is tax-free. The rules governing the
deductibility of contributions are explained later in this chapter. For
now, it’s important to understand why deductible contributions are
“before-tax” and why nondeductible contributions are “after-tax.”
This distinction is illustrated below.


Basic Concepts
Illustration of Tax Effect from “Before-Tax” and “After-Tax”
Contributions. Assume a taxpayer earns a $100,000 salary and
contributes $4,000 into a retirement account such as a traditional
IRA or a 401(k). Assume the current tax rate to be 25%.
 Will the $4,000 contribution be taxable when it is subsequently
distributed back to the taxpayer? As illustrated below, the answer
depends on whether or not the contribution was deductible.
 Will the income accumulating from the $4,000 contribution be
taxable when later distributed? Yes, unless the QP is a Roth IRA
or a Roth 401(k).


Basic Concepts
Formula: Description: Before Tax Cont’n After-Tax Cont’n

(a) = Given Contribution $4,000 $4,000

(b) = Given Deductible? (The rules for Assume Yes Assume No
qualifying for a deduction
are explained later in this
chapter.)

(c) = Given Gross income $100,000 $100,000

(d) = (a) only if Deduction (4,000) 0
(b)=“yes”

(e) = (c)–(d) Taxable income 96,000 100,000
(ignoring other deductions)

(f) = Given Tax rate 25% 25%

(g) = (e) x (f) Tax 24,000 25,000

(h) = (d) x (f) Immediate tax savings from the 1,000 0
$4m deduction


Basic Concepts
Formula: Description: Before Tax Cont’n After-Tax Cont’n
(i) = (d) x tax Estimated future taxes $1.000 $0
rate in payable when the (assuming a 25% future tax rate; if
effect in $4,000 is the future tax rate is lower (or
the year of subsequently higher) due to, say, lower
dist’n distributed (higher) retirement income, the
tax burden will be less (more)
than $1m)

If (b) =“yes:” Amount of income $4,000 $5,333
(j) = (a) needed to afford the (Same as the contribution amount. (To afford a $4,000
If (b) =“no:” $4,000 contribution This is why the contribution is contribution, the
(j) = (a) ÷ [1– “before-tax”.) taxpayer needs to earn
(f)] at least $5,333, which,
taxed at 25%, would
result in $4,000 cash
after-tax. This explains
why the nondeductible
contribution is
considered to be “after-
tax.”
Proof: 25% x $5,333 =
$4,000)


Comparison of Defined Contribution and
Defined Benefit Plans
Defined Contribution Plans (DCPs) Defined Benefit Plans (DBPs)
Contributions (a) Fixed percentages; or Determined actuarially based on
(b) Flat dollar amounts. defined benefits.
Contribution Limit Lesser of: N/A
(1) $50,000 in 2012, or
(2) 100% employee’s gross compensation (25%
for profit sharing, money purchase, or
stock bonus plans).
(Note: This limit applies to the aggregate of
employer and employee contributions, as
well as forfeitures allocated to the
employee’s account.)

Benefits The final benefits depend upon investment The final benefit is a fixed and pre-
performance of the trust account. Upon determinable lump-sum or
retirement, an employee is entitled to the annuity.
account balance, either as a lump-sum or an
annuity.


Comparison of Defined Contribution and
Defined Benefit Plans
Defined Contribution Plans (DCPs) Defined Benefit Plans (DBPs)
Benefit Limit N/A Lesser of:
(1) $200,000 in 2012
(2) Average salary for highest 3 years of
employment
(Adjustments based on age, years’ participation
or years’ employment may be required.)

Forfeitures Increase employee benefits, or Must reduce future contributions by
Reduce future contributions by employer. (Forfeitures cannot increase
employer. employee benefits.)
Ideal Employee More favorable for younger employees More favorable for older employees at the
Targets since, over a longer period of time the plan is adopted since it is
time, higher benefits may result. possible to fund higher benefits over a
shorter period.

Complexity Less than DBPs Require greater reporting requirements and
more actuarial and administrative costs.
(This explains why (a) it is impractical for
many small businesses and (b) there has
been a massive shift away from DBPs over
the past decade.)


Calculating RMDs Using the
Uniform Lifetime Table
Minimum amount of first distribution = (a) ÷ (b), where:
(a) = Accrued benefit or account balance as of December 31 of the
year preceding the year in which the taxpayer attains the age of
70 1/2, or retires, if applicable.
(b) = Hypothetical joint life expectancy provided in the Uniform
Lifetime table below, that is based on:
(i) the taxpayer’s age on December 31 of the year in which the
taxpayer attains the age of 70 1/2, (or retires, if applicable,)
and
(ii) a hypothetical beneficiary whose age is exactly ten years
younger than the taxpayer’s.


