4352 Module 5

Justin's employer grants him 1,000 shares of restricted stock worth $10 per share at the time of the grant. Justin pays nothing for the grant. The terms of the restriction require him to remain employed by his company for an additional five years. When he meets the five-year requirement, the stock is trading for $25 per share. What is the amount Justin must report as compensation (W-2) income for the year in which he meets the five-year requirement? A) $25,000 B) $12,500 C) $10,000 D) $0

a.) 25,000 Justin must report the value of the stock as compensation income in the year in which the stock is no longer subject to a substantial risk of forfeiture. Therefore, he must report $25,000 ($25 × 1,000 shares) of income for the current year.

Under which tax doctrine would the value of the benefit be includible as taxable income if an individual receives any economic or financial benefit or property as compensation for services? A) Economic benefit doctrine B) Assignment of income doctrine C) Constructive receipt doctrine D) Substantial risk of forfeiture

a.) Economic benefit doctrine Under the economic income doctrine, if an individual receives any economic or financial benefit, or property as compensation for services, the value of the benefit is includible as taxable income. Income is assumed to be received even if the employee does not have actual or constructive receipt.

Which of the following statements regarding tax considerations of nonqualified retirement plans is CORRECT? i. Under IRS regulations, a nonqualified plan benefit becomes currently taxable to an executive even before the benefit is actually received, if it has been constructively received by the executive. ii. Constructive receipt occurs if the deferred compensation is credited to an executive's account, set aside for the executive, or made immediately available to the executive. A) Both I and II B) II only C) Neither I nor II D) I only

a.) both

Which of the following statements regarding the income tax doctrines that apply to nonqualified deferred compensation plans is CORRECT? i. If constructive receipt occurs, the executive must report the funds that are constructively received as taxable income. ii. The economic benefit doctrine does not apply if the funds placed in a nonqualified plan remain subject to potential attachment by the employer's general creditors. A) Both I and II B) II only C) Neither I nor II D) I only

a.) both

For an executive to retain the tax benefits of deferred compensation, she must not have constructive receipt of the funds. the funds must not be set aside in a specific account for the executive. she must have substantial risk of forfeiture. the employer must make an unsecured promise to pay the compensation. A) I, II, III, and IV B) I and II C) I, II, and III D) III and IV

a.) i, ii, iii, and iv all of these statements must be true for an executive to retain the tax benefits of deferred compensation.

In which of the following circumstances is income considered to be constructively received by an employee? i. The employee's receipt of the income is subject to substantial limitations or restrictions. ii. The income is credited to the employee's account. iii. The income is set apart for the employee. iv. The income is made available so the employee may draw on it anytime, or could have drawn on it during the tax year if notice of intent to withdraw had been given. A) II, III, and IV B) I and IV C) II and III D) II and IV

a.) ii, iii, and iv Income is not constructively received if the employee's control of its receipt is subject to substantial limitations or restrictions.

Nonqualified plans i. provide the same tax advantages as a qualified plan. ii. are less flexible than qualified plans. iii. may defer taxes on compensation to employees. iv. are usually used to supplement qualified retirement benefits to key employees. A) III and IV B) I and IV C) II, III, and IV D) III only

a.) iii and iv Nonqualified plans do not provide the same tax advantages as qualified plans and are more flexible than qualified plans. Because compensation to employees is deferred, the income taxes on that compensation are deferred as well. Nonqualified plans are generally provided only to key employees.

The granting of a stock option is generally a _____ event because the option's exercise price is usually equal to the stock's trading price on the day of the grant. A) nontaxable B) taxable C) qualified D) discriminatory

a.) nontaxable The answer is nontaxable. The granting of a stock option is generally a nontaxable event because the option's exercise price is usually equal to the stock's price on the day of the grant. The option, therefore, has no readily ascertainable value, and there is no economic benefit to the employee to tax.

