1、Objectives Sessions 9 and 10 Tax Planning & Executive Compensation Taxation of various forms of compensation Multilateral planning perspective (both employee and employer costs are important) Incentive stock options (ISOs) Non-qualified stock options (NQSOs) Other issues 15.518 Fall 2002 Sessions 9
2、and 10 What is an employee? Classification of a worker as an employee: Employer subject to payroll taxes (i.e., Social Security, Unemployment) Employee subject to regular Social Security tax rather than higher self employment tax Employee unreimbursed business expenses are deductible only as itemize
3、d deductions and subject to a limitation Classification of a worker as an independentcontractor: Employer pays no payroll taxes Worker subject to self employment tax Workers business expenses are always deductible IRS does not allow taxpayers to choose whether they are employees, classification is b
4、ased on strict rules about the relationship between the employer and the employee (e.g., can the employer tell the employee how to do his or her job?) 15.518 Fall 2002 Sessions 9 and 10 Taxation of Various Forms of Compensation Current Salary Employee - taxable as currently paid Employer - deduction
5、s as currently paid Qualified deferred compensation (e.g., pensions) Employee - taxable when received in the future Employer - deductions received now 15.518 Fall 2002 Sessions 9 and 10 Taxation of Various Forms of Compensation Nonqualified deferred compensation Employee - taxable when received in t
6、he future Employer - deductions received in the future Fringe benefits Employee - never taxable Employer - deductions received now Stock options (discussed later) 15.518 Fall 2002 Sessions 9 and 10 Which Form of Compensation is Optimal? The optimal form of compensation cant be determined without kno
7、wing the following: The current and expected future marginal tax rates of the employee The current and expected future marginal tax rates of the employer The after tax rates of return available to the employer and employee The time horizon Nontax considerations 15.518 Fall 2002 Sessions 9 and 10 Sal
8、ary vs. Deferred Comp - Multilateral Perspective Tax rates: Year 1 Year 2 Employer 40% 60% Employee 20% 50% Both employer & employee can earn a 5% after tax return on investments Current plans are to pay the employee $2,000 of deferred compensation in year 2. 15.518 Fall 2002 Sessions 9 and 10 What
9、would each party prefer under a unilateral perspective? The employee prefers current salary: current salary yields $2,000 (1-.2) = $1,600 deferred comp. yields $2,000 (1-.5)/1.05 = $952 The employer prefers deferred compensation: current salary costs $2,000 (1-.4) = $1,200 deferred comp. costs $2,00
10、0 (1-.6)/1.05 = $762 15.518 Fall 2002 Sessions 9 and 10 Can employer be made better off while holding the employee indifferent? To hold the employee indifferent, she must receive the equivalent of $952 after tax in present value: Salary Deferred Comp. S(1-.2) = $952 $2,000(1-.5)/1.05= $952 S = $1,19
11、0 Now evaluate whether the employer still prefers $2,000 of deferred compensation: Salary Deferred Comp. $1,190 (1-.4) versus $2,000(1-.6)/1.05= $762 = $714 15.518 Fall 2002 Sessions 9 and 10 Can employee be made better off while holding the employer indifferent? To hold the employer indifferent, sh
12、e must face a compensation cost equivalent to $762 after tax in present value: Salary Deferred Comp. S(1-.4) = $762 $2,000(1-.6)/1.05= $762 S = $1,270 Now evaluate what the employee prefers: Salary Deferred Comp. $1,270 (1-.2) versus $2,000(1-.5)/1.05= $952 = $1,016 15.518 Fall 2002 Sessions 9 and 1
13、0 Can both be made better off? YES -any current salary between $1,190 and $1,270 will make both parties better off. (See below for $1,225) Employer is better off because PV after tax cost of $1,225 salary is less than the PV after tax cost of $2,000 of deferred compensation: $1,225(1-.4) - $2,000(1-
14、.6)/1.05 = $735 - $762 = -$27 Employee is better off because PV after tax benefit of $1,225 salary is more than the PV after tax benefit of $2,000 of deferred compensation: $1,225 (1-.2) - $2,000(1-.5)/1.05= $980 - $952 = $28 15.518 Fall 2002 Sessions 9 and 10 Nontax Costs of Salary & Deferred Compe