Minimum amount of subsequent distributions = (c) ÷ (d), where:
(c) = Accrued benefit or account balance as of December 31 of the
year preceding the year in which a distribution must be made
(e.g., use the balance as of December 31, Year 1 if a second
distribution is due by December 31, Year 2).
(d) = Redetermined joint life expectancy provided in the Uniform
Lifetime table below.]


Table 2: Uniform Lifetime Table
Age of IRA Owner Distribution Period
Age Life Age Life Age Life Age Life Age Life
Exp. Exp. Exp. Exp. Exp.
70 27.4 80 18.7 90 11.4 100 6.3 110 3.1
71 26.5 81 17.9 91 10.8 101 5.9 111 2.9
72 25.6 82 17.1 92 10.2 102 5.5 112 2.6
73 24.7 83 16.3 93 9.6 103 5.2 113 2.4
74 23.8 84 15.5 94 9.1 104 4.9 114 2.1
75 22.9 85 14.8 95 8.6 105 4.5 115 1.9
76 22.0 86 14.1 96 8.1 106 4.2 (or older)
77 21.2 87 13.4 97 7.6 107 3.9
78 20.3 88 12.7 98 7.1 108 3.7
79 19.5 89 12.0 99 6.7 109 3.4


Eve’s traditional IRA account balances for five years are shown below:

Date Account Balance
December 31, Year 1 $274,000


Eve becomes age 70 on June 1, Year 2, and retires at the end of Year 3. Since Eve’s
plan is not employer-sponsored, the retirement date is irrelevant in determining her
RMD. The initial RMD (deadline and amount) is based on the year in which she
becomes 70 ½ (Year 2). The deadlines and amounts associated with the first four RMDs
are shown below.
Distribution: Relevant Relevant Computation of RMD Amt.

No. RMD Acct. Bal. Age on (refer to the Uniform RMD
Date Date (12/31) Dec. 31 of: Lifetime Table above) Amount

1st 4/1 Yr 3 Yr 1 Yr 2: 70 $274,000 ÷ 27.4 $10,000
2nd 12/31, Yr 3 Yr 2 Yr 3: 71 [$296,200 - $10,000] ÷ 26.5 $10,800

3rd 12/31, Yr 4 Yr 3 Yr 4: 72 $320,000 ÷ 25.6 $12,500
4th 12/31, Yr 5 Yr 4 Yr 5: 73 $345,800 ÷ 24.7 $14,000

Chapter 14, Exhibit 5e CCH Federal Taxation Basic Principles 24 of 61

Portability Chart
ELIGIBLE ROLLOVER TO RECIPIENT PLAN? (Yes v. No)
Roth Keogh SEP Trad’l
403(b) Gov't. Plan IRA SIMPLE IRA Roth
TO: 401(k) 401(k)/
Plan 457(b) IRA IRA
403(b)
FROM:
401(k) - Other Than
Yd N Yc Yc Yd Y N Y Y
Roth 401(k)
403(b) - Other Than
Y N Y Y Y Y N Y Y
Roth 403(b)
Roth 401(k)/ 403(b) by
N Y N N N N N N Y
Direct Rollover
Governmental 457(b) Y N Y Y Y Y N Y Y
Keogh Yd N Yc Yc Yd Y N Y Y
SEP IRA Ya N Ya Ya Ya Y N Y Y
SIMPLE IRAb Y N Y Y Y Y Y Y Y
Traditional IRA Ya N Ya Ya Ya Y N Y Y
Roth IRA N N N N N N N N Y
Superscript Notes:
a
Only pretax amounts from a traditional IRA or SEP IRA may be rolled to these plans.

b

Chapter 14, Exhibit 6 CCH Federal Taxation Basic Principles 25 of 61

Common Retirement Plans for Large
Employers—Eligible Employers
Characteristics: 401(k) 403(b) 457(b) 457(b)
(“Tax Sheltered (Governmental) (Nongovernmental)
Annuity” Plan)
Description of Taxable • Tax-exempt • State and local • Tax-exempt
Eligible entities organizations governments organizations
Employers: • Public school
systems

Examples of eligible
employers:
For-profit employer Yes No No No
formed as a C
or S
corporation,
partnership,
LLC, or
proprietorship