The economic benefit doctrine (Section 83) requires A) restricted stock to be included as employee income if there is no longer a substantial risk of forfeiture. B) the present value of a not-to-compete restriction be currently included as employee income. C) that stock options are deductible by the employer in the year granted. D) future consulting fees to be paid after retirement to be currently included as employee income.

a.) restricted stock to be included as employee income if there is no longer a substantial risk of forfeiture. The answer is restricted stock to be included as employee income if there is no longer a substantial risk of forfeiture. Section 83 requires the employee to include as income any property that the employee has the right to enjoy, or the employee's right to the property is no longer subject to a substantial risk of forfeiture. Consulting services after retirement are subject to risk of forfeiture.

In 2020, Judy's employer granted her nonqualified stock options to purchase 500 shares of employer stock at $20 per share. Judy exercised the options in 2021 when the fair market value of the stock was $30. What is the amount that Judy must include as W-2 compensation income in 2021? A) $15,000 B) $5,000 C) $7,500 D) $0

b.) 5, 000 Judy must report the bargain element of $5,000 [($30 FMV - $20 exercise price) × 500 shares] as W-2 compensation income in 2021.

Which of the following statements, with respect to making a Section 83(b) election on restricted stock, is CORRECT? i. An employee who receives restricted stock may elect under Section 83(b) to recognize the income immediately rather than wait until the substantial risk of forfeiture expires. ii. The Section 83(b) election must be made within one year of receiving the restricted stock. iii. If the election is made, the employee immediately includes as long-term capital gain the fair market value of the stock at time of receipt, less any amount paid for the stock. iv. If the employee makes the election and then forfeits the stock, the employee is not allowed a deduction or refund of tax on previously reported income.

b.) i and iv The answer is I and IV. The Section 83(b) election must be made within 30 days of receiving the restricted stock. The employee recognizes ordinary income and not long-term capital gain when the election is made.

Corporate-owned life insurance is a very popular funding vehicle for nonqualified plans because i. the cash value buildup is not currently taxed. ii. the insurance policy may be purchased on the executive's life and still be owned by the employer to fund the promised benefit. iii. these policies provide the funds to pay the benefit in the event of the executive's death before retirement. A) I and III B) I, II, and III C) II and III D) I and II

b.) i, ii, and iii

Tax deferral in an unfunded plan A) may be achieved even if an executive's compensation is subject to constructive receipt. B) may be achieved if plan assets are subject to company creditors. C) may be achieved if the deferral is agreed upon at any time prior to the compensation being paid. D) depends on whether an executive's right to compensation is subject to a substantial risk of forfeiture.

b.) may be achieved if plan assets are subject to company creditors. Tax deferral in an unfunded plan may be achieved if plan assets are subject to company creditors. Substantial risk of forfeiture conditions do not need to be specified in an unfunded plan. If constructive receipt is deemed to have taken place, the executive is taxed. The employer's promise must be merely a naked promise and must not be secured in any fashion. The deferral must be agreed upon before the compensation is earned.

Which of the following statement(s) regarding phantom stock plans is CORRECT? i. These plans provide for adjustments to the fictional entries to track the real appreciation of the corporation's common stock. ii. At some event (usually retirement), the theoretical investment, valued to reflect cumulative gains and losses, is paid to the employee or the employee's designated beneficiaries. A) Both I and II B) Neither I nor II C) I only D) II only

both

Robin is granted 1,500 shares of restricted stock from her employer when the stock is trading at a fair market value of $25 per share. She is anticipating significant appreciation and wishes to minimize her future tax burden. As a result, she makes a Section 83(b) election. Assuming she is in the 35% marginal income tax bracket, how much income tax will be due on this transaction in the year of election? A) $50,625 B) $24,375 C) $13,125 D) $37,500

c.) 13, 125 She will owe $13,125 [(1,500 shares × $25 per share) × 35% tax bracket] of income tax on this transaction.

Two years ago, Marilyn, an executive vice president with ABC Bank, was granted a nonqualified stock option (NQSO) to purchase 100 shares of ABC stock at $10 per share. When the fair market value (FMV) of the stock reached $30 per share this year, she exercised the option. She is in the 24% marginal income tax bracket. If Marilyn chooses to use a cashless exercise, how many shares of ABC stock will she own after the transaction? A) 49 B) 30 C) 51 D) 100

c.) 51 The answer is 51. The cost to exercise the options is $1,000 (100 shares × $10 per share). Also, because the option is an NQSO, Marilyn will have to pay ordinary income taxes of $480 on the bargain element [($30 per share FMV - $10 per share exercise price) × 100 shares × 24% tax rate]. Marilyn's total cost to exercise the option is $1,480. Because this is a cashless exercise, enough shares of stock must be sold to cover Marilyn's cost of the option. Therefore, 49 shares of the stock must be sold ($1,480 ÷ $30 per share FMV). Marilyn will have 51 shares remaining (100 − 49).

