SMChap 012

Chapter 12 - Compensation
Chapter 12
Compensation
SOLUTIONS MANUAL
Discussion Questions:
1.
[LO 1] {Planning}Shane is an employee who has had a relatively consistent income

over the years. His withholding is pretty much right on target with his actual tax
liability, so he rarely has much of a tax refund or tax due with his tax return. At the
beginning of this year, Shane sold some property at a large gain. What issues relating to
withholding should Shane consider? What would you advise him to do?
The primary issue for Shane is deciding how to pay the taxes that he will owe due to the
gain on the property. It appears that his current withholding will not be enough to cover
the tax liability. Shane has several options with respect to withholding.
First, he could immediately complete a new Form W4 to decrease the number of
withholding allowances in order to increase the amount of taxes withheld from each
paycheck so that by the end of the year he will have enough tax withheld. Instead of
decreasing allowances, he could simply specify an additional amount to be withheld
from each paycheck so that the tax liability is covered by the end of the year.
Second, because tax withholding is generally treated as though it is made evenly
throughout the year, he could wait until his last few paychecks and have enough extra
tax withheld to cover the liability. This approach has the advantage of providing Shane
with an interest-free loan from the government until he pays the taxes. But, it may mean
that Shane wont have much cash flow for the last few paychecks of the year.
Finally, he could make an estimated tax payment, or he could wait and pay the tax with
the return. He may end up paying interest and penalties if he waits to pay tax with the
return.
2.
[LO 1] {Planning} Juanita recently started employment for Maple Corporation. For
tax purposes, Juanita files as a head-of-household filing status with three dependents.
Juanita needs to determine the number of withholding exemptions to claim on her W-4
form. Should she claim four withholding exemptions or should she claim more? What
factors should she consider in making this determination?
When she files her tax return, Juanita will be able to claim one personal exemption and
three dependency exemptions. These exemptions will reduce her taxable income and
correspondingly reduce her tax liability. So, when Juanita completes her W-4 form,
should she claim four withholding exemptions? In general, the withholding tables are
designed so that taxpayers will have withholding taxes fairly close to the amount of their
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actual tax liability when they claim the same number of withholding allowances as the
number of personal and dependency exemptions they are claiming on their tax return.
However, this is only a general rule. In certain circumstances, the taxpayer may need to
adjust her withholding exemptions in order to have the proper amount of taxes withheld.
For example, the withholding tables anticipate that the taxpayer will use the standard
deduction and will not itemize deductions. So, if the taxpayer is itemizing deductions,
the taxpayer may need to claim more withholding exemptions than personal and
dependency exemptions to ensure that she doesnt have more taxes than necessary
withheld.
Also the tables assume that the taxpayers salary is her only source of income.
Consequently, taxpayers with an income earning (employed or self-employed) spouse
may need to adjust their exemptions to account for this. Further, because taxpayers
with high incomes may be subject to the alternative minimum tax or may have certain
tax benefits phased-out, taxpayers with high incomes may need to report a different
number of withholding exemptions than personal exemptions.
Finally, because the tables dont anticipate that the taxpayer will have deductible losses,
taxpayers with deductible losses (e.g., capital losses, flow through losses from owned
entities, and rental losses), may need to increase their withholding exemptions above the
number of personal and dependency exemptions. Juanita may have these and other
reasons why she should claim more or less withholding exemptions than the number of
personal and dependency exemptions she will be claiming on her tax return. She will
need to project her income and tax liability for the year in order to determine the
appropriate amount of withholding tax to be withheld and the corresponding number of
withholding exemptions to claim.
3.
[LO 1] Nicole and Braxton are each 50 percent shareholders of NB Corporation.

Nicole is also an employee of the corporation. NB is a calendar-year taxpayer and uses
the accrual method of accounting. The corporation pays its employees monthly on the
first day of the month after the salary is earned by the employees. What issues must NB
consider with respect to the deductibility of the wages it pays to Nicole if Nicole is
Braxtons sister? What issues arise if Nicole and Braxton are unrelated?
If Nicole and Braxton are sister and brother, according to 267(b) of the Internal
Revenue Code Nicole and NB Corporation are considered to be related parties.
Nicole is treated as owning her 50 percent and her brothers 50 percent for a total of
100 percent ownership. Because NB and Nicole are related, NB is not allowed to deduct
the salary expense it accrued for book purposes on the salary it owes to Nicole until the
year in which Nicole recognizes income. This does not cause any issues until the last
paycheck of the year. For book purposes, NB accrues and deducts Nicoles
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December salary but for tax purposes, NB is not able to deduct the salary until January
1 when Nicole receives her check.
If Nicole and Braxton are unrelated, Nicole would own 50 percent of NB, and she would
not be considered a related party to NB because she does not own more than 50 percent
of NB. NB is allowed to deduct the compensation earned by Nicole in December of the
prior year as long as it pays the compensation within 2 months of year end (by March
15). In this case, NB pays the compensation at the beginning of January, so it would be
allowed to deduct the compensation expense it accrued in December for Nicole.
4.
[LO 1] Holding all else equal, does an employer with a higher marginal tax rate or
lower marginal tax rate have a lower after-tax cost of paying a particular employees
salary? Explain.
Holding all else equal (including the amount of the employees salary) an employer with
a higher marginal tax rate will have a lower after-tax cost of paying an employees
salary. The reason is that the employers after-tax cost of the salary is the before tax
cost minus the tax savings from deducting the employees salary. The tax savings from a
deduction are greater with the higher the marginal tax rate. Because the high marginal
tax rate employer has greater tax savings from deducting the employees salary, the high
marginal tax rate employer has a lower after-tax cost of paying the employees salary.
5.
[LO 1] What are nontax reasons why a corporation may choose to cap its executives
salaries at $1 million?
A corporation may choose to cap its executives salaries at $1 million, even if it is not
concerned about the loss of the tax deduction, to send a signal to shareholders. Not
exceeding the limit signals to the shareholders that the corporation is being fiscally
responsible by (1) not overpaying executives, and (2) ensuring that all compensation
paid to executives is tax deductible. Again, the focus here is the signal this policy sends
to the shareholders and not the actual tax benefits derived by capping salaries at $1
million.
6.
[LO 1] What are tax reasons why a corporation may choose to cap its executives
salaries at $1 million?
Corporations may cap their executives salaries at $1 million to ensure that the
company is able to deduct the compensation expense for the full amount of the (nonperformance based) salary. This is important because the government effectively
subsidizes the (non-performance based) salary up to $1 million dollars. This means for
a corporation in a 35 percent marginal tax bracket, the government would effectively be
paying $350,000 of the first $1 million in salary.
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However, for salary above $1 million, if the executive is the CEO or one of the other
four highest compensated officers, the government does not allow a tax deduction.
Consequently, the government does not subsidize this excess salary which makes the
salary above $1 million more expensive to provide, on an after-tax basis, than salary up
to $1 million.
7.
[LO 1] Lea is a highly paid executive with MCC, Inc., a publicly traded corporation.
What are the circumstances under which MCC will be able to deduct more than $1
million of compensation paid to Lea during the year?
This question deals with the 162(m) limitation on salary deductibility and its
exceptions. First, the 162(m) limitation applies to the CEO and the four other most
highly compensated officers. If Lea does not fit this description, MCC would be able to
deduct the full salary paid to Lea even if it exceeds $1 million. Second, 162(m)
provides exceptions to the general rule limiting the deductibility of compensation paid to
the CEO and the other four most highly compensated officers. The $1 million deduction
limitation does not apply to compensation that is (1) based on the companys
performance, (2) commission based, (3) in the form of a contribution to a qualified
retirement plan, and (4) compensation provided in the form of tax free benefits.
8.
[LO 2] From an employee perspective, how are incentive stock options treated
differently than nonqualified stock options for tax purposes? In general, for a given
number of options, which type of stock option should employees prefer?
Unlike nonqualified stock options, the bargain element of incentive stock options is not
included in the employees regular taxable income on the exercise date. Instead, the
bargain element present on the exercise date is deferred until the stock acquired from
the option exercise is sold. Further, with incentive stock options, the bargain element is
treated as long-term capital gain rather than ordinary income when the stock is sold.
For these reasons, employees generally prefer incentive stock options over an equivalent
number of nonqualified options.
9.
[LO 2] From an employer perspective, how are incentive stock options treated
differently than nonqualified stock options for tax purposes? In general, for a given
number of options, which type of stock option should employers prefer?
In contrast to nonqualified options, employers never receive a deduction related for
incentive stock options. Thus, employers generally prefer (unless the employers
marginal rate is 0 percent) nonqualified options over an equivalent number of incentive
stock options.
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10.
[LO 2] Why do employers use stock options in addition to salary to compensate their
employees? For employers, are stock options treated more favorably than salary for tax
purposes? Explain.
Because stock options reward employees for making choices that increase the share
price of the corporations where they are employed, this form of compensation is
considered to be superior to salary in terms of motivating employees to behave more like
ownersstock options align the incentives of employees and owners. In addition,
employers may use stock options to compensate their employees without a cash outlay.
Employers also use stock options to circumvent the $1 million 162(m) deduction
limitation on non-performance based salary payments to key executives because options
are considered to be a form of performance-based pay. Other than this advantage, there
is no other tax advantage to using options over regular salary to compensate employees,
because, at best, the bargain element from options exercises provides an ordinary
deduction for employers in the year of exercise.
11.
[LO 2] What is a disqualifying disposition of incentive stock options, and how

does it affect employees who have exercised incentive stock options?
In order to receive the favorable tax treatment afforded incentive stock options,
employees acquiring shares by exercising ISOs must hold the shares for at least 2 years
after the grant date and 1 year after the exercise date. Shares acquired with ISOs and
sold prior to meeting these holding period requirements trigger a disqualifying
disposition. Because disqualifying dispositions cause incentive stock options to be
treated as nonqualified options for tax purposes, the bargain element is taxed at the time
of sale at ordinary rates.
12.
[LO 2] Compare and contrast how employers record book and tax expense for stock
options.
Under ASC 718, employers expense the economic value of option grants (determined on
the grant date) ratably over the vesting period for book purposes for both incentive and
nonqualified stock options. For tax purposes, employers expense the bargain element
when nonqualified options are exercised. However, employers never receive a tax
deduction for incentive stock options.
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13.
[LO 2] How is the tax treatment of restricted stock different from that of
nonqualified options? How is it similar?
Employees with nonqualified options are taxed at ordinary rates on the bargain element
of the shares received on the date of exercise. In contrast, employees receiving
restricted stock are taxed at ordinary rates on the fair market value of the shares on the
date the restricted stock vests. The tax treatment of the two is similar in that both are
taxed at ordinary rates.
14.
[LO 2] Matt just started work with Boom Zoom, Inc., a manufacturer of credit card
size devices for storing and playing back music. Due to the popularity of their devices,
analysts expect Boom Zooms stock price to increase dramatically. In addition to his
salary, Matt received Boom Zoom restricted stock. How will Matts restricted stock be
treated for tax purposes? Should Matt consider making the section 83(b) election?
What are the factors he should consider in making this decision? From a tax
perspective, would this election help or hurt Boom Zoom?
If Matt doesnt make the 83(b) election, the fair market value of the stock on the vesting
date will be included in Matts salary income in the year the stock vests. Boom Zoom,
Inc. will take a corresponding ordinary deduction in the same year Matt includes the
value of the stock in his salary. If Matt makes an 83(b) election, he will include the fair
market value of the stock on the grant date in his salary income in the year of grant and
Boom Zoom will take a deduction of the same amount as compensation expense in the
year of grant. Matt should consider making this election to accelerate income if the
current stock price of Boom Zoom is small relative to his expectation of the future share
price of Boom Zoom.
Under these conditions, the current tax Matt pays now will pale in comparison to the tax
savings generated by converting the appreciation in share price from the grant date to
the vesting date into capital gain. However, an 83(b) election under these conditions
would be detrimental to Boom Zoom because its salary deduction, although accelerated,
will be much smaller at the same before-tax cost.
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15.
[LO 2] What risks do employees making an 83(b) election on a restricted stock