Annuity” Plan)
employers
(contd.):
Federal government No No No No
State and local No No Yes No
governments (unless it’s an
educational
institution)

Schools (K to No Yes for both Yes for Yes for 501(c)(3)
university level) (unless it’s a governmental governmenta organizations
for-profit (state & local) l (state &
business) or 501(c)(3) tax local)
exempt employers
organizations


Annuity” Plan)
employers (contd.):
Hospitals No Yes for 501(c)(3) Yes for Yes for 501(c)(3)
(unless it’s a organizations governmental organizations
for-profit (state & local)
business) employers

Museums that are tax- No Yes for 501(c)(3) Yes for Yes for 501(c)(3)
exempt organizations governmental organizations
(state & local)
employers

Libraries that are tax- No Yes for 501(c)(3) Yes for Yes for 501(c)(3)
exempt organizations governmental organizations
(state & local)
employers

Private research No Yes No Yes
foundations
Labor unions No Yes No Yes
Private clubs No Yes No Yes

Employers—Basic Features
Features: 401(k) 403(b) 457(b) 457(b)
Annuity” Plan)
Plan type Qualified Qualified Nonqualified Nonqualified
Able to discriminate? No No Yes Yes
Loans up to $50,000 OK? Yes Yes Yes No
Subject to 10% penalty on Yes Yes No (unless the No
premature withdrawals? distribution
consists of an
amount
previously
rolled over
from another
type of plan)

Subject to 50% penalty on Yes Yes Yes No
late RMDs?
Subject to $5,000 mandatory Yes Yes Yes No
cash-out rules?


Employers—Basic Features
Features: 401(k) 403(b) 457(b) 457(b)
Annuity” Plan)
Portable with other employer- Yes Yes Yes No
sponsored plans and
IRAs?
Subject to statutory vesting Yes Yes No No
rules for employer
contributions?
Must be for exclusive benefit of Yes Yes for Yes No
employees? retirement
income
accounts;
No, for annuity
contracts
and
custodial
accounts.

Protection from creditors of Yes Yes Yes No
employer?


Employers—Contribution Limits
Limits: 401(k) 403(b) 457(b) 457(b)
Annuity” Plan)
Are employee Yes, limited to the Yes, limited to the Yes, limited to the Yes, limited to the
elective lesser of: lesser of: lesser of: lesser of:
deferral (1) = 17,000; (1) = 17,000; (1) = 17,000; (1) = 17,000;
contributions (2) = 100% GC (2) = 100% GC (2) = 100% GC (2) = 100% GC
allowed? * + $5,500 if age * + $5,500 if age 50+ * + $5,500 if age + $15,000 (max.) if
(“GC” is defined 50+ + $3,000 (max.) if 50+ within 3 years
below) completed 15 years OR of retirement
of service + $15,000 (max.) if (The 50 + catch-up
within 3 years contribution is
of retirement not permitted.)

Aggregate Limit Lesser of: Lesser of: Same as employee Same as employee
on Employer (1) = $50,000 or (1) = $50,000 or elective elective
and (2) = 100% GC (2) = 100% GC deferral deferral
Employee plus catch-up plus catch-Up contribution contribution
Contributions contributions contributions limit above. limit above.

“GC:” Gross compensation is equal to the employee’s salary plus any qualified benefits such as medical insurance
premiums under a cafeteria plan.


Employers—Contribution Limits
Limits: 401(k) 403(b) 457(b) 457(b)
(“Tax Sheltered (Governmental) (Nongovernmental
Annuity” Plan) )
Are No for employer Same as 401(k) Same as 401(k) Yes
contribution contributions;
s subject to Yes for employee
FICA or contributions.
FUTA?

Are employee Yes if written into Same as 401(k) No No
supplement the plan
al after-tax
contribution
s allowed?

“GC:” Gross compensation is equal to the employee’s salary plus any qualified benefits such as medical
insurance premiums under a cafeteria plan.


401(k) Plans—Lecture Problem on Tax
Consequences
Facts:
• ABC Corp’s 401(k) plan provides that employees may elect to contribute 100% of their

“gross” compensation, up to $17,000, the elective deferral limit.
• ABC will match employee contributions up to 6% of “net” compensation.
• Cy elects to contribute 10% of his $25,000 salary in 2012.

Explain the tax consequences.

