Retirement Planning: Non-Qualified Plans (Module 3)

Amy is employed at Abacale Corporation and is a key employee. Abacale has a non-qualified plan for Amy and set aside money into it for her in 2016, 2017 and 2018. In 2019, Amy is allowed to take a withdrawal and does so. In what year may Abacale take a deduction? a. 2016 b. 2017 c. 2018 d. 2019

d. 2019 Abacale corporation may take a deduction in the year that Amy takes a distribution, or when the funds are made available, which is 2019

To compensate executives, larger corporations primarily use ISOs. They are generally not suitable for closely held corporations. Why?

- ISOs are valuable to executives only when stock can be sold, and there is usually no ready market for closely held stock, and - Shareholders of closely held corporations often do not want unrelated outsiders to become shareholders of the company.

There are two main types of stock option plans used for compensating executives, what are they?

- Incentive stock option (ISO) plans, and - Nonqualified (NQSO) stock options.

What are common financing methods are nonqualified plans?

- Reserve account maintained by employer - Employer reserve account with employee investment direction - Corporate-owned life insurance - Rabbi trust - Third-party guarantees

What are the type of formulas used to calculate benefits for a nonqualified plan?

- Salary continuation formula, - Salary reduction formula, - Excess benefit plan, and - Stock appreciation rights.

Two types of nonqualified deferred compensation plans are eligible for at least partial exemptions from the ERISA requirements, what are they?

- Unfunded excess benefit plan - Top-hat plan

What are the disadvantages of ISO plan's?

- corporation receives no tax deduction - exercise price must be at least the FMV of the stock when granted - As with all stock option plans, the executive gets no benefit unless he is able to come up with enough cash to exercise the option.

If an executive takes a loan from his company for a home mortgage, how are the interest payments taxed?

- deductible to the executive - taxable to the employer

What are the benefits of a phantom stock plan?

- employee pays taxes when benefit is paid not granted - employee not required to make cash contributions

What are disadvantages of non-qualified plans?

- employer cannot deduct it until the employee is taxed on it - unsecured promise to pay is a security concern for the employee - s corp and partnerships cannot take part

How are split dollar life insurance plans taxed?

- employer does not get tax deduction on premiums paid - employee recognizes income on the premium portion paid by the employer

What are the disadvantages to executive loans?

- high administrative costs for the employer - substantial portion of the loan is included as income

incentive stock option (ISO) plan

- is a tax-favored plan for compensating executives by granting options to buy company stock at specific exercise prices. - Unlike regular stock options, ISOs generally do not result in taxable income to executives either at the time of the grant or the time of the exercise of the option. - If the ISO meets the requirements of Internal Revenue Code Section 422, the executive is taxed only when stock purchased under the ISO is sold, except for the potential of Alternative Minimum Tax.

What are negatives of NQSO plans?

- market risk for the executive - The executive must have a source of funds to purchase the stock and pay taxes due in the year of exercise in order to benefit from the plan. Executives often borrow money with the anticipation that dividends from the stock purchased, plus immediate resale of some stock, will be sufficient to pay part or all of the interest on the borrowed funds.

Which of the following is true about a nonqualified deferred compensation plan? 1. The contribution may be structured as additional compensation to the employee. 2. The contribution may be paid from the current compensation. 3. The plan may provide for benefits in excess of qualified plan limits. 4. The plan may not discriminate.

1, 2, 3 I is correct. It describes a salary continuation plan. II is correct. It refers to a pure deferred compensation plan. III is correct because that is the purpose of nonqualified deferred compensation.

A rabbi trust would be used as a planning tool for which of the following situations? 1. Hostile takeover 2. Mergers 3. Acquisitions 4. Bankruptcy

1, 2, 3 The rabbi trust provides no benefit security for an executive should the employer file bankruptcy. The executive must stand in line with the other creditors.

Which of the following statements describe(s) the provisions of constructive receipt as it is applied to nonqualified deferred compensation plans? 1. Constructive receipt occurs when the funds are available to the employee. 2. Constructive receipt by employee results in taxation to the employee of the applicable benefits. 3. If a company goes through a merger or acquisition, the rabbi trust provisions will automatically trigger constructive receipt to the employee. 4. If a company owns the assets, its employee will not have constructive receipt.

1, 2, 4 A rabbi trust might trigger constructive receipt due to a merger or acquisition.

Mr. B receives 10,000 ISOs to purchase LMN Corporation stock at $10 per share. Within two years of the grant date, he exercises them when the stock is $25 per share. Several years later, he sells the 10,000 shares of LMN for $100 per share. Which of the following are true? 1. There is no taxable event on the grant of the options. 2. He'll have $150,000 of additional income for regular tax purposes upon exercise. 3. He'll have a long-term capital gain of $900,000 when he sells the stock. 4. He'll have a long-term capital gain of $750,000 when he sells the stock.

1, 3 Before selling the exercised ISO shares, he held them at least one year from the date of exercise and two years from the grant date. This is a "qualified" disposition. The bargain element (an AMT add-back item) is $15 per share. The gain (long-term) at the time of the sale is $90 per share.

John has a choice between nonqualified stock options or incentive stock options. The option price is $5/share, and he will exercise when the share price is $10/share, (The options vest a year and a day after the grant date). The option is for 10,000 shares. What is the tax ramification with each option if he sells the shares for $15/share and more than one year after he exercises them? 1. Under the ISO, $50,000 is an add-back item, and $100,000 is capital gains. 2. Under the ISO, $50,000 is an add-back item, and $50,000 is ordinary income. 3. Under the NSO, $50,000 is ordinary income, and $50,000 is capital gains. 4. Under the NSO, $100,000 is ordinary income.