In which of the following situations would it NOT be appropriate for the employer company to implement an equity-based compensation plan? A) Scott Technology wants to provide a deferred compensation benefit to its executives, but it has many employees, and the cost to implement this benefit for all would be excessive. B) Eagle Sporting Goods wants to provide certain key employees with tax-deferred compensation under terms or conditions different to those applicable to the rank-and-file employees. C) Steiner Industries wants to receive a deduction at the time of contribution to the plan. D) Domingo Foods wants to provide additional deferred compensation benefits to an executive who is already receiving maximum contributions under the company's existing retirement plan.

c.) Steiner Industries wants to receive a deduction at the time of contribution to the plan. If Steiner Industries wants to receive a deduction at the time of contribution, the company should consider a qualified plan, not an equity-based compensation plan. Nonqualified plans do not permit the employer to take a deduction for plan contributions until the employee reports income from the plan, which is often at retirement.

Which of the following statements regarding stock appreciation rights (SARs) are CORRECT? i. The executive to whom they are granted does not need to have cash available to exercise the stock appreciation rights (SARs). ii. They are similar to phantom stock, except that with SARs, the employee can choose when to exercise the right to share in the appreciation of the closely held company's stock. iii. Like phantom stock, they require cash to create and dilute ownership. iv. They are used heavily by closely held businesses. A) II and IV B) II, III, and IV C) I, II, and IV D) I and III

c.) i, ii, and iv Cash does not dilute company ownership. A primary feature of SARs is that dilution of ownership is avoided.

Numerous requirements must be met under the Internal Revenue Code (IRC) for a tax-favored incentive stock option (ISO). These include which of the following? i. The written plan must be approved by the stockholders of the corporation. ii. The option's exercise date cannot exceed 10 years from the date of the grant. iii. There is an annual limit of $100,000 on the value of the ISOs exercised during any one year to any employee; the stock is valued on the grant date. iv. The exercise price cannot be less than the market price of the stock on the date of the grant. A) III and IV B) I, II, and III C) I, II, III, and IV D) I and II

c.) i, ii, iii, and iv

Which of the following statements regarding the tax treatment of phantom stock are CORRECT? i. The employee is taxed upon receiving the grant. ii. The employee is taxed when payment is received at retirement. iii. The employer receives a tax deduction when payment is made to the employee. iv. The employer receives a tax deduction when the employee receives the grant. A) I, II, III, and IV B) III only C) II and III D) I and II

c.) ii and iii The employee is taxed when payment is received at retirement or termination. The employer receives a tax deduction only when the employee receives payment at retirement or termination.

A rabbi trust provides A) income tax payments for employees. B) security against employer bankruptcy. C) security for the employee against the employer's unwillingness to pay deferred compensation benefits. D) an immediate income tax deduction for employers.

c.) security for the employee against the employer's unwillingness to pay deferred compensation benefits. While the assets held in a rabbi trust are still subject to the company's general creditors, the trust does provide the executive with security against the employer's unwillingness to pay.

Mary, 54, is an executive with ABC Corporation, which provides a nonqualified deferred compensation (NQDC) plan. If Mary has unrestricted access to the assets in her NQDC plan, A) the assets are subject to a substantial risk of forfeiture, and she is not currently taxed. B) she will incur a 25% penalty. C) she has constructive receipt of the funds. D) the assets are subject to the claims of the employer's general creditors.

c.) she has constructive receipt of the funds. If Mary has unrestricted access to the funds, she is considered to have constructive receipt of the income and will be taxed in the current year.