Tax consequences:
Employee elective deferral contribution: $2,500 (= 10% x $25,000)
Employer contribution: $1,350 (= 6% x [$25,000 - $2,500])
Amt. of salary subject to employee $25,000 (i.e., elective employee contributions, but not
FICA: employer contributions, are subject to FICA tax.)
Amt. of salary currently subject to $22,500 (= $25,000 - [10% x $25,000])
federal income tax:
Amt. of salary currently escaping $3,850 (= $2,500 + $1,350)
federal income tax:

Note: If ABC’s plan had been a 403(b) or 457, the tax consequences would have been the same.


Common Retirement Plans for Small
Businesses—Basic Features
Features Solo 401(k) Keogh SEP SIMPLE
Form of plan: 401(k) Pension, profit- IRA IRA or 401(k)
sharing, or
both
Self as trustee Yes Yes No No
OK?
Permitted legal • LLCs, • LLCs, • LLCs, • LLCs,
entity type: • Partnerships • Partnerships • Partnerships • Partnerships
• Sole props. • Sole props. • Sole props. • Sole props.
• C or S • C or S corps.,
corporations

Limit on number Must not exceed 1 No limit No limit Must not exceed
of owner-employee 100 employees
employees: (except for
spouse)


Annual filing Annual IRS Form Annual IRS Form None. None.
requirements: 5500-EZ or 5500-EZ or (although certain (although certain W-
Form 5500 once Form 5500 once W-2 reporting 2 reporting is
balance exceeds balance exceeds is required.) required.)
$250,000 (by last $100,000, or
day of 7th month $250,000 for a
after year-end) one-participant
plan (by last
day of 7th month
after year-end)

Statutory By December 31 of By December 31 of By extension due By October 1 of
establishment the current year. the current date of current year.
deadline year. employer
(financial return.
institutions
may set earlier
deadlines):


Statutory Employee: By Dec. By extension due By extension due By extension due date
contribution 31 of current date of date of of employer
deadline: year; employer employer return.
Employer: By return. return.
extension due
date.

Vesting None Regular vesting None None
requirements: (since no employee rules (e.g., 3- (Employer (Employer
other than yr. cliff or 6- contributions contributions
spouse may be yr. graded) are always are always
employed) apply nonforfeitable) nonforfeitable)

Plan loans ok? Yes, up to $50,000 Yes, up to $50,000 No No


Participation Only owner- Each employee: Each employee: SIMPLE IRA:
requirements: employee (and • age 21 or • age 21 or over; Each employee:
spouse) may over; & • who performed • Any age limit;
participate • with 1 year of services in • Earn at least $5K
service (2 current year for any past 2
years with 2- and in 3 out of years and be
year vesting). past 5 years; expected to do so
• who earned at in current year.
least $550 for SIMPLE 401(k):
current year. (same as Keogh)

Rollovers Yes Yes Yes Yes, but rules are very
permitted? restrictive for
SIMPLE IRAs


Common Retirement Plans for Small Businesses—
Contribution and Deduction Limits
Contribution limits for Lesser of: N/A N/A Lesser of:
employees (or (1) = 17,000; (1) = 100% GC (or gross SEI), or
“deemed (2) = 100% GC or (2) = $11,500
employees”) (see gross SEI
“Terms” below):

Contribution limits for (See aggregate (See aggregate (See aggregate Elective contributions:
employers (or contribution contribution contribution Lesser of (a) or (b):
“deemed limit on the limit on the limit on the (a) = Employee (or “deemed”
employers”) next slide.) next slide.) next slide.) employee) contributions
(from above), or
(b) = 3% GC (or gross SEI) for
each participating employee
Nonelective contributions:
2% GC for each eligible employee

Terms:
• “GC” mean gross compensation, i.e., salary paid or accrued to employees.
• “Gross SEI” refers to (a) – (b) – (c) where
(a) = self-employed taxpayer’s gross income from the business;
(b) = business deductions;
(c) = 1/2 x self-employment tax actually paid (for Keoghs and SEP IRAs);
or [(a) – (b)] x .9235 (for solo 401(k)s & SIMPLE IRAs).
• “Net SEI” is equal to gross SEI – the actual retirement plan deduction.