15、nsation Moral Hazard - If we pay an employee a fixed salary with no “deferred component,” the employee has no incentive to work Risk of Employer Insolvency -In accepting a “future” component in their compensation, employees are accepting the risk that the employer will go bankrupt 15.518 Fall 2002 S
16、essions 9 and 10 Salary vs. Fringe Benefits What are the benefits of a fringe benefit such as employer- supplied life and health insurance? Fringe benefits are deductible by the employer and tax exempt to the employee From a strictly tax perspective, this is the “best” way to be compensated Would an
17、y employees prefer salary over the tax exempt benefits? 15.518 Fall 2002 Sessions 9 and 10 Qualified Plans (“Pensions”) Defined Contribution - the employer makes a contribution into an account that will accumulate pension benefits on behalf of the employee -contributions are fixed while outcomes dep
18、end on returns earned Defined Benefit -the employer promises the employee a fixed benefit at retirement, based on salary and/ or years of service, usually in the form of an annuity 15.518 Fall 2002 Sessions 9 and 10 Salary vs. Pension Employer doesnt care -gets deduction either way Employee investme
19、nt grows to: Pension: P = (1+Rcn)n(1-tpn) Salary: S = (1-tpo)(1+rpn)n where: Rcn = before-tax return on pension = after-tax return on employees investments tpo (tpn) = employees tax return today (in period n) rpn When P S prefer pensions 15.518 Fall 2002 Sessions 9 and 10 Deferred Compensation vs. P
20、ension Employer is indifferent between dollar of current salary and deferred compensation of $D when: D(1-tcn) / (1+rcn)n = $1(1-tco) D = (1-tco) (1+rcn)n / (1-tcn) Employees after tax deferred compensation d = D(1-tpn) 15.518 Fall 2002 Sessions 9 and 10 Deferred Compensation vs. Pension A dollar co
21、ntributed to a pension plan would yield the following at year n: p = (1+Rcn)n(1-tpn) When p d then employee prefers pension to deferred compensation Note: Employee tax rates are irrelevant because under both cases, employees pay tax in year n Employer tax rates matter because with a pension, the ded
22、uction is immediate 15.518 Fall 2002 Sessions 9 and 10 Why use “Stock Compensation” Plans in Rewarding Executives? Stock compensation plans provide rewards based on an increase in the value of a companys equity Plans provide for a direct link between executive compensation and shareholder returns -i
23、f executive performance improves the value of the company, both gain 15.518 Fall 2002 Sessions 9 and 10 % of Firms with Long-term Plans Any Plan Options Stock App. Rights Restricted Stock Performance Plans Financials Industrials Utilities Services Private 83% 91% 54% 88% 33% 75% 85% 39% 83% NA 45% 3
24、6% 34% 25% NA 33% 32% 15% 42% NA 42% 40% 4% 33% NA 15.518 Fall 2002 Sessions 9 and 10 “Stock Compensation” Plans Incentive stock options: A right granted by an employer to an employee to purchase stock at a particular price during a specific period of time Non-qualified stock options: A right grante
25、d by an employer to purchase stock at a particular price during a specific period of time Stock appreciation rights: Employee receives the appreciation in value of a specified # of shares Many others 15.518 Fall 2002 Sessions 9 and 10 Options Stock options are the most commonly used form of equity b
26、ased compensation (employed by over 80% of companies) Tax and financial reporting consequences can occur at 3 different points in time: Grant date Exercise date Final sale date 15.518 Fall 2002 Sessions 9 and 10 Incentive Stock Options (ISOs) ISO grant can only be made to an employee Option exercise
27、 price must be 100% or more of FMV at date of grant (110% if employee is 10% shareholder of the company) The life of the option cannot exceed 10 years Value of options exercised in any one year is limited to $100,000 (options exercised in excess of $100,000 become NQSOs) Option must be held 2yr (1yr
28、) from grant (exercise) date 15.518 Fall 2002 Sessions 9 and 10 Incentive Stock Options (ISOs) Federal Taxes - Employee Employee does not recognize income upon grant or exercise of an ISO Appreciation in value from the grant date to the final sale date is long-term capital gain Federal Taxes - Employer No deduction for compensation expense is allowed 15.518 Fall 2002 Sessions 9 and 10 Incentive Stock Options (ISO
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