Chapter 12

45. Francis works for a local fly fishing shop. The shop allows employees to purchase two fly rods per year at a discount. This year, Francis purchased one rod. The rod normally retails for $300, was purchased for $225, was sold to Francis for $250, and the employer's average gross profit percentage is 30 percent. What amount of the discount must be included in Francis' income? A. $0 B. $25 C. $40 D. Some other amount.

A. $0 Because the discount was less than the employer's average gross profit percentage, there is no income inclusion.

43. Which of the following benefits cannot be excluded as a no additional cost service fringe benefit? A. Free tax return preparation from a client. B. Complementary dry cleaning for employees at a laundry company. C. A car wash at an automobile dealership. D. Free local phone service for phone company employees.

A. Free tax return preparation from a client. The service must be provided at no additional cost by the employer.

27. Which of the following refers to the date stock options are awarded to an employee? A. Grant date. B. Exercise date. C. Lapse date. D. Vesting date.

A. The grant date is the date on which an employee receives the stock options.

48. Tasha receives reimbursement from her employer for dependent care expenses for up to $8,000. Tasha applies for and receives reimbursement of $6,000 for her 10 year old son. How much, if any, is includible in her income? A. $0 B. $1,000 C. $3,000 D. $6,000

B. $1,000 Employees may exclude up to $5,000 of dependent care expenses.

Tanya's employer offers a cafeteria plan that allows employees to choose among a number of benefits. Each employee is allowed $6,000 in benefits. For 2016, Tanya selected $3,300 ($275 per month) of parking, $2,200 in 401(k) contributions, and $800 of cash. How much must Tanya include in taxable income? A. $0 B. $1,040 C. $1,120 D. $4,000

B. $1,040 $1,040 is includable: $240 of parking benefits [$3,300 ($275 × 12) - ($255 excludable amount × 12)] and $800 of cash.

39. Grace's employer is now offering group-term life insurance. The company will provide each employee with $200,000 of group-term life insurance. It costs Grace's employer $700 to provide this amount of insurance to Grace each year. Assuming that Grace is 43 years old, use the table to determine the monthly premium that Grace must include in income as a result of receiving the group-term life benefit. EXHIBIT 12-10 Uniform Premiums for $1,000 of Group-Term Life Insurance Protection 5-Year Age Bracket Cost per $1,000 of Protection for One Month Under 25 $0.05 25 to 29 .06 30 to 34 .08 35 to 39 .09 40 to 44 .10 45 to 49 .15 50 to 54 .23 55 to 59 . 43 60 to 64 .66 65 to 69 1.27 70 and above 2.06 A. $0. B. $15.00. C. $22.00. D. $58.33.

B. $15.00. $200,000 policy less $50,000 exemption times 10 cents per month per thousand of coverage.

46. Kevin is the financial manager of Levingston BMW. The shop allows employees to purchase up to two vehicles at a discount. Levingston's average gross profit percentage is 15%. This year Kevin purchased a 530 model and a new M3. Model FMV Dealer Cost Employee Price 530 $63,000 $50,000 $54,000 M3 $70,000 $60,000 $57,000 What amount must Kevin include in income? A. $0 B. $2,500 C. $2,950 D. $22,000

B. $2,500 Kevin must include $2,500 into his gross income. This is because the $13,000 ($70,000 - $57,000) discount received on the M3 is larger than the qualified employee discount of $10,500 (sales price of $70,000 times the average gross profit percentage of 15%). There is no gross income from the purchase of the 530 since the $9,000 ($63,000 - $54,000) discount is less than the qualified employee discount of $9,450 ($63,000 times the average gross profit percentage of 15%).

Rachel receives employer provided health insurance. The employer's cost of the health insurance is $6,000 annually. What is her employer's after-tax cost of providing the health insurance, assuming that the employer's marginal tax rate is 35 percent and is profitable? A. $0 B. $3,900 C. $4,198 D. $6,000

B. $3,900 The after-tax cost is the $6,000 outflow less the $2,100 ($6,000 × 35 percent) of income tax benefit.

29. Maren received 10 NQOs (each option gives her the right to purchase 10 shares of stock for $8 per share) at the time she started working when the stock price was $6 per share. When the share price was $15 per share, she exercised all of her options. Eighteen months later she sold all of the shares for $20 per share. How much gain will Maren recognize on the sale of the shares and how much tax will she pay assuming her marginal tax rate is 39.6 percent? A. $0 gain and $0 tax. B. $500 gain and $100 tax. C. $500 gain and $175 tax. D. $1,200 gain and $180 tax.