Aggregate Lesser of: Lesser of: Lesser of: (Separate employee and
contribution limit (1) = $50,000 or (1) = $50,000 or (1) = $50,000 or employer limits apply
for employers (2) = 25% GC (or (2) = 100% GC (2) = 25% GC (or —see
and employees 20% gross or net SEI 20% gross preceding slide)
SEI) (25% for SEI)
single-
profit
sharing
plans)

$50,000 (of GC or net Yes Yes Yes For SIMPLE 401(k)s: Yes
SEI) limit in For SIMPLE IRAs: No,
contribution except for nonelective
formula? contributions

Terms:


Age 50+ catch-up Yes, $5,500 for 2012. Yes, $5,500 for 2012. Yes, $2,500 for 2012
contributions: (This is in (This is in
addition to the addition to the
$50,000 $50,000
aggregate limit.) maximum limit.)

Minimum None 1% to 3%, None The 3% employer
contribution depending contribution percentage
limits on the form shown above may be
of Keogh reduced to 1% in any 2
out of 5 years.

Terms:


Deduction limit Same as aggregate Lesser of: Same as aggregate For corporate employers:
for owner- contribution (1) = $50,000 contribution Same as employer
employees limit (see or limit (see limit above.
preceding slide) (2) = 25% GC preceding slide) For owner-employees:
or net SEI Sum of the separate
contribution limits for
deemed employees
and deemed
employers

Terms:


Personal Retirement Plans for Working
Individuals
Features: Traditional IRA Roth IRA
Ideal Investor Shorter time horizon Longer time horizon
Time Frame
Age of Must be age 18 but not 70 ½ or older No age restrictions.
Contributor
Minimum Yes Yes
Compensation
Requirement?
Establishment By filing due date (April 15 of following year). Same deadline
Deadline
Contribution By filing due date (April 15 of following year). Same deadline
Deadline
Maximum $5,000 ($6,000 if age 50+) aggregate limit for Same limit
Contribution traditional IRAs, deemed IRAs (SEP or SIMPLE),
Amount and Roth IRAs


Personal Retirement Plans for Working
Individuals
Features: Traditional IRA Roth IRA
Contribution None MFJ: $173,000 – 183,000
Phase-Out Single: $110,000 - $125,000
(MAGI Limits)
Deduction Phase- • For active participants: Never deductible
Out (MAGI MFJ: $92,000 – $112,000
Limits) Single: $58,000 – $68,000
• For nonparticipant spouses of active
participants: $173,000- $183,000)
• For nonparticipants (including married
taxpayers who are both nonparticipants):
Contributions are fully deductible

IRA Earnings Taxed when withdrawn Tax exempt if conditions are met
Penalty for Early 10% 10%
Withdrawals
Penalty for Late None
Withdrawals (no minimum distribution rules
apply while participant is living)
(


Applying the Two Qualifying Tests to
Roth Distributions
Ordering of Roth IRA Sources
1st 2nd 3rd 4th
Direct Taxable Nontaxable Earnings
Tests: Contributions Portion of Portion of
Rollover Rollover
Contributions Contributions
(1) Has the five-year holding period
requirement been met?
If yes: ⇒⇒⇒⇒⇒⇒⇒⇒⇒ Penalty-free Penalty-free Penalty-free Penalty-free only
if (2) below
is also met
If no: ⇒⇒⇒⇒⇒⇒⇒⇒⇒ Penalty-free 10% Penalty Penalty-free 10% penalty

(2) Has the age 59 ½, death, disability,
or 1st time home buying
requirement been satisfied?
If yes: ⇒⇒⇒⇒⇒⇒⇒⇒⇒ Tax-free Tax-free Tax-free
Tax-free

If No: ⇒⇒⇒⇒⇒⇒⇒⇒⇒ Tax-free Tax-free Tax-free Taxable


Employee Stock Purchase Plans—
Qualifying Distributions
Consider an ESPP with a 10% discount, a look-back provision, and a 6-month
offering period. Assume Avery Cobb is paid $90,000 annually and (on an
after-tax basis) contributes 5% of gross pay to purchase stock, or $4,500. Let
the share price be $50 on the first day of the offering period and $200 on the
last day of the offering period. With the discount and look-back, Avery gets to
purchase stock at a per share price of $45, which is equal to 85 percent of the
lesser of (a) the offering price ($50) or (b) the purchase price ($200). The total
number of shares purchased with the $4,500 contributed is thus 100 ($4,500 ÷
$45). Assume first that Avery holds the shares 18 months for a qualified
disposition. If the price per share at disposition is $250, the total gain per share
is $250 - $45 = $155. The discount at the start of offering period was $5 per
share ($50 × 10% ). This is less than the $155 per share total gain on sale, so
$5 per share is taxed as ordinary income and is subject to FICA and FUTA
taxes; the remainder, $150 per share, is taxed as a long-term capital gain.
Furthermore, because the shares were held for a qualified disposition, the
employer gets no corporate tax deduction. See per share computations below.