1, 3 If John is subject to the alternative minimum tax (on the ISO), his basis in the stock for AMT purposes will be increased by the amount included in income (unknown). If the stock is sold before the one-year holding period, John will lose preferential long-term capital gains treatment. 10,000 shares ISO exercise $10 $100,000 ISO option price -5 -50,000 (paid) ISO add back $5 $50,000 ISO sold $15 $150,000 ISO option price -5 -50,000 ISO capital gain $10 $200,000 With the NSO, at exercise the basis is $10/share, the option price ($5) plus the ordinary income ($5).

A large financial organization wants to hire Tom. Tom is a successful financial planner with a large practice. To entice Tom, the company is proposing a large nonqualified stock grant. The grant will be based on Tom's ability to build the financial planning division over the next five years. When will the grant be taxable to Tom? 1. The grant will be taxable in five years when the substantial risk of forfeiture expires. 2. The grant will be taxable now. 3. The grant will be taxable when Tom can freely transfer the stock. 4. The grant of restrictive stock will not be taxable until Tom sells the stock.

1, 3 The two major determinants of taxation are the following: -the free transferability of the employee's interest and -the presence of a "substantial risk of forfeiture"

On January 1, 2012, Sally (an employee of Able Corp.) is granted 1,000 ISOs to purchase shares of Able at the fair market value of the stock on the date of grant ($20). On June 30, 2012, Sally exercises all the ISOs when the stock's fair market value is $40. On December 30, 2013, she sells 500 shares for $50 per share. Which of the following are true? 1. This is a disqualifying disposition. 2. Sally will recognize ordinary income of $20,000. 3. Sally will recognize ordinary income of $10,000. 4. Sally will also recognize short-term capital gains of $5,000 when she sells the shares. 5. Sally will also recognize long-term capital gains of $5,000 when she sells the shares.

1, 3, 5 This is a disqualifying disposition (but only for the shares that were sold). The ordinary income is $40 less $20 times 500 or $10,000. Her basis in the shares sold is $40 per share. However, she only sold 500 shares at $50. ($50 less $40 times 500 equals $5,000.) The gain is long term. As long as the other 500 shares are not sold before January 1, 2014, they retain ISO tax treatment.

Which of the following is true about employee stock purchase plan requirements? 1. must be approved by stockholders 2. negotiable, can be bought or sold 3. must be exercised within a specific time period 4. all participants must receive equal amounts of shares 5. must be employee of corporation, its parent or subsidiary 6. the exercise price must not be less than 85% below FMV of the stock

1, 3, 5, 6

Nonqualified plans: Funded vs unfunded 1. Which follows ERISA vesting schedule 2. Which has no creditor security to employees 3. Which is more used in the industry?

1. Funded 2. Unfunded 3. Unfunded

Which of the following are considered advantages of a nonqualified plan? 1. the tax deduction is deferred 2. can provide deferral of taxes to employees 3. minimal governmental regulatory requirements 4. the design is flexible

2, 3, 4

Which of the following statements are true concerning a rabbi trust? 1. The rabbi trust provides complete protection. 2. The rabbi trust is informally funded. 3. The employer may fund the rabbi trust from the general assets of the company. 4. Employer contributions to the rabbi trust are not subject to payroll taxes. 5. The rabbi trust assets may be used for purposes other than discharging the obligations of the employee.

2, 3, 4, 5 The assets are always subject to the company's creditors. The employer may fund the trust from general assets. Contributions are not subject to payroll taxes, but distributions are subject to withholding and FICA. The rabbi trust offers no protection in case of bankruptcy or financial obligations of the company.

Which of the following is considered constructive receipt for income tax purposes? 1. Amount is payable upon termination 2. Amount is payable in five years 3. Set aside 4. Credited to an employee's account

3, 4 An amount is treated as received for income tax purposes, even if it is not actually received, if it is credited to the employee's account, set aside, or otherwise made available. Constructive receipt does not occur if the employee's control over the receipt is subject to a substantial limitation or restriction

Which of the following are not taxable fringe benefits? 1. Season tickets for the Pittsburgh Steelers (pro football) games 2. Use of a company apartment or lodge for weekend getaways 3. Occasional money for meals 4. Occasional typing of personal letters by the company secretary 5. Gifts for illness

3, 4, 5 Use of a company apartment or lodge for weekends is taxable. Occasional usage would not be taxable. The question is asking which benefits are not taxable.

What are the characteristics of funded and unfunded plans? 1. An unfunded plan must have its assets held by a third-party custodian. 2. A funded plan can be a naked promise to pay; but, it must be guaranteed by the employer. 3. Unfunded plan assets are beyond the reach of creditors in the event of a hostile takeover. 4. A funded plan is beyond the reach of an employer's insolvency and bankruptcy creditors.

4 An unfunded plan can be a "naked promise" to pay, but a funded plan cannot be. Certain unfunded plans (also known as informally funded) are within the reach of the employer's insolvency or bankruptcy creditors. Answer IV is the only correct answer.

XYZ establishes a secular trust for Bob. Which of the following is/are true? 1. Bob will be able to defer a portion of his current income. 2. The benefits will be subject to the creditors of XYZ. 3. The plan is an informally funded plan. 4. Because there is no substantial risk of forfeiture, taxation will occur at the time the contribution is made.

4 Because the assets in a secular trust are beyond the reach of the employer's bankruptcy or insolvency creditors, taxation will occur at the later of the following two dates: 1) when the funds are deposited into the plan or 2) when there is no longer a substantial risk of forfeiture. (Normally there is no substantial risk of forfeiture with a secular trust.) Since answer IV states, "there is no substantial risk of forfeiture," taxation will occur at the time the funds are deposited into the plan.

Harry is granted $250,000 of ISO options that vest in one year. Next year he exercises $150,000 of the options. What will be the result of this exercise? a. $100,000 will be treated as ISOs; $50,000 will be treated as NSOs. b. $50,000 will be treated as ISOs; $100,000 will be treated as NSOs. c. $75,000 will be treated as ISOs; $75,000 will be treated as NSOs. d. $150,000 will be treated as NSOs.