B. $500 gain and $100 tax. The gain realized is $500 (100 shares × $20) less basis (100 shares × $15 exercise price). The tax is calculated as follows: $500 × 20% (preferential rate).

Maren received 10 NQOs (each option gives her the right to purchase 10 shares of stock for $8 per share) at the time she started working when the stock price was $6 per share. When the share price was $15 per share, she exercised all of her options. Eighteen months later she sold all of the shares for $20 per share. What is the amount of Maren's bargain element? A. $0. B. $700. C. $900. D. $1,500. E. None of these.

B. $700. 10 options × 10 shares × ($15 market price at exercise - $8 exercise price)

21. Which of the items is incorrect regarding withholding? A. Employees that also have self-employment income can have additional amounts of federal tax withheld to avoid estimated tax payments. B. Employees cannot claim an allowance for a child unless they are entitled to claim the child as a dependent. C. Employees can claim exempt status and avoid withholding. D. Married employees can choose to have income tax withholding on wages withheld at the higher single rates.

B. Employees cannot claim an allowance for a child unless they are entitled to claim the child as a dependent. Additional allowances can be claimed for many purposes (e.g., large itemized deductions) in addition to personal and dependency exemptions.

47. Which of the following is false regarding dependent care expenses? A. Up to $5,000 of reimbursed expenses can qualify. B. Employers may discriminate among employees. C. Dependent children under 13 qualify. D. Spouses who are physically or mentally unable to care for themselves qualify.

B. Employers may discriminate among employees. Employers may not discriminate with respect to dependent care expenses.

40. Which of the following is not an example of a nontaxable fringe benefit? A. Monthly employer provided transit benefit of $100. B. Group-term life insurance policy providing $100,000 of coverage. C. Employer provided parking of $100 per month. D. Qualified employee discounts.

B. Group-term life insurance policy providing $100,000 of coverage. Only $50,000 of group-term life insurance qualifies as a nontaxable fringe benefit.

19. Which of the following statements regarding income tax withholding is incorrect? A. The withholding tables are designed so that employee withholding approximates the tax liability. B. Large itemized deductions require the need for additional withholding. C. The withholding tables vary based on filing status. D. Extra allowances can be claimed and reduce withholding.

B. Large itemized deductions require the need for additional withholding. Itemized deductions reduce the withholding required by the taxpayer.

33. Which of the following statements regarding restricted stock is false? A. Like stock options, restricted stock has to vest before it can be sold. B. Like nonqualified stock options, the employee's income inclusion for restricted stock is the bargain element. C. Even if the value of restricted stock decreases from the price on the grant date, it retains some value to the employee. D. There is no effective tax planning elections for restricted stock.

B. Like nonqualified stock options, the employee's income inclusion for restricted stock is the bargain element. Employees are taxed on the fair market value of the restricted stock.

31. Which of the following pairs of items is not needed to calculate the after-tax proceeds for a same-day sale? A. Strike price and market price on exercise date. B. Strike price and market price on grant date. C. Market price on sale date and market price on exercise date. D. Market price on sale date and marginal tax rate.

B. Strike price and market price on grant date. The market price on grant date is not needed.

26. Which of the following is true regarding stock options? A. A loss is realized when stock options lapse. B. There is typically no tax effect on the grant date. C. Income recognized on the exercise date is greater for incentive stock options than nonqualified options. D. The bargain element on a nonqualified option is taxed to employees at capital gain rates.

B. There is typically no tax effect on the grant date.

24. When a publicly traded CEO's salary exceeds $1,000,000, the employee _____ taxed on the entire amount, and the employer ______ allowed a deduction on the entire amount. A. is; is B. is; is not C. is not; is D. is not; is not

B. is; is not Section 162(m) limits the deduction for compensation paid by a publicly traded company to a covered employee to $1,000,000 per year.

When a publicly traded CEO's salary exceeds $1,000,000, the employee _____ taxed on the entire amount, and the employer ______ allowed a deduction on the entire amount. A. is; is B. is; is not C. is not; is D. is not; is not

B. is; is not Section 162(m) limits the deduction for compensation paid by a publicly traded company to a covered employee to $1,000,000 per year.