grant assume?
If, after making an 83(b) election, the market value of the restricted shares stays flat
(or declines), employees will have accelerated a tax payment without receiving the
benefit of converting what would otherwise have been ordinary income into capital
gain. Moreover, if the restricted stock doesnt become vested subsequent to the 83(b)
election, employees will have reported income that they did not actually receive
(phantom income).
16.
[LO 3] Explain the differences and similarities between a fringe benefit as a form of
compensation and salary.
A fringe benefit is a non-cash form of compensation. In contrast, salary is cash
compensation. They are similar in that both fringe benefits and salary are forms of
compensation provided to an employee by an employer. Salary and taxable fringe
benefits are taxable; while non-taxable fringe benefits are not taxable.
17.
[LO 3] When an employer provides group-term life for an employee, what are the
tax consequences to the employee? What are the tax consequences for the employer?
The premiums paid for group-term life insurance coverage of up to $50,000 by an
employer on behalf of an employee is excluded from an employees income. When an
employee receives more than $50,000 of coverage, the taxpayer must recognize taxable
income based on a formula determined by the regulations. A table requires a specified
amount of income (which varies according to age) per $1,000 of life insurance coverage
exceeding the threshold. The required income is likely to differ from the amount paid for
the insurance by the employer. The cost of group-term life premiums is always
deductible by the employer.
18.
[LO 3] Compare and contrast the employers tax consequences of providing taxable
and nontaxable fringe benefits.
From an employer perspective, both non-taxable and taxable fringe benefits are both
deductible as an ordinary, necessary, and reasonable compensation expense. The
advantage of non-taxable fringe benefits to an employer is that employees may be
willing to accept less cash compensation than it costs to provide the non-taxable fringe
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benefit. This lowers the actual cost of compensating employees which is possible
through an indirect government subsidy.
19.
[LO 3] Mike is working his way through college and trying to make ends meet.
Tara, a friend, is graduating soon and tells Mike about a really great job opportunity.
She is the onsite manager for an apartment complex catering to students. The job entails
working in the office for about 10 hours a week, collecting rent each month, and
answering after-hours emergency calls. The pay is $10 per hour, plus a rent-free
apartment (worth about $500 per month). Tara then tells him the best part: the rent-free
apartment is tax-free as well. Knowing that you are a tax student, Mike asks you if the
rent-free apartment is really tax free or if this is just another scam. Explain to Mike
whether the compensation for the apartment is really a nontaxable fringe benefit.
The value of an apartment or lodging to an employee may be excluded from taxable
income if the benefit is provided for the convenience of the employer and is required as
a condition of employment. Since Mike is required to live on the premises in order to be
an onsite manager, and he does so to provide services to the other tenants he may
exclude the value of the apartment from his income as a nontaxable fringe benefit under
132.
20.
[LO 3] Assume that a friend has accepted a position working as an accountant for a
large automaker. As a signing bonus, the employer provides the traditional cash
incentive but also provides the employee with a vehicle not to exceed a retail price of
$25,000. Explain to your friend whether the value of the vehicle is included, excluded,
or partially included in the employees taxable income.
An employer can provide a qualified employee discount from an employees taxable
income because it is a nontaxable fringe benefit. A qualified employee discount is a
discount not to exceed the cost of the good to the employer. As a result, the vehicle
bonus is partially taxable. The taxable portion would be the amount of the discount
below the actual cost to manufacture the vehicle. The remaining value of the vehicle
may be received as a nontaxable fringe benefit.
21.
[LO 3] Explain why an employee might accept a lower salary to receive a

nontaxable fringe benefit. Why might an employee not accept a lower salary to receive
a nontaxable fringe benefit?
Employees prefer nontaxable benefits over an equivalent amount of salary or taxable
benefits assuming that they need the benefits (e.g., health insurance) offered by the
employer. This is because the government subsidizes the cost of qualified fringe benefits
by allowing employees to receive them tax free. Therefore, the after-tax costs of
receiving lower salary and fringe benefits (non-qualified) are usually higher than
receiving only salary and purchasing the needed benefits with after-tax dollars. An
employee might be unwilling to accept a lower salary to receive a nontaxable benefit
when the employee either doesnt value the benefit or values the benefit less than the
amount of the reduced salary.
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22.
[LO 3] Describe a cafeteria plan and discuss why an employer would provide a
cafeteria plan for its employees.
A cafeteria plan is a set of fringe benefits an employer offers to employees while
allowing employees to choose which benefits they prefer from the cafeteria menu.
The simplest plans involve merely a choice between cash and a single nontaxable
benefit; while others offer a large number of benefits. The benefits potentially available
under a cafeteria plan are limited to cash and certain statutory benefits such as medical,
disability and other accident or health plans, group-term life insurance, dependent care
assistance, adoption assistance program, and 401(k) plan contributions.
Employers provide cafeteria plans to employees because different employees may have
different needs. With cafeteria plans, the employer provides employees with benefits of
equal value but allow each employee to choose the specific benefits they desire. If the
employee doesnt want any of the fringe benefits, the employee can take cash instead.
This ensures that employees will receive equal value and does not benefit one class of
employees over another. For example, if an employer simply offers health insurance,
employees with dependents will receive more benefits than employees without
dependents. Using a cafeteria plan, an employer can provide all employees with an
amount equal to health insurance for a family. Employees with dependents can take the
health insurance; single employees can choose the less expensive single health
insurance and receive cash or another benefit with the difference.
23.
[LO 3] Explain why Congress allows employees to receive certain fringe benefits
tax-free but others are taxable?
Congress allows employees to receive certain benefits (e.g. health insurance) tax free as
a subsidy to encourage them. Many of these benefits are considered to be in the publics
interest. For example, if employees have health insurance they are less likely to fall
under Medicaid. In addition, employers are allowed a deduction. Together these
incentives should decrease the cost of health insurance and result in increased coverage.
However, benefits that are considered luxuries (e.g., country club memberships) are
generally taxed as compensation. If all fringe benefits were nontaxable, Congress would
have to increase rates or broaden the base in order to pay for the subsidy. Further
employers and employees might get very creative in their compensation arrangements
such that most of what employees receive would be in fringe benefit form.
24.
[LO 3] Explain the policy reason for including the value of country club
memberships provided to an executive as a taxable fringe benefit.
Anytime Congress provides a tax benefit (through a nontaxable fringe benefit) they must
either raise taxes, decrease spending, or increase debt. Since a country club
membership creates little or no public benefit, it is likely unwise to raise taxes, cut other
programs, or increase debt to provide a subsidy for executive perquisites or fringe
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benefits. Companies like Google are famous for supplying benefits such as first-class
dining facilities, gyms, laundry rooms, massage rooms, haircuts, carwashes, and dry
cleaning however, the value of these benefits is taxable to its employees
25.
[LO 3] Describe the circumstances in which an employee may not value a

nontaxable fringe benefit.
If a nontaxable benefit is either duplicated or unwanted, an employee generally will not
place value on the benefit. For example, if a married taxpayers spouse receives an
incredible health insurance package then the employee probably doesnt value an
incremental health insurance plan. If an employee lives within walking distance to work
they probably would not take advantage of a qualified transportation fringe benefit
(e.g., employer provided parking). In these cases, the employee would likely prefer a
cafeteria plan that allows them to choose an alternative nontaxable fringe benefit or the
ability to choose cash (taxable) instead.
Problems
26. [LO 1] {Research} Anna is single with one four-year-old child and will file Head of
Household. She earns a monthly salary in 2013 of $5,000.
a. If she claims two withholding allowances, how much will her employer withhold
from her monthly paycheck? (Hint: Go to www.irs.gov and search for
withholding tables.)
b. If she claims four withholding allowances, how much will her employer
withhold from her monthly paycheck?
c. Assuming that she has no other income, claims the standard deduction, and
claims one personal and one dependency deduction, what is Annas tax liability
for the year? How many withholding allowances should she claim to equalize
(approximately) her withholding and her tax liability?
a)
b)
c)
Publication 15 (see IRS.gov) has withholding tables for taxpayers using the wage
bracket method to compute their withholding. The table on page59 indicates that a
single taxpayer, like Anna, claiming 2 withholding allowances and receiving salary of
between $5,000, and $5,040 per month, will have $707 withheld each month.
Publication 15 (see IRS.gov) has withholding tables for taxpayers using the wage
bracket method to compute their withholding. The table on page 51 indicates that a
single taxpayer, like Anna, claiming 4 allowances and receiving salary between
$5,000, and $5,040 per month, will have $545 withheld each month.
Annas filing status will be Head of Household. Using the 2013 Tax Rate Schedule
(not the Tax Table).
AGI
Standard
Deduction
Personal
Exemption
$60,000
$8,950
$7,800
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s
Taxable
Income
Tax
$43,250
$5,850
Annas tax is $5,850 which is $4,575 [($43,250- $12,750) 15%] + $1,275. On a