A A company cannot grant more than $100,000 of ISOs (based on exercise price) that are vested in the same year to any one employee if favorable ISO treatment is desired. If more than $100,000 of such ISOs that vest in the same year are granted, the excess options, once exercised, are treated as NSOs (for tax purposes).

Karen works for ATQ Corporation (a publicly traded company). On January 1, 2011, she was granted 10,000 nonqualified stock options and 5,000 incentive stock options, both with a strike price of $40. She intends to exercise the options as they vest. She will be 50% vested (NSOs and ISOs) on July 1, 2012, when the share price will be $47. The remaining options will vest on July 1, 2015 when the share price will be $67. She expects to sell all shares more than 12 months after exercise. What will Karen's total long-term/short-term capital gain be if the shares vested in 2012 are sold at $57 and the remaining shares are sold at $77? a. $135,000 LTCG - ISO; $100,000 LTCG - NSO b. $42,500 STCG and $92,500 LTCG - ISO; $100,000 LTCG - NSO c. $135,000 LTCG - ISO; $185,000 LTCG - NSO d. $50,000 LTCG - ISO; $185,000 LTCG - NSO

A For ISOs, if the shares are sold at least two years after the grant date and at least one year after the exercise date, ISO status is maintained, and the difference between the option (grant) price and the sale price is a long-term capital gain. If both holding-period requirements are met for ISOs, the resulting gain will always be a long-term capital gain. A short-term capital gain associated with an ISO indicates that a disqualifying disposition has taken place. (That is, the shares were sold within 12 months of the exercise date). For nonqualified stock options, the difference between the exercise price and the sale price is either a long- or short-term capital gain depending on the length of the holding period after exercise. NOTE: This does not violate the $100,000 rule because the vesting is 50%/50%. 2,500 x $40 per share is $100,000 ISO (granted 1/1/2010) (2012) Sell @ $57 strike price $40 = $17 x 2,500 = $ 42,500 (2015) Sell @ $77 strike price $40 = $37 x 2,500 = $ 92,500 Long-term capital gain = $135,000 NSO (granted 1/1/2010) (2012) Exercise @ $47 strike price $40 = $7 ordinary income; Basis increases to $47; Sell @ $57 basis $47 = $10 x 5,000 = $ 50,000 (2015) Exercise @ $67 strike price $40 = $27 ordinary income; Basis increases to $67; Sell @ $77 basis $67 = $10 x 5,000 = $ 50,000 Long-term capital gain = $100,000

Health Savings Account

A tax-advantaged personal savings account, set up to be used exclusively for medical expenses; must be paired with a high-deductible health insurance policy Employer contributions are fully deductible and any contributions made on behalf of the employee are fully vested and non-forfeitable.

NonQualified Plan Financing Methods: Rabbi Trust

A rabbi trust is a trust set up to hold property used for financing a deferred compensation plan, where the funds set aside are subject to the employer's creditors. The IRS has ruled that trusts designed this way do not constitute formal funding in the tax sense.

Nonqualified plan: Stock Appreciation Rights

A stock appreciation right (SAR) formula provides that the employee's future benefits are to be determined by a formula based on the appreciation value of the company's stock over the period between adoption of the plan and the date of payment.

The below-market loan rules between an executive and his company will not apply to a compensation-related loan for any day on which the amount of all loans between the executive and his company do not exceed which amount? a. $10,000 b. $1,000 c. $100 d. $100,000

A. $10k

Gail, an employee of Quick, Inc., is given an ISO of 1,000 shares of stock at $20 per share. Three years later, she exercises them when the stock is $30 per share. Then, two years later, she sells the stock at $35 per share. Which of the following is true? a. Gail's taxable gain will be $15,000 of capital gain. b. Gail's taxable gain will be $10,000 when she exercises her option and a $5,000 capital gain when she sells the shares. c. Quick, Inc. will get a deduction of $10,000 when Gail exercises her option. d. Gail's taxable gain will be $5,000 of capital gain.

A? (not c or d) With an ISO, the corporation will not receive a tax deduction when the shares are exercised.

Medical Savings Account

Alternative means of health care in which individuals make tax-deductible contributions to a special account that can be used to pay medical expenses. A self-employed individual may contribute if they maintain a high-deductible health plan.

Target SERP

a target SERP seeks to replace retirement benefits lost by ERISA, such as imposed limits, and counteract the Social Security benefit bias in favor of low-income workers. Thus, the employer may promise to provide selected executives with a total retirement benefit of a set percentage of their final pay, such as 75%.

Your client was granted ISOs valued at $75,000 (1,000 shares) in March 2013. This grant of ISOs vests in two years. In June 2014 your client was granted another $85,000 of ISOs (1,000 shares) that vest in one year. Your client exercises the options as they vest. (Stock price at time of exercise is $100.) What are the tax implications upon exercise? Assume the stock has not been sold. a. There is no income tax implication, but a bargain element of $60,000 is a add-back item for AMT. b. There is only an income tax liability because more than $100,000 of ISOs were exercised in the same year. c. There are no tax implications until the stock is sold. d. There is an income tax liability on the NSO portion (taxable wages) and a bargain element on the ISO portion (add-back item).

B? When more than $100,000 worth of ISOs are vested in the same calendar year, only the first $100,000 will be treated as ISOs, and the balance of options that are vested in the same year will be treated as NSOs (regardless of when they are exercised). The value of ISOs granted in a given calendar year does not cause any of the ISOs to be treated as NSOs so long as the value of ISOs vested in a given calendar year does not exceed $100,000. In other words, $200,000 of ISOs could be granted today, but as long as no more than $100,000 vests in any given year, no income tax liability will be generated upon exercise. For this type of problem just look for an answer that includes both an income tax liability and an AMT bargain element.