32. Brad received 20 NQOs (each option gives him the right to purchase 30 shares of stock for $10 per share) from his employer. At the time he started working, the stock price was $11 per share. Now that the share price is $25 per share, he intends to exercise all of the options. Two years later Brad sells the stock for $27 per share. What is Brad's basis in his stock for purposes of calculating the gain or loss? A. $6,000. B. $9,000. C. $15,000. D. $16,200.

C. $15,000. The basis is the $6,000 (600 shares × $10 strike price) cash paid and the $9,000 (600 shares × $15 bargain element) income recognized on the exercise—which is equal to the market price on the exercise date less the strike price.

38. Which of the following is not an example of a taxable fringe benefit? A. Personal use of corporate jet. B. $1,000,000 group term life insurance policy. C. $225 of employer provided parking. D. Automobile allowance.

C. $225 of employer provided parking. Employer provided parking is nontaxable up to $255 per month.

Bonnie's employer provides her with an annual dinner club membership costing $5,000. Her marginal tax rate is 25 percent. Her employer has a marginal tax rate of 35 percent. What is Bonnie's after-tax benefit? A. $0. B. $1,250. C. $3,750. D. $5,000.

C. $3,750. The after-tax benefit is the $5,000 benefit less the $1,250 ($5,000 × 25 percent) of tax.

37. Stevie recently received 1,000 shares of restricted stock from her employer, Nicks Corporation, when the share price was $8 per share. Stevie's restricted shares vested three years later when the market price was $11. Stevie held the shares for a little more than a year and sold them when the market price was $16. Assuming Stevie made a section 83(b) election, what is the amount of Stevie's ordinary income with respect to the restricted stock? A. $0. B. $5,000. C. $8,000. D. $11,000.

C. $8,000. $8,000 (1,000 shares × $8 market price on grant date)

Lara, a single taxpayer with a 30 percent marginal tax rate, desires health insurance. The health insurance would cost Lara $5,000 to purchase if she pays for it herself (Lara's AGI is too high to receive any tax deduction for the insurance as a medical expense). Lara's employer has a 40 percent marginal tax rate. Ignoring payroll taxes, what is the maximum amount of before-tax salary Lara would give up to receive health insurance? A. $1,500. B. $5,000. C. $7,143. D. $8,333.

C. 7,143 = $5,000/(1 - .3).

18. Which of the following forms is filled out by an employee, who is a citizen, at the beginning of an employment relationship? A. Form Q-2. B. Form W-2. C. Form W-4. D. Form 1099.

C. Form W-4 Employees fill out a W-4 to indicate their tax status, number of dependents and other items that affect income tax withholding.

20. Which of the following is not reported on the Form W-2? A. The employee's taxable salary and wages. B. Annual Federal and state withholding information. C. Indication as to whether an employee had more than one employer during the year. D. Annual amount of Social Security and Medicare tax withholding information.

C. Indication as to whether an employee had more than one employer during the year. The W-2 only provides information about the employer providing the statement.

50. Which of the following is a fringe benefit that employers can discriminate among employees? A. No additional cost service. B. Qualified employee discount. C. Qualified transportation fringe. D. Employee educational assistance.

C. Qualified transportation fringe. See Exhibit 12-12.

30. How is the bargain element for a stock option calculated? A. The difference between the strike price and the market price on the date of grant. B. The difference between the market price on the exercise date and the market price on the date of grant. C. The difference between the market price on the exercise date and the strike price. D. The difference between the market price on the sale date and the strike price.

C. The difference between the market price on the exercise date and the strike price. The bargain element is simply the difference between the market price on the exercise date and the strike price.

44. Which of the following is not a requirement of a "qualified employee discount"? A. The discount relates to goods or services of the employer. B. The discount on services doesn't exceed 20 percent of the price offered to customers. C. The discount can be elected up to five times annually. D. The employee discount on goods is not greater than employer's average gross profit.

C. The discount can be elected up to five times annually. There is no limitation on the number of times the employees can use the discount.