monthly basis, Anna should have $488 withheld ($5,850/ 12). Using the table, if Anna
claims 4 withholding allowances her monthly withholding would be $545.
Alternatively, if Anna claims 5 allowances her monthly withholding would be $464. If
Anna claims 4 allowances, she will be over withheld. If she claims 5 allowances she
will be under withheld.
27. [LO 1] North Inc. is a calendar-year, accrual-basis taxpayer. At the end of the year 1,
North accrued and deducted the following bonuses for certain employees for financial
accounting purposes.
$7,500 for Lisa Tanaka, a 30 percent shareholder.
$10,000 for Jared Zabaski, a 35 percent shareholder.
$12,500 for Helen Talanian, a 20 percent shareholder.
$5,000 for Steve Nielson, a 0 percent shareholder.
Unless stated otherwise, assume these shareholders are unrelated.
How much of the accrued bonuses can North Inc. deduct in year 1 under the following
alternative scenarios?
a. North paid the bonuses to the employees on March 1 of year 2.
b. North paid the bonuses to the employees on April 1 of year 2.
c. North paid the bonuses to employees on March 1 of year 2 and Lisa and Jared
are related to each other, so they are treated as owning each others stock in
North.
d. North paid the bonuses to employees on March 1 of year 2 and Lisa and Helen
are related to each other, so they are treated as owning each others stock in
North.
a. North may deduct $35,000 in year 1 because they were paid within 2 months of
year end.
Employee
Deductible Year 1
Deductible Year 2
Lisa Tanaka
$7,500
Jared Zabaski
$10,000
Helen Talanian
$12,500
Steve Nielson
$5,000
$35,000
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b. North may not deduct any of the bonus in year 1 because the bonuses were not
paid within 2 months of year end. It may deduct the $35,000 of bonuses in year 2.
Employee
Deductible Year 1
Deductible Year 2
Lisa Tanaka
$7,500
Jared Zabaski
$10,000
Helen Talanian
$12,500
Steve Nielson
$5,000
$35,000
c. North may deduct $17,500 in both year 1 and year 2. Helen and Steves bonuses
are deductible in year 1 because they were paid within 2 months of year end. Lisa
and Jareds bonuses are deductible in year 2 which is the year they take the bonuses
into incomesince they are related parties (own greater than 50 percent).
Employee
Deductible Year 1
Deductible Year 2
Lisa Tanaka
$7,500
Jared Zabaski
$10,000
Helen Talanian
$12,500
Steve Nielson
$5,000
$17,500
$17,500
d. North may deduct $35,000 in year 1. All of the shareholders bonuses are
deductible in year 1 because they were paid within 2 months of year end. Helen
and Lisa are not considered to be related parties because together they own 50
percent but not more than 50 percent of North.
Employee
Deductible Year 1
Deductible Year 2
Lisa Tanaka
$7,500
Jared Zabaski
$10,000
Helen Talanian
$12,500
Steve Nielson
$5,000
$35,000
28. [LO1] {Research}Jorgensen High Tech Inc. is a calendar-year, accrual-method
taxpayer. At the end of year 1, Jorgensen accrued and deducted the following
bonuses for certain employees for financial accounting purposes.
$40,000 for Ken.
$30,000 for Jayne.
$20,000 for Jill.
$10,000 for Justin.
How much of the accrued bonuses can Jorgensen deduct in year 1 under the
following alternative scenarios?
a. Jorgensen paid the bonuses to the employees on March 1 of year 2.
b. Jorgensen paid the bonuses to the employees on April 1 of year 2.
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c. Jorgensen paid the bonuses to the employees on March 1 of year 2, and there is a
requirement that the employee remain employed with Jorgensen on the payment date
to receive the bonus.
d. Jorgensen paid the bonuses to employees on March 1 of year 2, and there is a
requirement that the employee remain employed with Jorgensen on the payment date
to receive the bonus, if not the forfeited bonus is re-allocated to the other employees.
a. Jorgensen may deduct $100,000 in year 1 because they were paid within 2
months of year end.
Employee
Deductible Year 1
Deductible Year 2
Ken
$40,000
Jayne
$30,000
Jill
$20,000
Justin
$10,000
$100,000
b. Jorgensen may deduct $100,000 in year 2 because they werent paid within 2
months of year end.
Employee
Deductible Year 1
Deductible Year 2
Ken
$40,000
Jayne
$30,000
Jill
$20,000
Justin
$10,000
$100,000
c. Jorgensen may deduct $100,000 in year 2 because they werent fixed at the end of
year 1, see Reg. 1.461-1(a)(2)(i). The amounts were not considered fixed, because
employees are eligible to receive the bonus only if they are employed on the date the
bonuses were paid. This was the holding of the Tax Court in Bennett Paper Corp
(1982) 78 TC 458.
Employee
Ken
Jayne
Jill
Justin
Deductible Year 1
Deductible Year 2
$40,000
$30,000
$20,000
$10,000
$100,000
d. Jorgensen may deduct $100,000 in year 1 because they were paid within 2
months of year end and the amounts to be paid by Jorgensen were fixedsee Reg.
1.461-1(a)(2)(i). The amounts would be considered to be fixed at the end of the year,
because if an employee leaves before the bonus is paid, the forfeited amount is
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reallocated to the other eligible employees. Thus the amount paid by Jorgensen if
fixedeven if the specific recipient hasnt been determined yet.
29. [LO 1] Lynette is the CEO of publicly traded TTT Corporation and earns a salary of
$200,000 in 2013. Assume TTT has a 35 percent marginal tax rate. What is TTT
Corporations after-tax cost of paying Lynettes salary excluding FICA taxes?
TTTs after-tax cost is $130,000, calculated as follows:
Description
Amount
Explanation
Before tax cost of salary:
(1) Salary
$200,000
(2) (1 marginal tax rate)
65% (1 35%)
After tax cost of salary
$130,000 (1) (2)
30. [LO 1] Marcus is the CEO of publicly traded ABC Corporation and earns a salary of
$1,500,000. Assume ABC has a 35 percent marginal tax rate.
a. What is ABCs after-tax cost of paying Marcuss salary?
b. Now assume that Marcus, in addition to the $1.5 million salary, earns a
performance-based bonus of $500,000. What is ABCs after-tax cost of paying
Marcuss salary?
a. ABCs after-tax cost is $1,150,000, calculated as follows:

Description
Amount
Explanation
(1) Salary
$1,500,000
Taxes:
(2) Deductible portion
$1,000,000 Maximum deduction
(3) Marginal tax rate
x
35% Given
(4)Tax deduction
$350,000 (2) (3)
$1,150,000 (1) (4)
b. ABCs after-tax cost is $1,475,000, calculated as follows:
Description
Amount
Explanation
(1) Salary
$1,500,000
(2) Performance-based
$500,000
bonus
(3) Before tax cost of salary
$2,000,000
Taxes:
(4) Deductible base salary
$1,000,000 Maximum deduction
(5)Deductible performance$500,000
12-14
based bonus
(6) Deductible pay
(8)Tax deduction
$1,500,000
35%
$525,000
$1,475,000
(4) + (5)
(6) (7)
(3) (8)
31. [LO 1] {Planning} Ramon has finally arrived. He has interviewed for the CEO position
with MMM Corporation. They have presented him with two alternative compensation
offers. Alternative 1 is for a straight salary of $2,500,000. Option 2 is for a salary of
$1,000,000 and performance-based compensation of up to $2,000,000. Assume that
Ramon has a marginal tax rate of 40 percent, MMM has a marginal tax rate of 35
percent, and ignore FICA taxes for this problem. Answer the questions under each of
the following alternative scenarios.
a. If Ramon is 100 percent certain he can meet the qualifications for the full
performance-based compensation, which offer should he choose?
b. If Ramon believes there is only a 20 percent chance that he can meet the
performance-based requirements, which offer should he choose (assume he is
risk neutral)?
c. What is MMMs after-tax cost of providing Ramon with Option 1?
d. What is MMMs expected after-tax cost of providing Ramon with Option 2 if it
believes there is a 40 percent chance Ramon will qualify for the performancebased compensation?
a)
a. Option 2 has a higher expected value:

Option 1: $2,500,000 x (1-.4) = $1,500,000
Option 2: $3,000,000 x (1-.4) = $1,800,000
b)
Option 2 would be better from an expected value standpoint.

Option 1: $2,500,000 x (1-.4) = $1,500,000
Option 2: ($1,000,000 x (1-.4)) + ($2,000,000 x (1-.4) x 20%) = $840,000
c)
d)
32.
Option 1 would be better from an expected value standpoint.

Option 1: ($1,000,000 (1-.35)) + ($1,500,000 (1-.0)) = $2,150,000
Option 2: ($1,000,000 (1-.35)) + ($2,000,000 (1-.35) x 40%) = $1,170,000
[LO 2] {Tax Forms}Cammie received 100 NQOs (each option provides a right to
purchase 10 shares of MNL stock for $10 per share) at the time she started working for
MNL Corporation four years ago when MNLs stock price was $8 per share. Now that
12-15
MNLs stock price is $40 per share, she intends to exercise all of her options. After
acquiring the 1,000 MNL shares with her options, she held the shares for over one year
and sold them at $60 per share.
a. What are Cammies tax consequences on the grant date, the exercise date, and
the date she sold the shares assuming her ordinary marginal rate is 30 percent
and her capital gains rate is 15percent?
b. What are MNL Corporations tax consequences on grant date, exercise date, and
date of sale assuming its marginal tax rate is 35 percent?
c. Complete Cammies Schedule D for the year of sale.
a. Cammie recognizes $30,000 of ordinary income and pays tax of $9,000 in the
year of exercise, the calculations are as follows:
Description
(1) Shares acquired
(2) Exercise price
(3) Cash needed to exercise
(4) Market price
(5) Market value of shares
(6) Bargain Element (ordinary income)
(7) Marginal Tax Rate
Tax due in year of exercise
Amount
1,000
$10.00
$10,000
$40
$40,000
$30,000
30%
$9,000
Explanation
(100 10 shares)
(1) (2)
(1) (4)
(5) (3)
(6) (7)
She also recognizes $20,000 of capital gain and pays tax of $3,000 in the year of
sale, the calculations are as follows:
Description
(7) Shares acquired with NQOs
(8) Market price at sale
(9) Amount Realized
(10) Basis
(11) Long-term capital gain
Amount
1,000
$60.00
$60,000
$40,000
$20,000
15%
$3,000
Explanation
(1)
(7) x (8)
(5)
(9) - (10)
(11) x (12)
b. MNL has no tax consequences on the grant date or sale date. MNL does receive a
deduction equal to the $30,000 (line (6) above) bargain element on the date Cammie
exercises the options. This will reduce MNLs tax burden by $10,500.
c. See form below:
12-16
12-17
33. [LO 2] {Planning} Yost received 300 NQOs (each option gives Yost the right to
purchase 10 shares of Cutter Corporation stock for $15 per share) at the time he
started working for Cutter Corporation three years ago. Cutters stock price was $15
per share. Yost exercises all of his options when the share price is $26 per share.
Two years after acquiring the shares, he sold them at $47 per share.
a. What are Yosts tax consequences (amount of income/gain recognized and
amount of taxes payable) on the grant date, the exercise date, and the date he
sells the shares, assuming his ordinary marginal rate is 35 percent and his longterm capital gains rate is 15 percent?
12-18
b. What are Cutter Corporations tax consequences (amount of deduction and tax
savings from deduction) on the grant date, the exercise date, and the date Yost
sells the shares assuming its marginal tax rate is 25 percent?
c. Assume that Yost is cash poor and needs to perform a same-day sale in order to
buy his shares. Due to his belief that the stock price is going to increase
significantly, he wants to maintain as many shares as possible. How many shares
must he sell in order to cover his purchase price and taxes payable on the
exercise?
d. Assume that Yosts options were exercisable at $20 and expired after five years.
If the stock only reached $18 dollars during its high point during the five-year
period, what are Yosts tax consequences on the grant date, the exercise date, and
the date the shares are sold, assuming his ordinary marginal rate is 35 percent
and his long-term capital gains rate is 15 percent?
a. Yost has no tax consequences on the grant date.
Yost recognizes $33,000 of ordinary income and pays tax of $11,550 in the year
of exercise, the calculations are as follows:
Description
(1) Shares acquired
(2) Exercise price
(4) Market price
(8) Tax due in year of exercise
Amount
3,000
$15.00
$45,000
$26
$78,000
$33,000
35%
$11,550
Explanation
(300 x 10 shares)
(1) (2)
(1) (4)
(5) (3)
(6) x (7)
He also recognizes $63,000 of capital gain and pays tax of $9,450 in the year of
Description
(11) Amount Realized
(12) Basis
Tax due in year of sale
Amount
3,000
$47.00
$141,000
$78,000
$63,000
15%
$9,450
Explanation
(1)
(9) (10)
(5)
(11) - (12)
(13) (14)
b. Cutter has no tax consequences on the grant date or sale date. Cutter does
receive a deduction equal to the $33,000 (line (6) above) bargain element on
the date Yost exercises the options. Cutters taxes are reduced by $8,250.
12-19