Mr. Phillips has ISO options with a $15 strike price. He transfers the options one year later to his daughter Susan when the market price is $19. What is (are) the income ramification(s) if she exercises them at $25 two years later? Why? a. $10 ordinary income to Susan b. $4 ordinary income to Mr. Phillips / $6 ordinary income to Susan c. $10 ordinary income to Mr. Phillips d. $6 ordinary income to Mr. Phillips / $4 ordinary income to Susan e. $10 capital gains to Susan

C A gift before exercise to Susan is a disqualifying disposition. (The ISO becomes an NSO.) Mr. Phillips is charged with the income. The only exception to the transfer before exercise is if Mr. Phillips dies before he can exercise the options.If that occurs, it maintains its ISO status when his daughter exercises.

ABC company has a non-qualified plan. Gates, an employee, has contributed to the plan in 2016, 2017 and 2018. In 2019, he decides and is allowed to take a distribution. In what year does Gates have to pay taxes on the benefits? A. 2019 B. 2009 C. 2010 D. 2008

Correct Answer: A. 2019 Explanation: Gates has to pay taxes on the benefit in the year he takes a distribution from the non-qualified plan.

Aero Space rewards its employees for ideas by giving them ISOs. John (employee) was given a $50,000 option for company stock some years ago. At the time of exercise, the market value was $100,000. John exercised the option and sold the stock for $200,000 thirteen months later. What were the tax implications? a. $50,000 was subject to ordinary income tax at exercise, $100,000 capital gain at sale. b. $150,000 was subject to ordinary income tax at exercise, $0 at sale. c. $0 was subject to ordinary income tax at exercise, $150,000 capital gain at sale. d. $100,000 was subject to ordinary income tax at exercise, $50,000 capital gain at sale.

C There is no ordinary income tax at exercise. The basis is $50,000, and the difference is a capital gain. The grant was some years ago (more than 2).

Of the following entities, which can effectively implement a deferred compensation plan for its executives? a. Limited Liability Partnership b. S-corporation c. Corporation d. LLC e. General Partnership

C ll of these entities could use a deferred compensation plan. However, with pass-through entities contributions to nonqualified plans are nondeductible at the time of contribution. The owners will have to report the amount contributed to the deferred compensation plan on their personal returns. Regular corporations do not have this problem because they are separate tax entities.

The employer is the owner and beneficiary of the life insurance policies it purchases for participants in the SERP plan. A. True B. False

Correct Answer: A. True Explanation: An employer purchases life insurance for each plan participant to informally fund the plan. The employer policies are purchased, owned, and payable to the employer.

Typically, a split dollar plan involves an executive purchasing life insurance and naming the employer as beneficiary and owner of the contract. Why? A. True B. False

Correct Answer: B. False Explanation: Normally, the life insurance policy is owned by the employer who also controls and owns the cash value as well as enough of the death benefit to cover expenses if the executive dies. The balance of the death benefit goes to the executive's beneficiary.

In a split dollar life insurance plan, two parties divide, or "split," the responsibilities and the rights to which of the following? A. The policy premiums and life expectancy of the insured. B. The income tax deduction for premiums paid. C. The policy premiums, cash values, and death benefits. D. The income tax deduction for premiums paid and the income tax liability for the excess of the policy death proceeds less the policy's cash value.

Correct Answer: C. The policy premiums, cash values, and death benefits. Explanation: Split dollar life insurance is an arrangement between an employer and an employee which involves a sharing of the costs and benefits of the life insurance policy. Usually these plans involve a splitting of premiums, death benefits, and/or cash values.

Audrey is an employee of the Spencer Corporation. She borrows $250,000 from her employer. The applicable federal rate of interest for the first year is $16,000. The actual interest under the loan agreement is only $7,000. This loan results in additional taxable compensation income to Audrey for the first year of $9,000. What is the amount deductible by her employer? A. $7,500 B. $8,000 C. $8,500 D. $9,000

Correct Answer: D. $9,000 Explanation: The amount deductible by Audrey's employer is $9,000. This would be the difference between the applicable federal rate of interest less the actual interest under the loan agreement, that is, $16,000 less $ 7,000. The employer is treated as if it paid the additional compensation to the employee.

Which of the following factors determines the appropriate face amount of insurance coverage? 1. employer's after-tax costs of each participant's retirement benefits 2. premium funding requirements 3. the present value of any survivor benefits 4. the vesting period for each employee

Correct Answers: 1, 2, 3 Explanation: The appropriate face amount of insurance coverage is determined by the following factors: employer's after-tax costs of each participant's retirement benefits, premium funding requirements, the present value of any survivor benefits and, if preferred, the cost or time value of money.

Bruce, as an employer, would like to provide Tom with retirement benefits. He is looking at life insurance as a viable option. In which of the following situations could he use the split dollar insurance plan? 1. If Bruce would like to provide Tom a life insurance benefit at low cost. 2. If Tom is in his 30s, 40s, or early 50s. 3. If a preretirement death benefit for Tom is a major objective, and if Bruce is looking out for an alternative to an insurance-financed nonqualified deferred compensation plan. 4. If Bruce is seeking a totally selective executive fringe benefit. 5. Bruce does not want Tom to fund a cross-purchase buy-sell agreement to buy stock.

Correct Answers: 1, 2, 3, 4 Explanation: Bruce could use the split dollar life insurance option if he wants to provide Tom retirement benefits without having to spend too much on it. This option would be ideal if Tom is in his 30s, 40s or early 50's, as the plan requires a reasonable duration so as to build up adequate policy cash values and because the cost to the executive, that is the P.S. 58 or Table 2001 cost, can be excessive at later ages. He can also use it if a preretirement death benefit for Tom is a major objective. He will use this option if he is looking for a totally selective executive fringe benefit. The other situation where Bruce can use this option is when he wants to make it easier for shareholder-employees like Tom to finance a buyout of stock under a cross purchase buy-sell agreement, or to make it possible for non-stockholding employees to effect a one-way stock purchase at an existing shareholder's death.