42. Which of the following statements regarding employer provided educational benefits is true? A. All undergraduate tuition expenses can be excluded. B. Only educational benefits from public universities can be excluded. C. Up to $5,250 in tuition benefits can be excluded. D. All graduate tuition expenses are included.

C. Up to $5,250 in tuition benefits can be excluded. An annual benefit of $5,250 can be excluded.

Which of the following items is not included on an employee's Form W-2? A. Taxable wages, tips, and compensation B. Social Security withholding C. Value of stock options granted during the year D. Federal and state income tax withholding

C. Value of stock options granted during the year

Form W-4**

Completed when employees begin employment with a firm. Specifies withholding rate and allowances.

28. Aharon exercises 10 stock options awarded several years ago. The following information pertains to the options: (1) each option gives the employee the right to buy 10 shares, (2) the market price on the grant date was $7, (3) the strike price is $10, and (4) the market price on the exercise date was $15. How much will it cost Aharon to purchase the options on the exercise date? A. $90. B. $500. C. $700. D. $1,000.

D. $1,000. $1,000 (10 options × 10 shares × $10 exercise price).

36. Stevie recently received 1,000 shares of restricted stock from her employer, Nicks Corporation, when the share price was $8 per share. Stevie's restricted shares vested three years later when the market price was $11. Stevie held the shares for a little more than a year and sold them when the market price was $16. What is the amount of Stevie's ordinary income with respect to the restricted stock? A. $0. B. $5,000. C. $8,000. D. $11,000.

D. $11,000. $11,000 (1,000 shares × $11 market price on vesting date)

Tom recently received 2,000 shares of restricted stock from his employer, Independence Corporation, when the share price was $10 per share. Tom's restricted shares vested three years later when the market price was $14. Tom held the shares for a little more than a year and sold them when the market price was $20. What is the amount of Tom's income or loss on the vesting date? A. $0. B. $10,000. C. $20,000. D. $28,000.

D. $28,000. 2,000 × $14 (market price on vesting date).

34. Tom recently received 2,000 shares of restricted stock from his employer, Independence Corporation, when the share price was $10 per share. Tom's restricted shares vested three years later when the market price was $14. Tom held the shares for a little more than a year and sold them when the market price was $12. What is the amount of Tom's income or loss on the sale? A. $0 B. $2,000 loss C. $4,000 gain D. $4,000 loss

D. $4,000 loss $4,000 loss is $24,000 (2,000 shares × $12 market value on sale date) of sales proceeds less $28,000 (2,000 shares × $14 market price on vesting date) basis.

41. Which of the following does not qualify as a "for the convenience of the employer" nontaxable fringe benefit? A. The fair market value of the rent of an apartment manager living on the premises. B. An overtime meal provided to an employee while working late. C. A meal provided by a hospital to residents during their shift. D. A company picnic.

D. A company picnic. The value of a company picnic is a nontaxable fringe benefit, but it is not a "for the convenience of the employer" benefit.

49. Which of the following statements concerning cafeteria plans is true? A. Allows employees to choose from a menu of fringe benefits or to choose cash. B. Most of the menu choices are nontaxable fringe benefits. C. Any receipt of cash option that is elected is treated at taxable compensation. D. All of these are true statements

D. All of these are true statements.

Which of the following statements regarding compensation is false? A. Wages are usually paid by the hour. B. Salary is usually a form of fixed compensation. C. Bonuses are a form of compensation obtained if certain criteria are met. D. Bonuses paid within 2½ months of year-end are included in employee's compensation in the year they were earned.

D. Bonuses paid within 2½ months of year-end are included in employee's compensation in the year they were earned. Employees include compensation into income in the year received.

35. Which of the following is false regarding a section 83(b) election? A. The election freezes the value of the employee's compensation as of the grant date. B. The election is an important tax planning tool if the stock is expected to increase in value. C. The election must be made within 30 days of the grant date. D. If an employee leaves before the vesting date, any loss is limited to $3,000.

D. If an employee leaves before the vesting date, any loss is limited to $3,000. Employees are not allowed to deduct a loss if restricted stock subject to a section 83(b) election is forfeited.

25. Which of the following is not a purpose of equity-based compensation? A. Provide both risk and incentives to employees. B. Motivate employees by aligning employee and employer incentives. C. Avoid compensation limits for certain publicly traded company executives. D. Provides a low or no cost form of compensation.