(3) Tax benefit in year of exercise
$33,000
25%
$8,250
(6) above
(1) (2)
c. Yost must sell 2,175 shares to pay the $56,550 ($45,000 to exercise plus
$11,550 of tax) to complete the same day sale, the calculations are as
follows:
Description
(2) Tax due at exercise
(3) Cash needed for same-day sale
(4) Market price
(5) Shares needed to be sold
Amount
$45,000
$11,550
$56,550
$26
2,175
Explanation
(3) from part a
(8) from part a
(1) + (2)
(3) / (4)
d. Yost would not have exercised the options because the market price never
exceeded the strike price. As a result the options would expire unexercised
and there will be no tax consequences for either Yost or Cutter.
34.
[LO 2] Haven received 200 NQOs (each option gives him the right to purchase 20
shares of Barlow Corporation stock for $7 per share) at the time he started working for
Barlow Corporation three years ago when its stock price was $7 per share. Now that
Barlows share price is $50 per share, he intends to exercise all of his options. After
acquiring the 4,000 Barlow shares with his options, he intends to hold the shares for
more than one year and then sell the shares when the price reaches $75 per share.
a. What are the tax consequences of these transactions to Haven assuming his
ordinary marginal rate is 30 percent and his long-term capital gains rate is 15
percent?
b. What are the tax consequences for Barlow Corporation resulting from Havens
option exercise if Barlows marginal tax rate is 35 percent?
12-20
a. Haven has no tax consequences on the grant date.

Haven has an outflow of $28,000 on the exercise. Haven recognizes $172,000 of
ordinary income and pays tax of $51,600 in the year of exercise, the calculations
are as follows:
Description
(1) Shares acquired
(2) Strike price
(4) Market price
Amount
4,000
$7.00
$28,000
$50
$200,000
$172,000
30%
$51,600
Explanation
(200 x 20 shares)
(1) (2)
(1) (4)
(5) (3)
(6) (7)
He also recognizes $100,000 of capital gain and pays tax of $15,000 in the year of
Description
(12) Basis
Amount
4,000
$75.00
$300,000
$200,000
$100,000
15%
$15,000
Explanation
(1)
(9) (10)
(5)
(11) - (12)
(13) (14)
b. Barlow has no tax consequences on the grant date or sale date. Barlow does
receive a deduction equal to the $172,000 (line (6) above) bargain element on the
date Haven exercises the options.
12-21

(3) Tax benefit in year of exercise
35.
$172,000
35%
$60,200
(6) above
(1) (2)
[LO 2] Mark received 10 ISOs at the time he started working for Hendricks
Corporation five years ago when Hendrickss price was $5 per share (each option gives
him the right to purchase 10 shares of Hendricks Corporation stock for $5 per share).
Now that Hendrickss share price is $35 per share, he intends to exercise all options and
hold all of his shares for more than year. Assume that more than a year after exercise,
Mark sells the stock for $35 a share.
a. What are Marks tax consequences on the grant date, the exercise date, and the
date he sells the shares assuming his ordinary marginal rate is 30 percent and his
long-term capital gains rate is 15 percent?
b. What are Hendrickss tax consequences on these dates assuming its marginal tax
rate is 25 percent?
a. Mark has no tax consequences on the grant date.
Mark has no regular income tax consequences on the exercise date, but
recognizes $3,000 for AMT, the calculations are as follows:
Description
(1) Shares acquired
(2) Exercise price
(4) Market price
(6) Bargain Element (AMT
Amount
100
$5.00
$500
$35
$3,500
$3,000
Explanation
(10 x 10 shares)
(1) (2)
(1) (4)
(5) (3)
preference)*
*The bargain element is includable in AMTI, which may cause Mark to pay AMT.
12-22
In the year of sale, Mark recognizes $3,000 of long-term capital gain and pays tax of
$450, the calculations are as follows:
Description
(9) Amount Realized
(10) Basis
Amount
100
$35.00
$3,500
$500
$3,000
15%
$450
Explanation
(1)
(7) (8)
(3) above
(9) - (10)
(11) (12)
b. Hendricks has no tax consequences on the grant date, exercise, or sale date because
the options are ISOs.
36.
[LO 2] Antonio received 40 ISOs at the time he started working for Zorro
Corporation six years ago (each option gives him the right to purchase 20 shares of
Zorro stock for $3 per share). Zorros share price was $3 per share at the time. Now
that Zorros share price is $50 per share, he intends to exercise all of his options and
immediately sell all the shares he receives from the options exercise.
a. What are Antonios tax consequences on the grant date, the exercise date, and the
date the shares are sold assuming his ordinary marginal rate is 30 percent and his
b. What are Zorros tax consequences on these dates assuming its marginal tax rate
is 25 percent?
c. What are the cash flow effects of these transactions to Antonio assuming his
ordinary marginal rate is 25 percent and his long-term capital gains rate is 15
percent?
d. What are the cash flow effects to Zorro Corporation resulting from Antonios
option exercise if Zorros marginal tax rate is 35 percent?
12-23
a. Antonio has no tax consequences on the grant date.

Since Antonio exercises and sells the shares immediately he has a disqualifying
disposition of ISOs, so they are treated like NQOs. Antonio recognized $37,600
of ordinary income and pays $11,280 in taxes, the calculations are as follows:
Description
(1) Shares acquired
(2) Exercise price
(4) Market price
(5) Amount Realized
(6) Basis
(7) Bargain Element/Ordinary Income
Tax paid in year of sale
Amount
800
$3.00
$2,400
$50
$40,000
$2,400
$37,600
30%
$11,280
Explanation
(40 x 20 shares)
(1) (2)
(1) (4)
(3) above
(5) - (6)
(7) (8)
b. Because the options are treated like NQOs, Zorro has a deduction of $37,600
and tax savings of $9,400, calculated as follows:
Description
(1) Bargain Element
(4) Ordinary Marginal Tax Rate
Tax benefit when shares vest
Amount
$37,600
25%
$9,400
Explanation
From line 7 above
(1) (2)
c. Antonio has no cash flow consequences on the grant date.

Since Antonio exercises and sells the shares immediately he has a net cash
inflow of $28,200. The disqualifying disposition of ISOs is treated like NQOs.
Antonio recognized $40,000 (see line 5) of cash and he pays $2,400 (see line 3)
for the stock and $9,400 (see last line) in taxes, the tax calculations are as
follows:
12-24
Description
(1) Shares acquired
(2) Exercise price
(4) Market price
(5) Amount Realized
(6) Basis
(7) Bargain Element/Ordinary Income
Tax paid in year of sale
Amount
800
$3.00
$2,400
$50
$40,000
$2,400
$37,600
25%
$9,400
Explanation
(40 x 20 shares)
(1) (2)
(1) (4)
(3) above
(5) - (6)
(7) (8)
d. Zorro has positive cash flow of $15,560. Because the options are treated like
NQOs, Zorro has tax savings of $13,160, and $2,400 of cash proceeds from
Antonio (from line 6 above) calculated as follows:
Description
(1) Bargain Element
Amount
$37,600
35%
$13,160
Explanation
From line 7 above
(1) (2)
12-25
37.
[LO 2] {Planning} Harmer Inc. is now a successful company. In the early days
(before it became profitable), it issued incentive stock options (ISOs) to its employees.
Now Harmer is trying to decide whether to issue nonqualified options (NQOs) or ISOs
to its employees. Initially, Harmer would like to give each employee 20 options (each
option allows employees to purchase one share of Harmer stock). For purposes of this
problem, assume that the options are exercised in three years (three years from now) and
that the underlying stock is sold in five years (five years from now). Also assume the
following facts:
The after-tax discount rate for both Harmer, Inc. and its employees is 10
percent.
Corporate tax rate is 35 percent.
Personal (employee) ordinary income rate is 40 percent.
Personal (employee) capital gains rate is 15 percent.
Exercise price of the options is $7.
Market price of Harmer at date of grant is $5.
Market price of Harmer at date of exercise is $25.
Market price of Harmer at date of sale is $35.
Answer the following questions:

a.
Considering these facts, which type of option plan, nonqualified (NQO) or

incentive (ISO), should Harmer Inc. prefer? Explain?
b.
Assuming Harmer issues NQOs, what is Harmers tax benefit from the
options for each employee in the year each employee exercises the NQOs?
c.
Assuming Harmer issues ISOs, what is the tax benefit to Harmer in the year
the ISOs are exercised?
d.
Which type of option plan should Harmers employees prefer?
e.
What is the present value of each employees after-tax cash flows from year 1
through year 5 if the employees receive ISOs?
f.
What is the present value of each employees after-tax cash flows from year 1
through year 5 if the employees receive NQOs?
g.
How many NQOs would Harmer have to grant to keep its employees
indifferent between NQOs and 20 ISOs?
a. Harmer would prefer to issue NQOs. Profitable companies receive a tax
benefit equal to the employees bargain element upon exercise. In contrast,
Harmer receives no tax benefit if ISOs are used.
b. Harmers per employee tax benefit upon exercise of the NQOs is $126,
calculated as follows:
12-26
Description
(1) Shares acquired
(2) Exercise price
(4) Market price
(6) Bargain Element
Tax benefit in year of exercise
Amount
20
$7.00
$140
$25
$500
$360
35%
$126
Explanation
(20 x 1 shares)
(1) (2)
(1) (4)
(5) (3)
(6) (7)
c. Harmers per employee tax benefit upon exercise of the ISOs is $0, because
employers receive no deduction upon an ISO exercise.
d.
Harmers employees would prefer ISOs because the bargain element isnt
taxed upon exercise (creating tax deferral) and if held for more than one year
after exercise the entire amount is taxed at preferential capital gains rates.
e. The present value of ISOs to each employee is $277.40, calculated as