What are the advantages of a nonqualified stock option plan? 1. As there are few tax or other government regulatory constraints, these plans can be designed to suit the executive or the employer. 2. Income from the sale of these stocks can be eligible for preferential capital gains treatment. 3. These plans have little or no out-of-pocket cost to the company. 4. In the case of nonqualified stock options, tax to the employee is usually deferred at grant. 5. There is a deferral on the deductions for the employer.

Correct Answers: 1, 2, 3, 4 Explanation: The employer has the flexibility to design the plan to suit both himself or herself and the employee. The company bears little or no out-of-pocket cost for these plans. For the employee, tax is generally not payable at the time when a stock option is granted. Taxation occurs when the option is exercised.

Jennifer is the owner of a software corporation. As an employer she would like to enhance the retirement benefits received by Rob, a senior executive in the company. She consults her financial consultant, Randolph, and inquires about nonqualified plans. He tells her that it is indeed a good idea to opt for a nonqualified plan. He also gives her the various other instances where she can use the plan. Which situations would Jennifer be able to use the plan to benefit both Rob and her? 1. Jennifer would like to provide Rob with the benefits and at the same time not overshoot the allocated budget. 2. Jennifer would like to provide Rob a deferred compensation under conditions that are different from those applicable to the junior employees. 3. Rob would be able to create an investment program that will utilize Jennifer's tax savings to influence his future benefits. 4. Jennifer would be able to convey to Rob that his work in the company is appreciated. She would also be able to put to rest a fear that has troubled her regarding Rob not being content. 5. Jennifer would like to receive tax deduction the same year in which Rob defers his compensation.

Correct Answers: 1, 2, 4 Explanation: As an employer, Jennifer can use the deferred plan to her advantage, as she can provide additional benefits to Rob within the company's budget. She need not use the same benefit program for all other employees, that is, the plan gives her the flexibility to decide whom to include for the benefit plan. Also, by using the deferred plan she can make sure that Rob is happy with the working conditions in the company. However, Jennifer will not receive a tax deduction in the year that Rob receives the compensation. The deduction will be deferred until the year that the income is taxable to Rob, and this could take up to 30 years or more.

Chairman and owner of Winger Corporation, Jack Winger, would like to reward Denise for her hard work and perseverance. In 2010, she is granted non-qualified stock options of 1,000 shares of the company stock at $20 per share, the market value for the shares that year. She can use this option within the next three years. In 2011, Denise purchases 500 shares for a total of $10,000. If the fair market value of the shares in 2011 is $13,000, she has $3,000 of ordinary income in 2011. Denise re-sells the stock at a later point in time at $ 15,000. What tax implications would apply to both Denise and Jack Winger as a result of these transactions? 1. As a result of the sale of stock, Denise has capital gains income. 2. Winger Corporation gets a tax deduction of $3,000 in 2011. 3. When Denise sells the stock, Winger Corporation gets a further tax deduction. 4. Denise reports a capital gain of $2,000. 5. Denise reports a capital gain of $3,000.

Correct Answers: 1, 2, 4 Explanation: When Denise sells the stock she has a capital gain income of $2,000. Winger Corporation has a tax deduction of $3,000, as that is Denise's ordinary income amount. The corporation does not get a further tax deduction, as this rule is not applicable to nonqualified stock options. Denise would report a capital gain of $2,000, that is, the difference between the selling price and her basis of $13,000.

Which of the following are features of nonqualified plans? 1. These plans provide additional retirement benefits to employees. 2. They qualify under ERISA. 3. The employer has a great deal of flexibility while planning the program. 4. These plans can discriminate.

Correct Answers: 1, 3, 4 Explanation: Nonqualified plans provide employees additional retirement benefits. The plans are not qualified under ERISA requirements. As a result, the employer has freedom while planning the program. The employer can decide who is to be included in the plan. He may want to include only highly compensated employees or members of management. Plan benefits for these groups are forfeitable in full at all times.

Which of the following options regarding nonqualified plan vesting rules are true? 1. The qualified vesting plan rules apply if the plan covers rank-and-file employees. 2. They must always meet certain vesting schedules. 3. The qualified vesting rules do not apply if the plan covers a select group of management or highly compensated employees. 4. For nonqualified deferred compensation benefits to remain tax deferred to the employee, the benefits are forfeitable in full at all times.

Correct Answers: 1, 3, 4 Explanation: The qualified plan vesting rules apply in the case of rank-and-file employees. If the plan covers only independent contractors or a select group of management or highly compensated employees, benefits may be forfeitable in full at all times.

Senior executive Emily Thompson is covered under her company's incentive stock option plan. She is granted an option in 2011 to purchase company stock for $150 per share. In May 2012, she purchases 150 shares for a total of $22,500. The fair market value of the 150 shares in May 2012 is $25,000. In September 2012, Emily sells the 150 shares for $27,500. Emily's taxable gain is $5,000. In such a situation, which of the following are possible? 1. The company gets a tax deduction as it has granted Emily an ISO. 2. The company gets a deduction for the compensation income element. 3. Emily's compensation income for the year 2012 is $2,500.

Correct Answers: 2, 3 Explanation: Under the incentive stock option, the company will get a tax deduction for Emily's compensation income element because the stock was sold before the two-year/one-year holding period. However, it will not receive a deduction for granting Emily an ISO. Emily's compensation income for the year 2012 will be $2,500, that is, the fair market value at exercise less the stock purchase cost.

Christopher is an executive working in a software company. One day he approaches Veronica, the company's financial advisor, because he needs some information on the loan programs that the company runs for its employees. During the conversation Veronica tells him the situations in which the company may sanction a loan, such as a loan for a new home if the company moves him to a different city. For which of the following situations would Christopher be sanctioned a loan? 1. To build a vacation retreat in Nevada. 2. To pay for his son Michael's college tuition. 3. To meet the medical expenses incurred during his mother's yearlong illness. 4. To settle credit card dues. 5. To purchase life insurance.