Qualifying Distributions
Formula Description Per Share Amt.

(a) = Given Grant price (FMV at beginning of offering $50
period)
(b) = Given Purchase price (FMV at end of offering period) $200

(c) = Given Sale price (upon disposition of stock) $250

(d) = Given Employee purchase discount % 10%
(e) = (d) x [the lesser of ( a) or (b)] Employee purchase discount amount: $5
10% x $50 = $5
(f) = [the lesser of ( a) or (b)] – (e) Actual cost to employee: $45
$50 – $5 = $45
(g) = the lesser of: Ordinary income = the lesser of: $5
• (c) - (f); • $250 - $45 = $205
• (a) x (d) • $50 x 10% = $5
(h) = (f) + (g) Tax basis for computing capital gain: $50
$45 + $5 = $50
(i) = (c) – (h) Capital gain: $250 - $50 = $200 $200


Disqualifying Distributions
Referring to the preceding example, assume that the shares were disposed
of immediately after purchase in a same-day sale. The sale would be a
disqualifying disposition for either of two reasons: Avery would have
sold the stock (1) within one year or less from the exercise (purchase)
date and (2) less than two years after the offering (grant) date. In this
case, the disposition is $200 per share and the gain per share is $200 -
$45 = $155, all of which is taxed as ordinary income and is subject to
FICA and FUTA taxes. Because the shares were sold in a disqualifying
disposition, the employer gets a corporate tax deduction for the
compensation amount of $155 per share. The employer’s statutory FICA
and FUTA taxes on the $155 per share ordinary income are deductible as
well. The formula for disqualifying dispositions is provided in the
computations in the next slide.


Formula Description Per Share
Amt.
(a) = Given Grant price (FMV at beginning of offering period) $50
(b) = Given Purchase price (FMV at end of offering period) $200
(c) = Given Sale price (upon disposition of stock) $200
(d) = Given Employee purchase discount % 10%
(e) = (d) x [the lesser of ( a) or (b)] Employee purchase discount amount: 10% x $50 = $5
$5
(f) = [the lesser of ( a) or (b)] – (e) Actual cost to employee: $45
$50 – $5 = $45
(g) = (b) - (f) Ord. income: $200 - $45 = $155 $155
(h) = (f) + (g) Tax basis for computing capital gain: $45 + $155 = $200
$200
(i) = (c) – (h) Capital gain: $200 - $200 = $0 $0


Incentive Stock Options—Qualifying
Distributions
ABC Corp. grants George Willingham 1,000 ISOs on January 1, Year 1
(the “grant” date). On this date, the stock’s fair market value is $10 per
share and each ISO entitles the holder to buy one share of ABC stock for
$10 (the exercise price). George can exercise the ISO after one year of
employment but not more than 10 years after the grant date and not more
than three months after the effective severance date in the event his
employment is terminated. George exercises the ISOs on December 31,
Year 2 (the “exercise” date) when the stock is worth $200 per share. He
sells the stock on January 1, Year 4 (the “sale” date) for $250 per share.
Neither the granting nor exercising of the stock will have regular tax
consequences to George in a qualifying disposition (but see discussion
on AMT below). In the year of sale, George will report a $240 per share
long-term capital gain. ABC is not allowed any deduction in connection
with the ISOs, since no ordinary income was recognized by George. See
per share computations in the next slide.


Incentive Stock Options—Qualifying
Distributions
Key Dates Qualifying Disposition
No ordinary income (OI); ISO’s tax basis = $0 per ISO
• ISO tax basis = $0 cost + $0 ordinary income


Incentive Stock Options—
Referring to the foregoing example, suppose that George Willingham
sold his shares on June 30, Year 3. Because the stock was not held for
one year from the exercise date, December 31, Year 3, George made a
disqualifying disposition of the stock. As before, George will recognize
no income on the grant date or on the exercise date. On June 30, Year 3
(the sale date) however, George will recognize $190 per share in ordinary
income ($200 - $10) and $50 per share short-term capital gain ($250 -
$200). The holding period of a disqualified ISO begins on the day after
the exercise date; thus, George’s holding period is short-term (from
January 1, Year 3, the day after the exercise date, to June 30, Year 3, the
sale date). ABC is allowed a corresponding deduction of $190 per share
for its tax year which includes December 31, Year 3, George’s year-end.