follows:
Description
(1) Shares acquired
(2) Exercise price
(4)Present Value Factor
(5) Present Value of Cash to Exercise
Amount
Description
(6) Shares acquired
(7) Market Price at Sale
(8) Amount Realized
(9) Basis in Stock
(11)Marginal Tax Rate
(12) Tax paid on capital gain in year of
Amount
20
$7.00
$140
.751
$105.14
20
$35.00
$700
$140
$560
15%
$84
sale
(13) Net cash inflow at sale
(15) Present Value of Sale Proceeds
Present Value of ISOs
$616
.621
$382.54
$277.40
Explanation
(20 x 1 shares)
(1) x (2)
10% discount rate for 3 years
(3) x (4)
Explanation
(20 x 1 shares)
(6) x (7)
(3)
(8) - (9)
(10) x (11)
(8) - (12)
(13) x (14)
(15)- (5)
f. The present value of NQOs to each employee is $202.79, calculated as

follows:
Description
Amount
Explanation
12-27
(1) Shares acquired

(2) Exercise price
(4) Market price
(6) Bargain Element
(8) Tax paid on bargain element in year
20
$7.00
$140
$25
$500
$360
40%
$144
of exercise
(9) Cash outflows at exercise date
(11) Present Value of Cash to Exercise
Description
(12) Shares acquired
(13) Market Price at Sale
(15) Basis in stock
(18) Tax paid on capital gain in year of
$284
.751
$213.28
Amount
20
$35.00
$700
$500
$200
15%
$30
sale
(19) Net cash inflow at sale
(21) Present Value of Sale Proceeds
Present Value of NQOs
$670
.621
$416.07
$202.79
(20 x 1 shares)
(1) x (2)
(1) x (4)
(5) (3)
(6) x (7)
(3)+(8)
(9) x (10)
Explanation
(20 x 1 shares)
(6) x (7)
from (5) above
(14)-(15)
(16) x (17)
(14) - (18)
(19) x (20)
(21)- (11)
g. The number of NQOs necessary to make employees equal to receiving ISOs

would be 28. This can be solved algebraically as follows by dividing the
present value of ISOs by the present value of NQOs and multiplying the
product by the number of ISOs received, calculated as follows:
Description
(1) PV of ISOs
(2) PV of NQOs
(3) Ratio
(4)ISOs received
(5) NQOs to break even with ISOs
NQOs to be received
Amount
$277.40
$202.79
1.368
20
27.36
28
Explanation
Part e, line 16
Part f, line 22
(1) / (2)
(3) x (4)
Line 5 rounded up to nearest
whole option
Alternatively, the solution can be obtained algebraically as follows:

12-28
First, lets find out how many additional NQOs Harmer would have to grant to their
employees to keep them indifferent between receiving ISOs and NQOs.
We already determined above that the after-tax present value to each employee of receiving
ISOs is $277.40. In essence, we have to give each employee enough additional NQOs so
that on an after-tax basis the present value of receiving NQOs is $277.40.
By solving the following equation for the variable X, we can determine how many total
NQOs each employee should be given to keep them indifferent across the two alternatives:
12-29
Cash Outflows in 3 Years
Cash Flows in 5 Years
277.40 = .751{-X options [$7 + ($25-$7)(40%)]} + .621{X shares [$35 ($35-$25)(15%)]}
Strike Price
Tax on Bargain
Element
Selling Price
Capital Gains Taxes
What? You thought the algebra you learned back in high school would never be good for
anything? Solving for X:
X = 27.37 NQOs. Well assume Harmer does not want to issue fractional shares, so well
round up to 28 NQOs. So, Harmer will have to give each employee 8 more NQOs than
ISOs to keep them indifferent.
38.
[LO 2] On January 1, year 1, Dave received 1,000 shares of restricted stock from his
employer, RRK Corporation. On that date, the stock price was $7 per share. Daves
restricted shares will vest at the end of year 2. He intends to hold the shares until the
end of year 4 when he intends to sell them to help fund the purchase of a new home.
Dave predicts the share price of RRK will be $30 per share when his shares vest and will
be $40 per share when he sells them.
a. If Daves stock price predictions are correct, what are the tax consequences of
these transactions to Dave if his ordinary marginal rate is 30 percent and his
b. If Daves stock price predictions are correct, what are the tax consequences of
these transactions to RRK if its marginal rate is 35 percent?
a. Dave has no tax consequences on the grant date. On the vesting date he will
recognize ordinary income of $30,000 and pay taxes of $9,000, which is
Description
(1) Shares acquired
(2) FMV at vesting date
(3) Ordinary income on vesting date
(5) Tax due when shares vest
Amount
1,000
$30.00
$30,000
30%
$9,000
Explanation
(1) x (2)
(3) x (4)
12-30
Dave will owe $1,500 on the sale date, which is calculated as follows:
Description
(6) Amount realized
(7) Adjusted basis
(9) Preferential Marginal Tax Rate
Tax due when shares sold
Amount
$40,000
30,000
$10,000
15%
$1,500
Explanation
1,000 shares x $40 per share
From line 3 above.
(6) (7)
(8) x (9)
b. RRK will receive a tax benefit of $10,500 on the vesting date, which is calculated
as follows:
Description
(1) Shares acquired
(3) Ordinary deduction on vesting date
Amount
1,000
$30.00
$30,000
35%
$10,500
Explanation
(1) x (2)
(3) x (4)
RRK receives no benefit on the grant date or when Dave sells the shares.
39.
[LO 2] On January 1, year 1, Dave received 1,000 shares of restricted stock from his
employer, RRK Corporation, On that date, the stock price was $7 per share. On
receiving the restricted stock, Dave made the 83(b) election. Daves restricted shares
will vest at the end of year 2. He intends to hold the shares until the end of year 4 when
he intends to sell them to help fund the purchase of a new home. Dave predicts the
share price of RRK will be $30 per share when his shares vest and will be $40 per share
when he sells them. Assume that Daves price predictions are correct and answer the
following questions:
a. What are the tax consequences of these transactions to Dave if his ordinary
marginal rate is 30 percent and his long-term capital gains rate is 15 percent?
b. What are the tax consequences of these transactions to RRK if its marginal rate
is 35 percent?
12-31
a. Daves tax consequences on the grant date is that he will recognize $7,000 of
ordinary income and pay taxes of $2,100, which is calculated as follows:
Description
(1) Shares acquired
(2) FMV at grant date
(3) Ordinary income on grant date
(5) Tax due on grant date
Amount
1,000
$7.00
$7,000
30%
$2,100
Explanation
(1) x (2)
(3) x (4)
Dave will owe no tax on the vesting date since he made the 83(b) election.
Dave will owe $4,950 on the sale, which is calculated as follows:
Description
(6) Amount realized
(7) Adjusted basis
Amount
$40,000
7,000
$33,000
15%
$4,950
Explanation
1,000 shares x $40 per share
From line 3 above.
(6) (7)
(8) x (9)
b. RRK will receive a tax benefit of $2,450 on the grant date, which is calculated as
follows:
Description
(1) Shares acquired
(3) Ordinary deduction on vesting date
Amount
1,000
$7.00
$7,000
35%
$2,450
Explanation
(1) x (2)
(3) x (4)
RRK receives no benefit on the vesting date or when Dave sells the shares.
12-32
40.
[LO 2] On January 1, year 1, Jessica received 10,000 shares of restricted stock from
her employer, Rocket Corporation. On that date, the stock price was $10 per share. On
receiving the restricted stock, Jessica made the 83(b) election. Jessicas restricted shares
will all vest at the end of year 4. After the shares vest, she intends to sell them immediately
to fund an around-the-world cruise. Unfortunately, Jessica
decided that she couldnt wait four years and quit her job to start her cruise on
January 1, year 3.
a. What are the year 1 tax consequences of these transactions to Jessica, assuming
her marginal tax rate is 33 percent and her long-term capital gains rate is 15
percent?
b. What are the year 3 tax consequences of these transactions to Jessica, assuming
her marginal tax rate is 33 percent and her long-term capital gains rate is 15
percent?
a. If Jessica makes the 83(b) election, she will owe $33,000 which is calculated
as follows:
Description
(1) Shares acquired
(2) FMV at section 83(b) election
(3) Ordinary income on election date
Tax due at election
Amount
10,000
$10.00
$100,000
33%
$33,000
Explanation
(1) x (2)
(3) x (4)
b. If Jessica leaves before the shares vest there are no tax consequences. She will
recognize no loss and lose her compensatory basis in the restricted stock (the
$33,000 recognized at the 83(b) election).
41.
[LO 2] On May 1, year 1, Anna received 5,000 shares of restricted stock from her
employer, Jarbal Corporation. On that date, the stock price was $5 per share. On
receiving the restricted stock, Anna made the 83(b) election. Annas restricted shares
will all vest on May 1, year 3. After the shares vest, she intends to sell them
immediately to purchase a condo. True to her plan, Anna sold the shares immediately
after they were vested.
a. What are the tax consequences of these transactions to Anna in year 1?
b. What are the tax consequences of these transactions to Anna in year 3 if the
stock is valued at $1 per share on the day the shares vest?
c. What are the tax consequences of these transactions to Anna in year 3 if the stock
is valued at $9 per share on the day the shares vest?
12-33
d. What are the tax consequences of these transactions to Anna in year 3 if the stock
is valued at $5 per share on the day the shares vest?
a. If Anna makes the section 83(b) election, she will recognize $25,000 on the
election date which is calculated as follows:
Description
(1) Shares acquired
(2) FMV at section 83(b) election
Ordinary income on election date
Amount
5,000
$5.00
$25,000
Explanation
(1) x (2)
b. There are no tax consequences to Anna when the stock vests. When Anna sells
her stock for $1 a share, she will recognize a long-term capital loss of $4 per
share because her basis in each share is $5 ($20,000 loss in total).
c. There are no tax consequences to Anna when the stock vests. When Anna sells
the stock for $9 per share, she will recognize a long-term capital gain of $4 per
share because her basis in each share is $5 ($20,000 gain in total).
d. There are no tax consequences to Anna when the stock vests. When Anna sells
the stock for $5 per share, she will not recognize any capital gain or loss
because her basis in the stock is $5 per share.
42.
[LO 2] {Planning} On January 1, year 1, Tyra works for Hatch Corporation. New
employees must choose immediately between receiving seven NQOs (each NQO
provides the right to purchase for $5 per share 10 shares of Hatch stock) or 50 restricted
shares. Hatchs stock price is $5 on Tyras start date. Either form of equity-based
compensation will vest in two years. Tyra believes that the stock will be worth $15 per
share in two years and $25 in four years when she will sell the stock. Tyras marginal
tax rate is 30 percent and her long-term capital gains rate is 15 percent. Assume that
Tyras price predictions are correct, answer the following questions (ignore present
value, use nominal dollars):
a. What are the cash-flow effects to Tyra in the year she receives the options, the
year the options vest and she exercises the options, and in the year she sells the
stock if she chooses the NQOs?
b. What are the cash-flow effects to Tyra in the year she receives the restricted
stock, in the year the stock vests, and in the year she sells the stock if Tyra
chooses the restricted stock?
12-34
c. What are the cash-flow effects to Tyra in the year she receives the restricted
stock, the year the stock vests, and the year she sells the stock if she makes a
83(b) election?
d. What recommendation would you give Tyra? Explain.
a. Tyras net cash flow for the NQOs is $1,085, which calculated as follows:
Description
(1) Amount Realized
(2) Cash outflow for shares at exercise
(3) Cash outflow for taxes at exercise
(4) Cash outflow for taxes at sale
Net cash flow
Amount
$1,750
$350
$210
$105
$1,085
Explanation
Line 11 from table below
(1)-(2)-(3)-(4)
There is no cash flow on the grant date. The cash flow is negative $560 on the
exercise date ($350 for the share purchase + $210 in taxes due at exercise). The
cash flow on the sale date is $1,645 ($1,750 in sale proceeds less $105 in taxes due
on the sale date).
She must pay $350 for the shares on the exercise and pay $210 in taxes, the
calculations are as follows:
Description
(1) Shares acquired
(2) Exercise price
(4) Market price
Amount
70
$5.00
$350
$15
$1,050
$700
30%
$210
Explanation
(7 x 10 shares)
(1) x (2)
(1) x (4)
(5) (3)
(6) x (7)
12-35
She realizes $1,750 on the sale and pays $105 in taxes on the sale, the calculations
are as follows:
Description
(12) Basis
Amount
Explanation
70
$25.00
$1,750
$1,050
$700
15%
$105
(1)
(9) x (10)
(5)
(11) - (12)
(13) x (14)
b. Tyras net cash flow for the restricted stock is $950, which is calculated as
follows:
Description
(1) Amount Realized
(2) Cash outflow for taxes at exercise
Net cash flow
Amount
$1,250
$225
$75
$950
Explanation
(1)-(2)-(3)
There is no cash flow on the grant date. The cash flow is negative $225 on the
vesting date for taxes due. The cash flow on the sale date is $1,175 ($1,250 in sale
proceeds less $75 in taxes due on the sale date).
Tyra will owe $225 of taxes on the vesting date.
Description
(1) Shares acquired
(3) Ordinary income on vesting date
Tax due when shares vest
Amount
50
$15.00
$750
30%
$225
Explanation
(1) x (2)
(3) x (4)
12-36
are as follows:
Description
(6) Amount realized
(7) Adjusted basis
Amount
$1,250
750
$500
15%
$75
Explanation
50 shares x $25 per share
From line 3 above.
(6) (7)
(8) x (9)
c. Tyras net cash flow for the restricted stock is $1,025, which calculated as
follows:
Description
(1) Amount Realized
(2) Cash outflow for taxes at election
Net cash flow
Amount
$1,250
$75
$150
$1,025
Explanation
(1)-(2)-(3)
There is $75 negative cash flow on the grant date for taxes paid. There is no cash
flow on the vesting date. The cash flow on the sale date is $1,100 ($1,250 in sale
proceeds less $150 in taxes due on the sale date).
Tyra will owe $75 of taxes on the vesting date.
Description
(1) Shares acquired
(2) FMV at election date
(3) Ordinary income on election date
Tax due when election is made
Amount
50
$5.00
$250
30%
$75
Explanation
(1) x (2)
(3) x (4)
12-37
are as follows:
Description
(6) Amount realized
(7) Adjusted basis
Amount
$1,250
250
$1,000
15%
$150
Explanation
50 shares x $25 per share
From line 3 above.
(6) (7)
(8) x (9)
d. Tyra should elect the NQOs because it has the highest net cash flow of the three
options. The additional shares that can be purchased through the NQOs is superior
to the ability to lower the tax bill through the 83(b) election on the restricted stock.
43.
[LO 3] Nicoles employer, Poe Corporation, provides her with an automobile