Correct Answers: 2, 3, 5. Explanation: The company will sanction a loan to pay for Michael's education and to clear the medical expenses that the family had to incur during Christopher's mother's yearlong battle against cancer. It would also sanction a loan if he wanted to buy a life insurance policy. The company will, however, reject the loan for the house in Nevada and for settling credit card dues. According to the company policy, only if Christopher were to move from his current office to a different city would a loan be sanctioned for a new home.

Which of the following requirements must be met to qualify for a mortgage loan exception? 1. the loan must be payable in full in 15 days after the old principal residence is sold. 2. the loan is secured by a mortgage on the new principal residence of the employee. 3. the old residence must not be converted to business or investment use. 4. the loan is compensation-related and is a demand or a term loan. 5. the new principal residence is acquired in connection with the transfer of the employee to a new principal place of work and meets the distance and time requirements for a moving expense deduction under Code Section 217.

Correct Answers: 2, 4, 5 Explanation: It is necessary for the loan to be secured by a mortgage on the employee's new residence. The loan has to be compensation-related. Also, it must be a demand or term loan. The new residence has to be acquired in connection with the transfer of the employee to a new principal place of work. It must meet the distance and time requirements for a moving expense deduction under Code Section 217. There is no obligation for the loan to be payable in full in 15 days after the old principal residence is sold. The rule that the old residence must not be converted to business or investment use does not apply here.

On January 1, 2013, Harry (an employee of Zebra) was granted 1000 ISOs to purchase Zebra stock at the fair market value on the date of grant ($20). On June 30, 2013, he exercised all of the ISOs when the market price was $35, and he sold them for $35 the next day. Which of the following is true? a. Harry will have to recognize $15 per share as short-term capital gain on the date of the sale. b. Harry will have an AMT adjustment of $15 on the exercise date. c. There is no taxable event on the exercise of the options. d. Harry will have to recognize $15 per share as compensation (ordinary income) on the date of exercise. There will be no gain or loss at the time of sale.

D Exercise to sale less than 1 year is a disqualifying event. The ISOs became NSOs. Harry will have no gain or loss on the date of sale since his basis ($35) is the same as the sale price ($35). If he had sold them for a gain, the gain would have been short-term. If he sold them for a loss, the loss would have been short-term.

Myles Levings, an executive, and his corporate employer executed an agreement to defer a portion of future compensation using a deferred compensation plan. The plan provides for contributions based on corporate profits otherwise paid in bonuses to Myles at the end of the corporation's fiscal year. Contributed amounts remain an asset of the employer at all times although the plan is credited with investment earnings on Myles' behalf. At age 60 or his date of retirement, whichever occurs first, Myles will be entitled to distributions from the plan. Which statement correctly identifies the income tax implication of this deferred compensation plan for Myles? a. This is a funded salary continuation plan. Contributed amounts remain an asset of the employer; thus, the employee has no current taxation. b. Contributions are based on bonuses paid at the end of the fiscal year; therefore, they are taxed to the employee. c. This type of funded plan can use life insurance as an investment vehicle to avoid taxation of the cash value growth to the employee until he attains age 60 or retires. d. The employer takes a deduction for the plan contributions and earnings only at the time Myles includes them in income (i.e., age 60 or date of retirement).

D The rest are wrong because this is an unfunded plan, not a funded plan. The investment remains an asset of the employer at all times.

John has just joined his grandfather's firm (grandfather-CEO and father-President). John has extensive experience as sales manager of a competitor and has been made V.P. of sales. The firm has established a nonqualified restricted stock grant plan for John. He will qualify if he stays with the firm for ten years. Are the benefits taxable income now or in the future? a. This is a funded plan and stock grant is taxable now. b. This is an informally funded plan; the stock grant will be taxable when exercised. c. This is an unfunded plan, where forfeiture provisions are unnecessary; the stock grant will be taxable in the future. d. There is a substantial risk of forfeiture; the stock grant will be taxable in the future. e. There is no substantial risk of forfeiture; the stock grant is taxable now.

E There is no substantial risk of forfeiture. When your grandfather and father run the firm, there is no substantial risk of forfeiture. Informally funded plans mainly use life insurance, not stock grants or options. Stock grant plans (Restricted stock grants) normally have provisions for substantial risk of forfeiture and are not taxable under normal circumstances.

You demanded an extra incentive to join FP, Inc. FP gave you a $10 million variable life policy. FP paid the premium. Which of the following is true? a. The premiums are nondeductible by FP. b. This is a funded nonqualified deferred compensation program. c. This is an unfunded nonqualified deferred compensation program. d. The program is informally funded. e. The premiums are taxable to you.

E You have constructive receipt. This is a Section 162 insurance plan. Section 162 insurance is a direct cash bonus made to an insurance company to pay the premium on a policy owned by the employee. A 162 double bonus is an additional cash bonus to the employee to pay the tax on the bonus. This is not a funded nonqualified deferred compensation plan.

Employee Stock Purchase Plans (ESPPs)

Employee stock purchase plans are similar to stock option plans. These enable the employee to buy stock. This generally is brought about by deductions in salary in the offering period ranging from 3 to 27 months. The price normally is 15% less than the market price. These plans are usually tax-qualified under Section 423. This makes it possible for all full-time employees with two or more years of service to participate.

Health Reimbursement Arrangement

Employer-provided reimbursements for medical expenses that are excluded from taxable income, but subject to maximum dollar limits for a coverage period. Unused funds at the end of the period can be carried forward to subsequent periods. A self-employed individual in not eligible to contribute.

Nonqualified plan: Excess Benefit Plan

Excess benefit plans are designed to provide benefits only for executives whose annual projected qualified plan benefits are limited under the dollar limits of Code Section 415. An excess benefit plan makes up the difference between the percentage of pay that top executives are allowed under Section 415 and that which rank and file employees are allowed.

An employer that provides interest-free loans to executives must do the same for rank and file employees. True or false?

False There are no discrimination rules for executive loan programs. Loans can be provided to selected groups of executives or even a single executive

If a split dollar arrangement is treated as a loan transaction, the employer does not have to recognize taxable income. True or false? Why?