Incentive Stock Options—
Key Dates Disqualifying Disposition
Jan. 1, Year 1 No ordinary income (OI); ISO’s tax basis = $0 per ISO
(ISO is granted.) • ISO tax basis = $0 cost + $0 ordinary income

December 31, Year 2 No tax effect; stock basis = $10 per share
(ISO is exercised.) • Stock basis = $10 cost + $0 ordinary income

June 30, Year 3 (a) $190 per share ordinary income (OI)
(Stock is sold.) • $190 OI = $200 exercise price - $10 stock basis
(b) $50 per share short-term capital gain (STCG)
• $50 STCG = $250 sale price - $200 FMV at exercise date
• The holding period begins on January 1, Year 3, the day
after the exercise date; therefore, the holding period is
short-term.


Nonqualified Stock Options (NSOs)—
Value Known at Grant Date
XYZ Corp. grants Wesley Bloeme 1,000 NSOs on January 1, Year 1 (the
“grant” date). Each NSO grants the holder the right to buy 1 share of
XYZ stock for $10. Wesley can exercise the NSO after one year of
employment. The stock’s readily ascertainable fair market value on the
grant date is $50 per share. (Note that with NSOs, the exercise price may
be below the market value of the stock since the Code Sec. 422(b)(4)
pricing rules do not apply as they do for incentive stock options.) Wesley
exercises the NSO on December 31, Year 2 (the “exercise” date) when
the stock is worth $200 per share. He sells the stock on January 1, Year 4
(the “sale” date) for $250 per share. Wesley must recognize $50 per share
ordinary income on the grant date and XYZ is allowed a corresponding
deduction of $50 per share for its tax year which includes December 31,
Year 1, Wesley’s year-end. Wesley must also report a $190 per share
long-term capital gain in the year of sale. See per share computations in
the next slide.


Value Known at Grant Date
Key Dates Readily Ascertainable Value at Grant Date

Jan. 1, Year 1 Ordinary income (OI) = $50 per share
(NSO is granted.) • $50 OI = $50 NSO market value - $0 cost
NSO tax basis = $50 per NSO
• $50 NSO tax basis = $0 cost + $50 OI

Dec. 31, Year 2 No ordinary income (OI); stock basis = $60
(NSO is exercised.) • $60 stock basis = $10 cost + $0 OI + $50 NSO basis

Jan. 1, Year 4 $190 per share long-term capital gain (LTCG)
(Stock is sold.) • $190 LTCG = $250 selling price - $60 stock basis
after grant date; therefore, the holding period is long-term.


Value Unknown at Grant Date
Referring to the foregoing example, suppose that the XYZ
stock had no readily ascertainable value on the grant date.
Wesley recognizes no taxable income on the grant date. He
recognizes $190 per share of ordinary compensation income
on December 31, Year 2, when he exercises the NSO. XYZ
will be allowed a deduction of the same $190 per share for its
taxable year which contains December 31, Year 2, Wesley’s
year-end. Wesley will also recognize a $50 per share long-
term gain upon the sale of the stock on January 1, Year 4,
since his holding period was more than twelve months
(January 1, Year 3 – January 1, Year 4.


Value Unknown at Grant Date
Key Dates No Readily Ascertainable Value at Grant Date

Jan. 1, Year 1 No ordinary income (OI); NSO tax basis = $0 per NSO
(NSO is granted.) • NSO tax basis = $0 cost + $0 ordinary income

Dec. 31, Year 2 Ordinary income (OI) = $190 per share
(NSO is exercised.) • $190 OI = $200 stock value - $10 cost]
Stock basis = $200 per share
• $200 stock basis = $10 cost + $190 OI

Jan. 1, Year 4 $50 per share long-term capital gain (LTCG)
(Stock is sold.) • $50 LTCG = $250 selling price - $200 stock basis
after exercise date; therefore, the holding period is long-
term.