allowance of $20,000 every other year. Her marginal tax rate is 30 percent. Poe
Corporation has a marginal tax rate of 35 percent. Answer the following questions
relating to this fringe benefit.
a. What is Nicoles after-tax benefit if she receives the allowance this year (ignore
FICA taxes)?
b. What is Poes after-tax cost of providing the auto allowance?
a. Nicoles after tax benefit is $$14,000, calculated as follows:
Description
(1) Automobile allowance
(3) Income tax on allowance
Total after-tax benefit
Amount
$20,000
30%
$6.000
$14,000
Explanation
Taxable fringe benefit
(1) x (2)
(1) - (3)
12-38
b. Poes after tax cost is $13,000, calculated as follows:

Description
(1) Automobile allowance
(3) Tax benefit of allowance
Total after-tax cost
44.
Amount
$20,000
35%
$7,000
$13,000
Explanation
Taxable fringe benefit
(1) x (2)
(1) - (3)
[LO 3] {Research} Bills Corporation runs a defense contracting business that

requires security clearance. To prevent unauthorized access to its materials, Bills
requires its security personnel to be on duty except for a 15-minute break every two
hours. Since the nearest restaurants are a 25-minute round trip, Bills provides free
lunches to its security personnel. Bills has never included the value of these meals in its
employees compensation. Bills is currently under audit, and the IRS agent wants to
deny Bills a deduction for past meals. The agent also wants Bills to begin including the
value of the meals in employee compensation starting with the current year. As Bills
tax advisor, give it a recommendation on whether to appeal the agents decision (Hint:
see Boyd Gaming Corp., CA-9, 99-1 USTC 50,530 (Acq.), 177 F3d 1096).
The primary question is whether the meals are for the convenience of the
employer. In Boyd Gaming, the Ninth Circuit held that a casino providing a
cafeteria on its premises for security and logistic reasons was allowed to exclude the
meals as a de minimis fringe benefit because they were provided for the employers
convenience. One important fact is that Boyd Gaming had a policy requiring
employees to stay on the business premise during lunch breaks. The IRS
subsequently acquiesced (will not challenge other taxpayers with similar fact
patterns) in Announcement 99-77 (1999-32 CB 243). Bills Corporation should be
12-39
able to rely on the Boyd Gaming decision; however, whether or not Bills requires
employees to stay on its business premises is likely to be an important fact.
45.
[LO 3] {Planning} Lars Osberg, a single taxpayer with a 35 percent marginal tax
rate, desires health insurance. The health insurance would cost Lars $8,500 to purchase
if he pays for it himself (Larss AGI is too high to receive any tax deduction for the
insurance as a medical expense). Volvo, Larss employer, has a 40 percent marginal tax
rate. Answer the following questions about this benefit (ignore FICA taxes in your
analysis).
a. What is the maximum amount of before-tax salary Lars would give up to receive
health insurance from Volvo?
b. What would be the after-tax cost to Volvo to provide Lars with health insurance
if it could purchase the insurance through its group plan for $5,000?
c. Assume that Volvo could purchase the insurance for $5,000. Lars is interested in
getting health insurance and he is willing to receive a lower salary in exchange
for the health insurance. What is the least amount by which Volvo would be
willing to reduce Larss salary while agreeing to pay his life insurance?
d. Will Volvo and Lars be able to reach an agreement by which Volvo will provide
Larss health insurance?
a. Lars would be willing to trade at most $13,077 of before-tax salary to receive
$8,500 [i.e., $8,500 / (1 35%)] of health insurance benefits. Lars should
be indifferent between receiving $13,077 of compensation and $8,500 of
nontaxable fringe benefits.
b. The after-tax cost of providing Lars with the $5,000 of health insurance (a
nontaxable fringe benefit) is $3,000 [$5,000 x (1 - .40)].
c. Volvo would reduce Larss salary by a minimum of $5,000 if it pays his
health insurance. This is because whether the compensation is in the form of
salary or fringe benefits the amounts are deductible.
d. Lars would be indifferent between reducing his before-tax salary by $13,077
or receiving the health insurance benefits. Lars would prefer to reduce his
salary by less than $13,077 and still receive the benefits. Volvo, on the other
hand would be indifferent between reducing his salary by reducing his salary
by $5,000 or providing the health insurance (not both the salary and the
health insurance are tax deductible to Volvo so the after-tax cost of these
expenses for a given before-tax cost is equivalent). Although, Volvo is better
off if it reduces his salary by more than $5,000. Consequently, given that
Volvo provides the insurance, any salary reduction of less than $13,077
makes Lars better off and any salary reduction greater than $5,000 makes
Volvo better off. So, any salary reduction greater than $5,000 and less than
$13,077 makes both parties better off.
12-40
12-41
46.
[LO 3] {Tax Planning} Seikos current salary is $85,000, and she fancies European
sports cars. She purchases a new auto each year. Seiko is currently a manager for an
office equipment company. Her friend, knowing of her interest in sports cars, tells her
about a manager position at the local BMW and Porsche dealer. The new position pays
only $75,000 per year, but it allows employees to purchase one new car per year at a
discount of $15,000. This discount qualifies as a nontaxable fringe benefit. In an effort
to keep Seiko as an employee, her current employer offers her a $10,000 raise. Answer
the following questions about this analysis (ignore FICA taxes in your analyses).
Assume that Seikos marginal tax rate is 30%.
a. What is the annual after-tax cost to her current employer (office equipment
company that has a 35 percent marginal tax rate) to provide Seiko with the
$10,000 increase in salary?
b. Financially, which offer is better for Seiko on an after-tax basis and by how
much? (Assume that Seiko is going to purchase the new car whether she
switches jobs or not.)
c. What salary would Seiko need to receive from her current employer to make her
financially indifferent (after taxes) between receiving additional salary from her
current employer and accepting a position at the auto dealership?
a. The after-tax cost of providing Seiko with $10,000 of additional salary is $6,500.
This is calculated as follows:
Description
(1) Additional salary
(3) Income tax benefit
After-tax cost of additional salary
Amount
$10,000
35%
$3,500
$6,500
Explanation
Given
Given
(1) x (2)
(1) - (3)
b. The after-tax value to the employee of the current employers package is $66,500,
calculated as follows::
Salary with $10,000 raise
$95,000
x (1-.30)
$66,500
After-tax benefit from salary
The after-tax value to the employee of the car dealers package is $67,500,
Salary
$75,000
x (1-.30)
$52,500
15,000
$67,500
After-tax benefit
After-tax benefit of discount
After-tax value of second package
12-42
c. The current employer would have to offer her $96,429, because the after-tax
difference between the two offers is $1,000. Therefore, if Seikos current employer
provided her with $1,429 of additional salary [$1,000/(1-.3)] she would be
indifferent.
Salary increase
$1,429
x (1-.30)
$1,000
After-tax benefit of extra salary

Salary (with $10,000 + 1,429 raise)
$96,429
x (1-.30)
$67,500
After-tax benefit from salary