D. Provides a low or no cost form of compensation. Employers have to repurchase shares or dilute ownership (incurring opportunity costs) to provide equity-based compensation.

22. Which of the following regarding the Form W-4 is incorrect? A. Determines an employee's income tax withholding. B. Employees can claim more allowances than personal exemptions that will be claimed. C. Employees can specify additional amounts to be withheld each month. D. The form can only be adjusted at the beginning of year or start of employment.

D. The form can only be adjusted at the beginning of year or start of employment. Employees may adjust the Form W-4 throughout the year.

23. Which of the following statements is true regarding the $1,000,000 limit on covered employees for publicly traded companies? A. The limitation applies to all employees. B. The limitation applies to all officers. C. The limitation applies only to the CEO and three other highest compensated officers. D. The limitation applies only to the CEO and three other highest compensated officers, not including the CFO.

D. The limitation applies only to the CEO and three other highest compensated officers, not including the CFO. The limitation applies to the CEO and three other highest compensated officers, but does not apply to the CFO.

FICA taxes

Employees must pay FICA taxes on their wages. FICA tax consists of both a Social Security and a Medicare component.

incentive stock options (ISOs).

Employees prefer these because they can be taxed at long term capital gains. Employees who acquire shares through the exercise of ISOs have an additional tax benefit. If they hold the shares for at least two years after the grant date and on year after the exercise date, they will not be taxed until they sell the stock. When they sell, employees will treat the difference between the sales proceeds and the tax basis (the exercise price) as a long-term capital gain in the year of disposition.

Limits on Salary Deductibility

Employers are generally allowed to deduct reasonable compensation paid to employees. The amount of salary in excess of the amount considered reasonable is not deductible. The reasonable compensation limit typically applies to closely held businesses where the employee is also an owner of the company or the employee is a relative of the business owner.

T/F? The employee's income for restricted stock is typically measured on the grant date.

FALSE Income for restricted stock is typically measured on the vesting date

T/F? A section 83(b) election freezes the value of restricted stock for compensation purposes on the vesting date.

FALSE The 83(b) election values the restricted stock on the grant date instead of the vesting date.

T/F? Employers always prefer to award incentive stock options rather than nonqualified stock options.

False

Nontaxable Fringe Benefits

For policy reasons, Congress specifically excludes certain fringe benefits from employees' gross income to encourage employers to provide the benefits. Employers are generally prohibited from discriminating among employees with respect to nontaxable fringe benefits

tax gross-up

Frequently, when corporations provide taxable fringe benefits to senior executives, they also provide the executives enough cash to cover the taxes so the benefit actually costs the executive nothing.

Employee Considerations for Taxable Fringe Benefits

From an employee's perspective, taxable fringe benefits are treated just like cash. Employees recognize ordinary compensation income when they receive taxable fringe benefits and pay FICA taxes on the value of the benefit.

Common Nontaxable Fringe Benefits

Group-Term Life Insurance, Health and Accident Insurance and Benefits, Meals and Lodging for the Convenience of the Employer (dinner for working OT,) Employee Educational Assistance (up to 5,250) Dependent Care Benefits (up to $5,000 for children under 13 or disabled dependents) No-Additional Cost Services (hotel with free rooms, no substantial cost and space available basis) Qualified Employee Discounts (can't be greater then gross profit percentage or 20% off) De Minimis Fringe Benefits (using copy machine, can discriminate) Qualified Transportation Fringe Benefits ($255 per month) Qualified Moving Expense Reimbursement (cost of moving household items and travel ) Cafeteria Plans and Flexible Spending Arrangements (FSAs: allow employees to set aside a portion of their before-tax salary for payment of either health care or dependant care benefits)

Section 83(b) Election**

If the employee makes the Section 83(b) election, the value of the restricted stock is taxed on the grant date rather than the date on which the stock vests. Without the Section 83(b) election, the employee reports no income when the shares are granted but is taxed on their fair market value at ordinary tax rates when the stock vests. Making this election assumes the price will go up.

Employer Considerations for Taxable Fringe Benefits

Like employees, employers treat taxable fringe benefits just like cash compensation. The employer deducts its cost of the benefit, not the value of the benefit to the employee.

