Smeal College of Business Taxation and Management Decisions: ACCTG 550Pennsylvania State University Professor HuddartCompensation Planning1. IntroductionCategory Employee tax effectNon-taxable fringe benefits Never taxedPensions Deferred tax and exempt investment returnsIncentive stock options (ISOs) Deferred tax at capital gains ratesDeferred compensation Deferred tax at ordinary ratesNon-qualified stock options (NQOs) Deferred tax at ordinary ratesInterest-free demand loans Deferred tax at ordinary ratesInterest-free term loans Immediately taxed at ordinary ratesCash salary Immediately taxed at ordinary rates2. Deferred compensation• If tax rates for the employee and the employer are constant overtime, and the after-tax rate of return on investments is the same forthe employee and employer, then both parties are indifferent betweencurrent and deferred compensation.• In any other circumstance, there may be an opportunity for tax planningthrough the deferral or acceleration of compensation payments to theemployee.2.1 Deferred Compensation—Employer Indifference• $1 of salary today costs the employer (1 − T0).cSteven Huddart, 1995–2005. All rights reserved. www.smeal.psu.edu/faculty/huddartACCTG 550 Compensation Planning• If salary not paid today, the employer can invest (1 − T0) dollars for nperiods to accumulate(1 − T0)(1 + rc)n.where T0is the employer’s tax rate now, and rcis after-tax employeraccumulation rate.• A deferred payment to an employee of Dncosts the firmDn(1 − Tn).• Indifference requires that the net-of-tax cost to the employees be thesame under either plan.• Therefore, the deferred payment must equal the n period accumulationorDn(1 − Tn)=(1− T0)(1 + rc)n.2.2 Deferred Compensation—Employee Preference• Before-tax deferred compensation from the firm:Dn=(1 − T0)(1 − Tn)(1 + rc)n.• After personal tax deferred compensation from the firm:Dn=(1 − T0)(1 − Tn)(1 + rc)n(1 − tn)where Tnis the personal tax rate at period n.• After-tax accumulation from investing salary for n periods:(1 − t0)(1 + rp)nwhere t0is the employee’s tax rate now, and rpis after-tax employeeaccumulation rate.Page 2Compensation Planning ACCTG 5502.3 Summary and examples• Salary is preferred whenever salary exceeds deferred compensationSalaryDeferred Compensation> 1or,(1 − t0)(1 − tn)1+rp1+rcn(1 − Tn)(1 − T0)> 1.• Deferred compensation is desirable when– the employer tax rate is increasing (take deduction when rates arehigh)– the employee tax rate is decreasing (take income when rates low)– the employer can earn at a higher after-tax rate than the employee(employee effectively saves through employer)• Example: §162(m) of the Internal Revenue Code denies a deduction forsome forms of compensation (including salary) to an employee in excessof $1 million per year. Postponing some of this compensation until ayear when the employee’s income is lower (e.g., retirement) representsan opportunity to save taxes. In the context of the formula, T0=0in the current year if compensation exceeds $1 million and Tn= 35%when compensation is less than this threshold. If t0= tnand rp= rc,then current compensation leaves only 65% after tax of the amount thatwould be available if compensation were deferred.• Example: Suppose the firm repurchases its own stock and agrees tocompensate the employee in the future an amount equal to the futurevalue of these shares. The rate of return on this “investment” by thefirm is favorable because the corporation does not pay capital gainstax on the sale or repurchase of its own stock, or on any dividends itpays on repurchased stock. Thus, the return on this form of deferredcompensation is the pre-tax rate of return on the employer’s stock.This is more efficient than paying the employee salary and requiringthe employee to buy stock with this cash.Page 3ACCTG 550 Compensation Planning2.4 Rabbi trust• This type of trust was first set up for a rabbi to hold his deferredcompensation. The name has stuck.• A rabbi trust is an irrevocable trust established by the employer whichnames the employee as beneficiary. A portion of the employee’s futureearnings will by paid to the trust by the employer. The employerdirects the trustee to pay the principal and income to the employeeor the employee’s estate upon the occurrence of a certain event, such asretirement, disability, or death. The trust may also permit paymentupon the employee’s financial hardship. Plans may pay lump-sumbenefits or distribute benefits as annuities.• Assets in the trust are subject to the claims of the employer’s creditors.This is an important risk for the employee to consider when the futureof the company is clouded by financial difficulties.• Employer contributions to the trust are not deductible by the employerand not taxable to the employee until paid out of the trust or availableto the employee.• Income from the trust assets that is not distributed to the beneficiaryis taxable to the employer• Increases in the value of employee’s account in the trust is not taxableuntil gains on investments are realized.3. Meals and entertainment3.1 Background• The rate of reimbursement for meal and entertainment expenses hasfallen since the mid-eighties.– Prior to the Tax Reform Act of 1986, 100% of meal and entertain-ment expenses were deductible.–From 1987 through 1992, 80% of expenses were deductiblePage 4Compensation Planning ACCTG 550– Revenue Reconciliation Act of 1993, Section 13209 amended Sec.274 to disallow deductions for 50% of business meal and entertain-ment expenses.1• The reduction in deductibility constitutes a blow against the private clubbusiness, since it increases the after-tax cost of these goods to employeesand employers.• Rep. Richard Zimmer (R-NJ) introduced a bill (HR 2734) on December6, 1995 to restore the 100 percent tax deduction for business meals andentertainment.Zimmer said the tax break mainly benefits small busi-nesses, rather than large corporations. He said in a newsrelease that “the concept of wealthy business executiveswriting off three-martini ‘business’ lunches at posh restau-rants is grossly misleading. Fully 70 percent of businessmeals are purchased by people earning less than $50,000annually and 39 percent are purchased by people earningless than $35,000.”23.2 Analysis• Under current rules, either the employee or the employer deducts 50%of the cost