Restricted Stock Plans—With and Without
Section 83(b) Election
CTK Corp. transfers one hundred shares of its common stock to Matt Andres, an
executive of CTK on January 1, Year 1. On the date of the transfer, the stock has a
market value of $50 per share. Matt’s cost of the shares is discounted to $10 per share.
The stock is intended as a bonus for Matt’s work for the year, but is issued with the
restriction that if Matt leaves CKS’s employment within the next two years, he must
return the shares to the corporation. On December 31, Year 2, when the restrictions
expire, the stock is trading publicly at $200 per share. On January 1, Year 4, Matt sells
the stock for $250 per share. Matt will recognize $40 per share ordinary income in Year
1 under the special Code Sec. 83(b) election, or he may postpone recognizing any
ordinary income until the expiration of the restriction in Year 2. However, his
recognized ordinary income would be $150 per share more. One of the principal
advantages of the Code Sec. 83(b) election is the conversion of what would be ordinary
income into a more favorable capital gain. For example, if Matt had sold the stock at its
market value on the date of the lapse of the restrictions, December 31, Year 2, the entire
gain of $190 would have been taxed as ordinary income without the election. With the
election, he would have converted $150 per share of ordinary income into long-term
capital gain. Since the ordinary tax rate can be substantially higher than the long-term
capital gain rate, the Code Sec. 83(b) may be advantageous, despite accelerating the
recognition of a portion of the income. See per share computations in the next slide.


Restricted Stock Plans—With and Without
Section 83(b) Election
Dates: Without Sec. 83(b) Election With Sec. 83(b) Election
Jan. 1, Yr. 1 No ordinary income (OI) Ordinary income (OI) = $40 per share
(Stock is Stock basis = $10 per share • $40 OI = $50 stock value - $10
issued.) • Stock basis = $10 cost + $0 OI stock cost]

Dec. 31, Yr. 2 Ordinary income (OI) = $190 per share No ordinary income (OI)
(Restriction is • $190 OI = $200 stock value - $10 stock Stock basis = $50 per share (Unchanged
lifted.) cost] from above)

Jan. 1, Yr. 4 $50 per share long-term capital gain $200 per share long-term capital gain
(Stock is (LTCG) (LTCG)
sold.) • $50 LTCG = $250 selling price - $200 • $200 LTCG = $250 selling price -
stock basis $50 stock basis
• The holding period begins on January 1, • The holding period begins on
Year 3, the day after the restriction is January 2, Year 1, the day after the
lifted; therefore, the holding period is stock is issued; therefore, the
long-term. holding period is long-term.


Savings Plans for Education
Item: Coverdell ESA 529 Prepaid Tuition Plan 529 Savings Plan
Purpose: Tax-exempt accumulation of Tax-exempt accumulation Tax-exempt accumulation of
income to pay for the of income to pay for income to pay for the
qualified kindergarten the qualified qualified postsecondary
through postsecondary postsecondary education expenses of a
education expenses of a education expenses of beneficiary.
beneficiary under age 30. a beneficiary.

Age Restrictions: • For qualified None None
contributions: the
beneficiary must not be
over age 18 at the end of
the contribution year.
• For qualified
distributions: the
beneficiary must not be
more than age 30 at the
end of the distribution
year.

Establishment By December 31 of current Depends on the plan Depends on the plan
Deadline: year.


Contribution By filing due date (April 15 of Depends on the plan Depends on the plan
Deadline following year).
Maximum $2,000 per beneficiary (not per Determined by each state Determined by each state
Contribution contributor) per year
Amount
Contribution MFJ: $190,000- $220,000 None None
Phase-Out Other: $95,000 - $110,000
(MAGI
Limits)

Control of the In most states, account assets In most states, control of In most states, control of the
Account: become property of the the account will account will always remain
beneficiary at age 18. always remain with with the contributor.
the contributor.

Assignability to Immediate family of Same as CESA Same as CESA
Other beneficiary, including
Relatives: cousins, step-relatives,
and in-laws


Earnings: Tax exempt if conditions are Same as CESA Same as CESA
met.
Penalty for Non- Earnings are taxed as ordinary Same as CESA Same as CESA
Qualified income to contributor, plus
Withdrawals: a 10% penalty.
Effect on Considered to be an asset of the Considered to be the Assets are considered to be
Financial Aid beneficiary, which means a student’s resource and property of the account
Calculation: large portion of the assets thus reduces financial owner, which—unless the
will be considered in the aid dollar-for-dollar. owner is also the
financial aid calculation. beneficiary—means only a
small portion of the assets
will be considered in the
financial aid calculation.

Coordination Credits can be claimed in the Credits can be claimed in the Credits can be claimed in the
with Hope same year as tax-free same year as tax-free same year as tax-free
and Lifetime withdrawals provided that withdrawals provided withdrawals provided that
Learning the distribution is not used that the distribution is the distribution is not used
Credits for the same expenses for not used for the same for the same expenses for
which a credit is claimed. expenses for which a which a credit is claimed.
credit is claimed.


2013 cch basic principles ch14

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2013 cch basic principles ch14