Equity-Based Compensation Summary

NQO: Employee gets taxed as ordinary income while the employer gets an ordinary deduction at the exercise date. ISO: No deduction for employer, LT capital gain when employees sell shares. Restricted stock: Ordinary income/deduction on the vest date. For all 3, capital gains are always paid when shares are sold.

cashless exercise

NQOs immediately sell all or a significant portion of the shares acquired on the exercise date

Form W-2**

Received by employees at the end of the year to summarize their salary or wage compensation and the various withholding amounts made during the year.

Taxable fringe benefits**

Taxable fringe benefits include below market interest rate loans, gym memberships, season tickets to sporting events and an automobile allowance for a personal automobile. Employers may discriminate between employees when providing taxable benefits.

Section 162(m) of the Internal Revenue Code

This provision limits the deduction for compensation paid by publicly traded corporations to covered employees to $1 million per year. Covered employees include the principal executive officer (CEO) and the next three highest paid officers (not including the principal financial officer - the CFO).

Performance based.

To be deductible, compensation to executives in excess of $1 million must be performance based.

T/F? Employees will always prefer to receive incentive stock options over nonqualified stock options.

True

T/F? Employer's expense for stock options is typically recognized earlier for book than tax purposes.

True

T/F? Employers computing taxable income receive a deduction for reasonable salary and wages paid to employees.

True

T/F? Employers computing taxable income under the accrual method to unrelated taxpayers may deduct wages accrued as compensation expense in one year and paid in the subsequent year, as long as the company makes the payment within 2½ months after the employer's year-end.

True

T/F? Employers sometimes pay a "gross-up" to employees to cover taxes associated with taxable fringe benefits they provide.

True

T/F? Flexible spending accounts allow employees to set aside before-tax dollars for medical and dependent care expenses.

True

T/F? Fringe benefits are generally a form of non-cash compensation.

True

T/F? Group-term life insurance is a fringe benefit that can be partially taxable and partially tax free

True

T/F? Health insurance is an example of a nontaxable fringe benefit.

True

T/F? Hotel employees can receive free nights lodging on a space available basis without incurring compensation.

True

T/F? Qualified employee discounts allow employees to purchase employer goods at a discount.

True

T/F? Taxable fringe benefits include automobile allowances, gym memberships, and personal use tickets to the theatre or sporting events

True

T/F? The date on which stock options are no longer subject to forfeiture is called the vesting date.

True

T/F? When stock options are exercised they are converted into actual employer stock.

True

vesting

When stock options vest, employees are legally entitled to buy or exercise employer stock at a stipulated price, referred to as the exercise price (or strike price). Options may be exercised any time between the vesting date and the expiration date of the options (generally 10 years).

alternative minimum tax

When taxpayers exercise incentive stock options, the bargain element is added to their alternative minimum taxable income. This increases the likelihood that taxpayers exercising incentive stock options will be required to pay the alternative minimum tax.

Employer Considerations for Stock Options

With NQOs, employers deduct the bargain element that employees recognize as income when the employees exercise the NQOs. Employers typically do not view incentive stock options favorably as NQOs. As long as the employee does not sell the stock in a disqualifying disposition, the employer does not get a tax deduction for ISOs. Employers frequently use NQOs to circumvent the $1,000,000 limitation imposed by Section 162(m).

salary

earn a fixed amount of compensation for the year no matter how many hours worked

provide group-term life insurance

employees must recognize a certain amount of gross income when employers pay life insurance premiums for employee policies with a death benefit in excess of $50,000. Consequently, a portion of the group-term life insurance benefit is taxable and a portion is nontaxable.

Restricted Stock

employees receiving restricted stock are taxed on the full fair market value of the shares on the date the restricted stock vests. Any subsequent appreciation in the value of the stock is taxed as long-term or short-term capital gain or loss when the taxpayer sells the stock.

wages

paid by the hour

disqualifying disposition

premature sale of stock, Taxed as if a NQO

nonqualified stock options (NQOs)

report ordinary income equal to the total bargain element on the shares of stock acquired (as if they were sold) whether they hold the shares or sell them immediately. A taxpayer's basis in nonqualified stock options acquired is the fair market value on the date of exercise. Thus, the basis includes the exercise price plus the ordinary income the taxpayer recognizes on the exercise (the bargain element).

bargain element

the difference between the exercise price and the market value of the acquired shares on the date of exercise