47.
[LO 1, 3] JDD Corporation provides the following benefits to its employee, Ahmed
(age 47):
Salary
Health insurance:
Dental insurance:
Life insurance:
Dependent care:
Professional dues:
Personal use of company jet:
$300,000
$10,000
$2,000
$3,000
$5,000
$500
$200,000
Assume the life insurance is a group-term life insurance policy that provides
$200,000 of coverage for Ahmed. Assuming Ahmed is subject to a marginal tax rate
of 30 percent, what is his after-tax benefit of receiving each of these benefits
(ignoring FICA taxes)?
The after-tax benefit of Ahmeds salary and benefits is $370,419, calculated as
follows:
Description
Taxable Benefits
(1) Salary
(2) Personal use of company jet
(3) Life Insurance (taxable portion)
Amount
(4) Taxable Total

(6) Income tax on benefits
(7) After-tax benefit of taxable items
Nontaxable Benefits
(8) Health Insurance
(9) Dental Insurance
(10) Life Insurance (nontaxable portion)
$500,270
30%
$150,081
$350,189
$300,000
$200,000
$270
$10,000
$2,000
$2,730
Explanation
($150,000 x (.15 cents per

$1,000) x 12
(1) + (2) + (3)
(4) x (5)
(4) (6)
$3,000 (3)
12-43
(11) Dependent Care

(12) Professional Dues
(13) Nontaxable Total
$5,000
$500
$20,230
After-tax benefit of salary and benefits

48.
$370,419
(8) + (9) + (10) + (11) +

(12)
(7) + (13)
[LO3] Grays employer is now offering group-term life insurance. The company
will provide each employee with $100,000 of group-term life insurance. It costs Grays
employer $300 to provide this amount of insurance to Gray each year. Assuming that
Gray is 52 years old, determine the monthly premium that Gray must include in income
as a result of receiving the group-term life benefit.
Because Gray is 52, the amount included into income is 23 cents per $1,000 of
coverage. The monthly premium that must be included in income is as follows:
(1) Amount of Life Insurance

(2) Tax free benefit limit
(3) Taxable Benefit
(4) Divide by 1,000
(5) Cost Per $1,000
Monthly Premium
49.
$100,000
($50,000)
$50,000
50
0.23
$11.50
Statutory limit
(1)-(2)
Exhibit 12-11
(4) x (5)
[LO3] Brady graduated from SUNY New Paltz with his bachelors degree recently.
He works for Makarov & Company CPAs. The firm pays his tuition ($10,000 per year)
for him so that he can receive his Masters of Science in Taxation which will qualify him
to sit for the CPA exam. How much of the $10,000 tuition benefit does Brady need to
include in income?
Section 127(a)(2) allows individuals to exclude up to $5,250 of tuition benefits from income
annually. Bradys taxable amount is calculated as follows:
(1) Tuition benefit
(2) Excludable amount
Taxable amount
50.
$10,000
($5,250 Statutory limit
)
$4,750 (1)-(2)
[LO3] Meg works for Freedom Airlines in the accounts payable department. Meg
and all other employees receive free flight benefits (for the employee, family, and 10
free buddy passes for friends per year) as part of their employee benefits package. If
Meg uses 30 flights with a value of $12,350 this year, how much must she include in her
compensation this year?
The flight benefits qualify as a no additional cost service and may be excluded from
gross income under 132(a)(1). The Treasury Regulations (1.132-2) specifically
exclude airline benefits from gross income.
12-44
51.
[LO3] {Tax Research} Sharmilla works for Shasta Lumber, a local lumber supplier.
The company annually provides each employee with a Shasta Lumber shirt so that
employees look branded and advertise for the business while wearing the shirts. Are
Shastas employees required to include the value of the shirts in income?
132(a)(4) excludes de minimis fringe benefits from taxable income. However, 132(e)
defines fringe benefits any property or service the value of which is (after taking into
account the frequency with which similar fringes are provided by the employer to the
employer's employees) so small as to make accounting for it unreasonable or
administratively impracticable. The Treasury regulations under 132 (1.132-1) give
specific examples which suggest that a shirt with a company logo may be excluded from
gross income. However, the authority doesnt explicitly mention the benefit received by
Sharmilla. As a practical matter, most employers provide similar types of benefits and
exclude the amount from employees income.
52.
[LO3] {Tax Research} LaMont works for a company in downtown Chicago. The
firm encourages employees to use public transportation (to save the environment) by
providing them with transit passes at a cost of $250 per month.
a. If LaMont receives one pass (worth $250) each month, how much of this benefit
must he include in his taxable income each year?
b. If the company provides each employee with $250 per month in parking benefits,
how much of the parking benefit must LaMont include in his taxable income
each year?
a) Under 132(f)(5)(A), an employer may exclude transit passes as a qualified
transportation fringe benefits. The amounts described in the Code are not indexed,
but the IRS annually provides the indexed amounts in a Revenue Procedure. For
2013, the amount is $245 for qualified transportation fringe as described in Rev.
Proc.2013-15. LaMont must include $60 per year into taxable income ($5($250 of
benefits less $245 exclusion) per month into income).
b) Under 132(f)(5)(C), an employer may exclude qualified parking as a qualified
transportation fringe benefits. The amounts described in the Code are not indexed,
but the IRS annually provides the indexed amounts in a Revenue Procedure. For
2013, the amount is $245 for qualified parking as described in Rev. Proc.2013-15.
LaMont must include $60 per year into taxable income ($5($250 of benefits less
$245 exclusion) per month into income).
53.
[LO3] Jasmine works in Washington, D.C. She accepts a new position with her
current firm in Los Angeles. Her employer provides the following moving benefits:
Temporary housing for one month$3,000

Transportation for her household goods$4,500
Flight and hotel for a house-hunting trip$1,750
Flights to Los Angeles for her and her family$2,000
12-45
What amount of these benefits must Jasmine include in her gross income?
Employers can exclude qualified moving expense reimbursements from income
under 132(g). However, the amounts must be deductible under the moving expense
rules contained in 217. Amounts that can be excluded include a reasonable amount
for moving household belongings and the cost of traveling to the new residence.
Therefore, Jasmine can exclude $4,500 for the transportation of the household
goods and $2,000 for flights to Los Angeles. Jasmine must include the $3,000 of
temporary housing and $1,750 for house hunting into her taxable income.
54.
[LO 3] Jarvie loves to bike. In fact, he has always turned down better paying jobs to
work in bicycle shops where he gets an employee discount. At Jarvies current shop,
Bad Dog Cycles, each employee is allowed to purchase four bicycles a year at a
discount. Bad Dog has an average gross profit percentage on bicycles of 25 percent.
During the current year, Jarvie bought the following bikes:
Description
Retail Price
Cost
Employee Price
Specialized road bike
$3,200 $2,000
$2,240
Rocky Mountain mountain bike
$3,800 $3,200
$3,040
Trek road bike
$2,700 $2,000
$1,890
Yeti mountain bike
$3,500 $2,500
$2,800
a. What amount is Jarvie required to include in taxable income from these

purchases?
b. What amount of deductions is Bad Dog allowed to claim from these
transactions?
a) Under 132(a)(2), an employer may exclude from an employees income
discounts that do not exceed the employers cost of goods it provides in the
ordinary course of its business. Therefore, Jarvie must include $270 into
taxable income:
12-46
Description
Retail price less average

gross profit percentage
Employee
Price
Incom
e
Specialized road
bike
$2,400
$2,240
$160
Rocky Mountain
mountain bike
$2,850
$3,040
$0
Trek road bike
$2,025
$1,890
$135
Yeti mountain bike
$2,625
$2,800
$0
Income
$295
b) Bad Dog is not allowed a deduction for the employee discounts it provides its
employees. It may include the $9,700 ($2,000 + $3,200 + $2,000 +$2,500) for the
cost of the goods sold to employees in its cost of goods sold.
55.
[LO 1, 3] Matt works for Fresh Corporation. Fresh offers a cafeteria plan that allows
each employee to receive $15,000 worth of benefits each year. The menu of benefits is
as follows:
Benefit
Cost
Health insurance--single
$5,000
Health insurance--with spouse
$8,000
Health insurance--with spouse and dependents

Dental and vision
$11,000
$1,500
Dependent care--any specified amount up to $5,000
Variable
Adoption benefits--any specified amount up to $5,000
Variable
Educational benefits--any specified amount (no limit)
Variable
401(k)--any specified amount up to $10,000
Variable
Cash-- any specified amount up to $15,000 plan benefit
Variable
12-47
For each of the following independent circumstances, determine the amount of income
Matt must recognize and the amount of deduction Fresh may claim (ignore FICA taxes):
a.
Matt selects the single health insurance and places $10,000 in his
401(k).
b.
Matt selects the single health insurance, is reimbursed $5,000 for

MBA tuition, and takes the remainder in cash.
c.
Matt selects the single health insurance and is reimbursed for MBA
tuition of $10,000.
d.
Matt gets married and selects the health insurance with his spouse
and takes the rest in cash to help pay for the wedding.
e.
Matt elects to take all cash.
a. Matt must recognize $0, because each of the benefits is a nontaxable fringe
benefit.
b. Matt must recognize $5,000, because he receives cash and two nontaxable fringe
benefits. Educational assistance benefits have a maximum nontaxable amount of
$5,250.
c. Matt must recognize $4,750 of taxable income because his MBA tuition exceeded
the maximum nontaxable amount of $5,250.
d. Matt must recognize $7,000 of taxable income for the cash received. The $8,000
of health insurance is a nontaxable fringe benefit.
e. Matt must recognize $15,000 of taxable income for the cash received.
12-48
Comprehensive Problems
56.
[LO 1, 2] {Planning}{Tax Forms} Pratt is ready to graduate and leave College Park.
His future employer offers the following four compensation packages from which Pratt
may choose. Pratt will start working for Ferndale on January 1, year 1.
Benefit Description
Salary
Option 1
Option 2
Option 3
Option 4
$60,000
$50,000
$45,000
$45,000
Health Insurance
$0
$5,000
$5,000
$5,000
Restricted stock
$0
$0
1,000 shares
$0
NQOs
$0
$0
$0
100 options
Assume that the restricted stock is 1,000 shares that trade at $5 per share on the grant
date (January 1, year 1) and are expected to be worth $10 per share on the vesting date
at the end of year 1 and that no 83(b) election is made. Assume that the NQOs (100
options that each allow the employee to purchase 10 shares at $5 exercise price). The
stock trades at $5 per share on the grant date (January 1, year 1) and is expected to be
worth $10 per share on the vesting date at the end of year 1 and that the options are
exercised and sold at the end of the year. Also assume that Pratt spends on average
$3,000 on health-related costs that would be covered by insurance if he has coverage.
Assume that Pratts marginal tax rate is 35 percent. Assume that Pratt spends $3,000 in
after-tax dollars for health expenses when he doesnt have health insurance coverage
(treat this as an outflow), and that there is no effect when he has health insurance
coverage.
a. What is the after-tax value of each compensation package for year 1?
b. If Pratts sole consideration is maximizing after-tax value for year 1, which option
should he select?
c. Assuming Pratt chooses Option 3 and sells the stock on the vesting date (on the last
day of year 1), complete Pratts Schedule D for the sale of the restricted stock.
a. The solution assumes that no 83(b) election is made for Option 3. Pratts
after-tax value for each of the options is $36,000, $32,500, $35,750, and $30,750
respectively, calculated as follows:
12-49
Description
(1) Salary
(2) Restricted Stock
(3) Taxable Total
Option 1
Amount
$60,000
Explanation
$0
$60,000
(1) + (2)
(4) Tax Rate
35%
(5) Tax Paid
$21,000
(3) x (4)
(6) After-tax cash value
$39,000
(3) (5)
(7) NQOs
(8) Health care expenses
After-tax value
$0
$3,000
$36,000
Description
(1) Salary
Option 2
Amount
$50,000
$0
(3) Taxable Total
$50,000
(6) + (7) (8)
Explanation
(1) + (2)
(4) Tax Rate
35%
(5) Tax Paid
$17,500
(3) x (4)
$32,500
(3) (5)
(7) NQOs
$0
$0
After-tax value
$32,500
Description
(1) Salary
Option 3
Amount
$45,000
$ 10,000
(3) Taxable Total
$55,000
(6) + (7) (8)
Explanation
(1) + (2)
(4) Tax Rate
35%
(5) Tax Paid
$19,250
(3) x (4)
$35,750
(3) (5)
(7) NQOs
$0
12-50
$0
After-tax value
$35,750
Description
(1) Salary
(6) + (7) (8)
Option 4
Amount
$45,000
(2) NQOs
$5,000
(3) Taxable Total
$50,000
(4) Tax Rate
35%
(5) Tax Paid
$17,500
(6) Cash paid at exercise
$5,000
$32,500