False. If a split dollar plan is treated as a loan, the employer may recognize taxable income as a part of the transaction

Flo Smith, an executive, is covered under her company's ISO plan. Under the plan, Flo is granted an option in 2017 to purchase company stock for $100 per share. In January 2019, Flo exercises this option and purchases 100 shares for a total of $10,000. The fair market value of the 100 shares, in January 2019, is $14,000. In October 2019, Flo sells the 100 shares for $16,000. What are the tax consequences?

Flo's taxable gain is $6,000, that is, the $16,000 amount realized less the $10,000 cost. Of this amount, $4,000, the fair market value of $14,000 less $10,000 exercise price, is treated as compensation income for the year 2019. The remaining $2,000 is capital gain.

Lee, an executive, was given an option in 2015 to purchase 1,000 shares of Employer Company stock at $100 per share, the 2015 market price. Lee can exercise the option at any time over the next five years. In 2019, Lee purchases 400 shares for a total of $40,000. If the fair market value of the shares purchased in 2019 is $60,000. What are the tax consequences for Lee and the employer? What happens if Lee sells the stock? What would be the cost basis?

Lee has $20,000 of ordinary income and FICA income in 2019. Employer Company gets a tax deduction of $20,000 in 2019 (assuming that Lee's total compensation meets the reasonableness test), which is the same amount as Lee's compensation income. If Lee resells this stock at a gain in a later year, he has capital gain income. Employer Company gets no further tax deduction, even though Lee realizes and reports capital gain income from selling the stock. The executive's basis in shares acquired under a stock option plan is equal to the amount paid for the stock, plus the amount of taxable income reported by the executive at the time the option was exercised. In the example, Lee's basis for the 400 shares purchased in 2019 is $60,000, that is, the $40,000 that Lee paid, plus the $20,000 of ordinary income that he reported in 2019.

NonQualified Plan Financing Methods: Corporate-owned life insurance

Life insurance policies on the employee's life, owned by and payable to the employer corporation, can provide financing for the employer's obligation under nonqualified deferred compensation plans. With life insurance financing, the plan can provide a substantial death benefit, even in the early years of the plan. This is of significant value to younger employees.

Can NQSO by transferred or gifted?

Nonqualified stock options may be transferred, during the life of the individual who owns the options, to certain members of their family or to a trust for their benefit. In addition, they can also transfer NQSOs to charitable organizations, as long as the NQSO permits for such a transfer.

Split dollar life insurance plan: Disadvantages

One of the biggest disadvantages of the split dollar plan is that the employer receives no tax deduction for its share of premium payments. The employee has to pay income taxes each year on the current cost of life insurance protection under the plan, or for an employee owned policy, the employee mjst pay taxes on the imputed income less any premiums paid by the employee.

in 2019, through an ISO Plan at Sally's work, she is given the right to buy 100 shares of stock at $15 per share for 10 years. After five years, in 2023, the stock is priced at $24, and Sally can buy the $24 stock for $15. Subsequently, she sells the shares for $30 per share (the fair market value (FMV)) in 2026. Sally has met the minimum holding requirements of waiting two years after the options were granted and one year after exercising the options. Whatre the tax consequences?

Sally pays no tax when she exercises her options, and the company gets no tax deduction. In this scenario, Sally pays capital gains tax on $6, the difference between the market value when exercised ($24) and the sale price ($30) and the capital gains tax on $9, which was the difference between the exercise price ($15) and the market value ($24) at the time of exercise. If the holding period is not met, the gain will be ordinary income and taxed as such. If the ISO rules are not met, then the options are taxed like a non-qualified option.

Excess SERP

Supplemental executive retirement plan providing a benefit amount equal to the difference between (1) the amount that would be paid to the executive under the employer's qualified retirement benefit formula ignoring any ERISA-imposed limits and (2) the actual retirement benefit payable to the executive under the qualified retirement plan and Social Security

Top-Hat Plan

The top-hat plan involves the most important ERISA exemption. Under ERISA, if a nonqualified plan is unfunded and maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees, the plan is exempt from all provisions of ERISA except for the reporting and disclosure requirements, and ERISA's administrative and enforcement provisions.

What are the advantages of ISO's?

The ISO provides greater deferral of taxes to the executive than a nonqualified (nonstatutory) stock option. Income from the sale of the stock obtained through exercise of an ISO may be eligible for preferential capital gains treatment, enhancing the value of the tax deferral. The ISO is a form of compensation with little or no out-of-pocket cost to the company.

NonQualified Plan Financing Methods: Reserve account maintained by employer

The employer maintains an actual account, invested in securities of various types. There is no trust in this case. Funds are fully accessible to the employer and its creditors. The plan is considered unfunded for tax and ERISA purposes.

What is the main difference between phantom stock and stock options?

The main difference between phantom stock and stock options is ownership. Stock options offer an employee the opportunity to purchase actual shares of stock at a predetermined amount at a future date. The taxation of a stock option will depend on if it is an ISO or NQSO. Phantom stock does not give an employee the opportunity for ownership in the company unless the payout is in the form of company stock, and it follows the nonqualified deferred compensation rules for taxation.

What is the most common form of split dollar life insurance?

The most common form of Split Dollar, Endorsement, will have the employer own the policy and all of the cash value. The employer gets enough of the death benefit to pay back their costs with the balance going to the employee.

executive Flint borrows $100,000 from her employer. Assume that interest at the applicable federal rate for the first year would be $12,000, but actual interest under the loan agreement is only $5,000. What are the tax consequences?

This loan results in additional taxable compensation income of $7,000 to Flint for the first year ($12,000 less $5,000). If interest is deductible, for example, if the loan qualifies as a home mortgage loan, Flint can deduct $12,000 (the actual $5,000 plus the deemed $7,000) as an interest payment. Flint's employer can deduct $7,000 as compensation paid to Flint for year 1, regardless of whether Flint can deduct any of the interest. A total of $12,000 is taxable to the employer (the $5,000 actually received and the $7,000 deemed to have been received).