ADM Inc., a closely held business, wishes to provide Jackie, a key employee, with a plan that gives her a choice of when to exercise the right to share in the appreciation of the company's stock. Therefore, the company should consider using A) restricted stock. B) phantom stock. C) stock appreciation rights. D) junior class shares.

c.) stock appreciation rights. The answer is stock appreciation rights. Stock appreciation rights (SARs) are similar to phantom stock plans, except SARs give the employee/executive a choice of when to exercise the right to share in the appreciation of the closely held company's stock.

Tamu Enterprises, Inc., would like to set up an equity-based compensation plan that has the following features: Shares that are a separate class of common stock Shares that are usually convertible into common shares Shares that allow employees to purchase company stock below fair market value Shares with rights that are subordinate to regular common stock shares Which of the following would be the best choice for the company? A) Incentive stock options B) Stock appreciation rights C) Restricted stock D) Junior class shares

d.) Junior class shares Junior class shares are a separate class of common stock. The voting, liquidation, and dividend rights of junior class shares are subordinate to regular common stock shares. Junior class shares are generally convertible into common shares of stock upon specified requirements, such as achieving certain years of service or performance goals. Conversion can be automatic or at the employee's discretion.

The tax treatment of junior class shares of stock include which of the following? i. The employee is not taxed when the junior class shares are purchased and issued. ii. The employee is not taxed when the junior class shares are converted to common shares. iii. The employee is taxed when the junior class shares are converted to common shares and then sold. iv. When the common shares are sold, the employee incurs ordinary income taxes based on the sales price. A) I and II B) III and IV C) I, II, III, and IV D) I, II, and III

d.) i, ii, and iii The answer is I, II, and III. The employee is neither taxed on the date the junior class shares are issued nor when the junior class shares are converted to common shares. Upon sale of the common shares, the employee is taxed on the capital gain (the difference between the sales price of the stock and the employee's basis in the stock). The employee's basis is the amount paid for the junior class shares.

Which of the following are characteristics of phantom stock plans? i. Company stock is issued to the employee as a reward for meeting performance goals. ii. Each year, the employee becomes vested in shares according to a written agreement. iii. The plan is a way to reward employees without giving them actual ownership in the company. iv. Upon retirement or some other event, the employee receives the vested value of his account in cash. A) I and II B) III and IV C) I, II, and III D) II, III, and IV

d.) ii, iii, and iv

A supplemental employee retirement plan (SERP) is i. a qualified deferred compensation plan. ii. often referred to as a salary continuation plan. iii. a method of providing additional retirement income to executives. iv. a plan that complements existing retirement plans to bring executive benefits up to desired levels. A) I, II, and III B) I and II C) III and IV D) II, III, and IV

d.) ii, iii, and iv The answer is II, III, and IV. A SERP is a nonqualified deferred compensation plan and is often referred to as a salary continuation plan because the executive is not required to decrease his current salary. In addition, a SERP is a method of providing additional retirement income to executives over and above that which is provided by qualified plans, and it complements existing retirement plans to bring executive benefits up to desired levels.

Closely held corporations that would like to reward valuable employees but do not want additional shareholders may consider using A) junior class shares. B) NQSOs. C) restricted stock. D) phantom stock.

d.) phanton stock The answer is phantom stock. Closely held corporations wishing to reward their highly valued employees without adding more shareholders may use phantom (or shadow) stock arrangements. Such arrangements are structured as fictional deferred compensation accounting entries, where the base value is equal to the current value of the corporation's common stock.

All of the following statements regarding the taxation of nonqualified stock options are correct except A) if the nonqualified stock option does not have a readily ascertainable fair market value at the date of the grant, the employee is not taxed until the date of the exercise of the option. B) on the exercise date, the bargain element represents income to the employee. C) the employer receives a deduction for the amount of the bargain element when the employee brings the amount into income. D) the stock's holding period, for purposes of determining long- or short-term capital gains treatment to the employee, begins with the grant date.

d.) the stock's holding period, for purposes of determining long- or short-term capital gains treatment to the employee, begins with the grant date. The stock's holding period, for purposes of determining long- or short-term capital gains treatment to the employee, begins with the exercise date. All of the other statments are correct.

Which of the following are the major differences between a nonqualified plan and a qualified retirement plan? i. Tax benefits ii. Distributions iii. ERISA requirements A) I, II, and III B) I only C) II and III D) I and II

i, ii, and iii