After-tax value
Explanation
Bargain element 1000 shares *
($10 $5)
(1) + (2)
(3) x (4)
$5 x 1,000 shares
(3) (5)
$0
$32,500
(7) - (8)
c. Pratt should select Option 1 ($36,000) because it maximizes his after-tax value.
d. ADD SCHEDULE D and Form 8949.
57. Santinis new contract for 2013 indicates the following compensation and benefits:
Benefit Description
Amount
Salary
$130,000
Health insurance
$9,000
Restricted stock granted
$2,500
Bonus
$5,000
Hawaii trip
$4,000
Group-term life insurance
$1,600
Parking ($275 per month)
$3,300
Santini is 54 years old at the end of 2013. He is single and has no dependents. Assume
that the employer matches $1 for $1 for the first $6,000 that the employee contributes to
his 401(k) during the year. The 100 ISOs each allow the purchase of 10 shares of stock
at a strike price of $5 (also the market price on the date of grant). The ISOs vest in two
12-51
years when the stock price is expected to be $15 and Santini expects to sell the shares in
three years when the market price is $20. The restricted stock grant is 500 shares granted
when the market price was $5 per share. Assume that the stock vests on December 31,
2013, and that the market price on that date is $7.50 per share. Also assume that Santini
is willing to make any elections to reduce equity-based compensation taxes. The Hawaii
trip was given to him as the outstanding sales person for 2012. The group-term life
policy gives him $150,000 of coverage. Assume that Santini does not itemize deductions
for the year. Determine Santinis taxable income and income tax liability for 2013.
Santinis taxable income is $132,136 , and his income tax liability is $30,291 , each
is calculated as follows:
Description
Taxable Benefits
(1) Salary
(2) Restricted stock grant
Amount
Explanation
$130,000
$2,500
$130,000 (given)
500 shares x $5 on grant
date with an 83(b) election
Given
Given
$100,000= (.23 cents per
$1,000) x 12 months
$30 per month ($275 per
month - $245 (statutory
limit)) x 12 months
Sum of items (1) through (6)
2013 single standard
deduction
2013 personal exemption
(7) (8) (9)
[((10) -$87,850) x 28%]+
$17,891.25
(3) Bonus
(4) Hawaii trip
(5) Life Insurance (taxable portion)
$5,000
$4,000
$276
(6) Parking
$360
(7) AGI
(8) Standard Deduction
$142,136
$6.100
(9) Personal Exemption

(10) Taxable Income
(11) Income Tax Liability
$3,900
$132,136
$30,291
58.
[LO 1, 3] {Planning} Sylvana is given a job offer with two alternative compensation
packages to choose from. The first package offers her $250,000 annual salary with no
qualified fringe benefits. The second package offers $235,000 annual salary plus health
and life insurance benefits. If Sylvana were required to purchase the health and life
insurance benefits herself, she would need to pay $10,000 annually after taxes. Assume
her marginal tax rate is 33 percent.
12-52
a. Which compensation package should she choose and by how much would she
benefit in after-tax dollars by choosing this package?
b. Assume the second package offers $240,000 plus the benefits instead of
$235,000 plus benefits. Which compensation package should she choose and by
how much would she benefit in after-tax dollars by choosing this package?
a. Sylvana is better off by $50 by choosing Option 1. Option 1 ($157,500) has a
higher after-tax value than Option 2 ($157,450). So Sylvana would be better off
taking Option 1 and purchasing her own health insurance.
Option 1
Salary
$250,000
(1-.33)
ATCF from salary

Cost of benefits
$167,500
($10,000
)
After tax dollars
$157,500
Option 2
$235,00
0
(1-.33)
$157,45
0
$0
$157,45
0
b. Sylvana is better off by $3,300 by choosing Option 2. Option 2 ($160,800) now

has a higher after-tax value than Option 1 ($157,500). So Sylvana would be better
off taking Option 2.
Salary
ATCF from
salary
Cost of benefits
After tax dollars
Option 1
$250,00
0
(1-.33)
$167,50
0
($10,00
0)
$157,50
0
Option 2
$240,00
0
(1-.33)
$160,80
0
$0
$160,80
0
59. {Planning} In 2013, Jill, age 35, received a job offer with two alternative
compensation packages to choose from. The first package offers her $90,000 annual
salary with no qualified fringe benefits, requires her to pay $3,500 a year for
parking, and pay her life insurance premiums at a cost of $1,000. The second
package offers $80,000 annual salary, employer provided health insurance, annual
free parking (worth $300 per month), $200,000 of life insurance (purchasing on her
own would have been $1,000 annually), and free flight benefits (she figures that it
will save her $5,000 per year). If Jill chooses the first package, she would purchase
the health and life insurance benefits herself at a cost of $5,000 annually after taxes
and spend another $5,000 in flights while traveling. Assume her marginal tax rate is
28 percent.
12-53
a. Which compensation package should she choose and by how much would she
benefit in after-tax dollars by choosing this compensation package instead of the
other compensation package?
b. Assume the first package offers $100,000 salary with no qualified benefits
instead of $90,000 salary plus benefits. Which compensation package should
12-54
she choose and by how much would she benefit in after-tax dollars by choosing
this package?
a. Jill is better off by $7,935 by choosing Option 2. Option 2 ($58,235) has a higher
after-tax value than Option 1 ($50,300). So Jill would be better off taking Option 2.
Salary
Includible health insurance
Includible life insurance
Includible parking
Includible flight benefits
ATCF from salary
Cost of health insurance
Cost of parking
Cost of life insurance
Cost of flights
After tax dollars
Option 1
$90,000
0
0
0
0
(1-.28)
$64,800
($5,000
)
($3,500)
$(1,000)
($5,000)
$50,300
Option 2
80,000
0
$162
$660
0
(1-.28)
$58,192
$0
0
0
0
$58,192
b. Jill is better off by $692by choosing Option 2. Option 2 ($58,192) still has a
higher after-tax value than Option 1 ($57,500). So Jill would be better off taking
Option 2.
Salary
Includible health insurance
Includible life insurance
Includible parking
Includible flight benefits
ATCF from salary
Cost of health insurance
Cost of parking
Cost of life insurance
Cost of flights
After tax dollars
Option 1
$100,00
0
0
0
0
0
(1-.28)
$72,000
($5,000
)
($3,500)
$(1,000)
($5,000)
$57,500
Option 2
80,000
0
$162
$660
0
(1-.28)
$58,192
$0
0
0
0
$58,192
12-55

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Chapter 12 - Compensation

[LO 1] {Planning}Shane is an employee who has had a relatively consistent income

[LO 1] Nicole and Braxton are each 50 percent shareholders of NB Corporation.

[LO 2] What is a disqualifying disposition of incentive stock options, and how

[LO 2] What risks do employees making an 83(b) election on a restricted stock

[LO 3] Explain why an employee might accept a lower salary to receive a

[LO 3] Describe the circumstances in which an employee may not value a

Annas tax is $5,850 which is $4,575 [($43,250- $12,750) 15%] + $1,275. On a

a. ABCs after-tax cost is $1,150,000, calculated as follows:

a. Option 2 has a higher expected value:

Option 2 would be better from an expected value standpoint.

Option 1 would be better from an expected value standpoint.

(1) Bargain Element (ordinary income)

a. Haven has no tax consequences on the grant date.

(1) Bargain Element (ordinary income)

a. Antonio has no tax consequences on the grant date.

c. Antonio has no cash flow consequences on the grant date.

Answer the following questions:

Considering these facts, which type of option plan, nonqualified (NQO) or

Which type of option plan should Harmers employees prefer?

e. The present value of ISOs to each employee is $277.40, calculated as

f. The present value of NQOs to each employee is $202.79, calculated as

(1) Shares acquired

g. The number of NQOs necessary to make employees equal to receiving ISOs

Alternatively, the solution can be obtained algebraically as follows:

Cash Outflows in 3 Years

Cash Flows in 5 Years

277.40 = .751{-X options [$7 + ($25-$7)(40%)]} + .621{X shares [$35 ($35-$25)(15%)]}

Capital Gains Taxes

[LO 3] Nicoles employer, Poe Corporation, provides her with an automobile

b. Poes after tax cost is $13,000, calculated as follows:

[LO 3] {Research} Bills Corporation runs a defense contracting business that

After-tax benefit from salary

After-tax benefit of extra salary

After-tax benefit from salary

(4) Taxable Total

($150,000 x (.15 cents per

(11) Dependent Care

After-tax benefit of salary and benefits

(8) + (9) + (10) + (11) +

(1) Amount of Life Insurance

Temporary housing for one month$3,000

Specialized road bike

Rocky Mountain mountain bike

Trek road bike

Yeti mountain bike

a. What amount is Jarvie required to include in taxable income from these

Retail price less average

Trek road bike

Yeti mountain bike

Health insurance--with spouse

Health insurance--with spouse and dependents

Dependent care--any specified amount up to $5,000

Adoption benefits--any specified amount up to $5,000

Educational benefits--any specified amount (no limit)

401(k)--any specified amount up to $10,000

Cash-- any specified amount up to $15,000 plan benefit

Matt selects the single health insurance, is reimbursed $5,000 for

Matt elects to take all cash.