Penalty or haircut provision

This provision has multiple withdrawal reasons stated, including the request of the participant, but there are penalties for early withdrawal.

Hardship withdrawal provision

This provision provides withdrawal in case of death, disability or financial emergencies. Rules of Section 401(k) do not apply for this provision.

Suspension of participation provision

This provision temporarily stops the employee's participation in the plan for a period such as six months after withdrawing money from the plan.

Unfunded excess benefit plans

This type of nonqualified deferred compensation plan, designed solely to supplement the qualified retirement benefits limited in amount by Code Section 415, is not subject to any ERISA requirements.

An excess benefit plan makes up the difference between the percentage of pay that top executives are allowed under Section 415 and that which rank and file employees are allowed. True or false? Why?

True. High compensated employees receive the difference between the amounts payable under their qualified plan and the amount they would have received if there were no benefit limitations under Code Section 415

Sally has the opportunity to participate in a nonqualified stock option plan. Sally has the right to buy 100 shares of stock at $15 per share for 10 years. After five years, the stock is at $24, and Sally could buy the $24 stock for $15. How is it taxed?

Under the NQSO plan, Sally will immediately pay tax on the $9 difference at ordinary income tax rates. The company gets a corresponding tax deduction on the amount on which Sally is taxed. This remains true whether the employee keeps the shares or sells them. Subsequently, when Sally sells the stock, she pays capital gains on the difference between the sale price and the $24 value of the stock at the time of purchase.

suppose an employee is covered under a funded nonqualified deferred compensation plan that has an irrevocable trust for the benefit of the employee. What are the tax consequences?

Under the economic benefit doctrine, the employee will be taxed as soon as the employee is vested in contributions made to the fund, even though the employee does not, at that time, have a right to withdraw cash. This factor makes funded plans extremely unattractive.

NonQualified Plan Financing Methods: Employer reserve account with employee investment direction

With this variation, the employee obtains greater security by having the right to direct or select investments in the account. He or she must limit this right to a choice of broad types of investment such as equity, bonds and a family of mutual funds. The ability to choose specific investments may lead to constructive receipt by the employee. Also, the investment direction by the participant must be advisory only and not binding.

What are the tax consequences of an ESPP?

a participant is generally not taxed until the sale of the shares. The participant will pay ordinary income tax on a portion or the entire purchase price discount and will recognize a capital gain or loss for the value difference between their basis in the stock and the proceeds from the sale.

Phantom Stock Plan

a plan through which employees participate in the appreciation of company shares and any associated dividends, without ever owning any company stock

supplemental executive retirement plan (SERP)

is a nonqualified retirement plan that provides retirement benefits to selected employees only. Because the plan purposefully is not qualified under the IRC or ERISA, the business has great flexibility as to whom to include and exclude as well as the benefit arrangements. Benefits can be set at any level desired and can be paid for life or for a set number of years.

How are amounts deferred in nonqualified plans taxed by social security?

are not subject to Social Security taxes until the year in which the employee no longer has any substantial risk of forfeiting the amount, provided the amounts are reasonably ascertainable. In other words, as soon as the covered executive cannot lose his interest in the plan, he will be subject to Social Security taxes. Conceivably, this could be earlier than the year of actual receipt.

Death benefits from nonqualified plans that are payable to a beneficiary, how are they taxed?

are taxable as income in respect as a decedent to a recipient.

A nonqualified stock option that has a readily ascertainable FMV at the time it is granted to an employee will result in taxable ordinary income to the employee: a. in the year stock purchased under the option is sold b. in the year stock purchased under the option is sold, if sold at a gain c. in the year stock is purchase under the option d. in the year the option is granted

d. A non-qualified stock option that has a readily ascertainable FMV at the time it is granted to an employee will result in taxable ordinary income to the employee in the year the option is granted

Fred, a participant in ZZZ nonqualified deferred compensation plan, has passed away. Where will the value of the payments made to Fred's beneficiary by included?

in Fred's estate

The amount of any death benefit payable to a beneficiary under a nonqualified deferred compensation plan is generally _____________________ in the deceased employee's estate for federal estate tax purposes, at its then present value.

included

Nonqualified plan: Salary Reduction Formula

involves an elective deferral of a specified amount of the compensation that the employee would have otherwise received. The employer contribution under this type of plan could be in the form of a bonus, without actual reduction of salary. The plan is somewhat similar to a defined contribution type of qualified plan, although the qualified plan restrictions do not apply.

Split dollar life insurance

is an arrangement, typically between an employer and an employee, in which there is a sharing of the costs and benefits of the life insurance policy.

A demand loan

is payable in full at any time upon demand of the lender.

Nonqualified plan: Salary Continuation Formula

plan that provides a specified deferred amount payable in the future. For example, the contract might provide that at retirement, disability, or death, the XYZ Corporation will pay you or your designated beneficiary $50,000 a year for 10 years starting at age 65.

Nonqualified (NQSO) stock options

provide a right to purchase shares of company stock at a stated price that is the option price for a given period of time, frequently ten years

A SERP that is formally funded will trigger a current _____________ to the participant

tax

NonQualified Plan Financing Methods: Third-Party Guarantees

there is a guarantee from a third party to pay the employee if the employer defaults. The guarantor could be an insurance company or some other entity. On occasion, third-party guarantees have received favorable tax treatment. But the law in this area is not entirely clear. Employer involvement raises the possibility that the guarantee will cause the plan to be deemed formally funded for tax purposes. However, it appears that if the employee, independently of the employer, obtains a third-party guarantee, the IRS would not necessarily view the plan as formally funded.

Stock acquired by an employee under the ISO must be held for at least ______ years after the grant of the option and _______ years from the date stock is transferred to the employee. This requirement is waived upon the employee's death.

two ; one