Fit Chap012

Chapter 12 - Compensation
Chapter 12
Compensation
SOLUTIONS MANUAL
Discussion Questions:
1. [LO 1] 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 won’t 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, but he may end up paying interest and penalties if he waits to pay tax with the
return.
2. [LO 1] 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.
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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 doesn’t have more taxes than necessary withheld.
Also the tables assume that the taxpayer’s salary is her only source of income.
Consequently, taxpayers with an income earning (employed or self-employed) spouse
may need to adjust her 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 don’t 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] Are taxpayers’ entire wages subject to the FICA tax? Explain.
Employees must pay FICA taxes on their wages. This tax consists of both a Social
Security and a Medicare component. The Social Security tax is intended to provide basic
pension coverage for the retired and disabled. The Medicare tax helps pay medical costs
for qualifying individuals. Employees pay Social Security tax at a rate of 6.2 percent on
the wage base and Medicare tax at a rate of 1.45 percent on their wages. The wage base
on which Social Security taxes are paid is limited to an annually determined amount.
The 2010 limit is $106,800 which isthe same as the 2009 limit . Because there is no wage
base for the Medicare component of the FICA tax, a taxpayer’s entire wages will be
subject to this portion of the FICA tax.
4. [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 tax-payer 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 Braxton’s 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 brother’s 50 percent for a total of 100
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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 Nicole’s 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 ½ 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.
5. [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
employee’s salary? Explain.
Holding all else equal (including the amount of the employee’s salary) an employer with
a higher marginal tax rate will have a lower after-tax cost of paying an employee’s
salary. The reason is that the employer’s after-tax cost of the salary is the before tax cost
minus the tax savings from deducting the employee’s salary. The tax savings from a
deduction are greater the higher the marginal tax rate. Because the high marginal tax
rate employer has greater tax savings from deducting the employee’s salary, the high
marginal tax rate employer has a lower after-tax cost of paying the employee’s salary.
6. [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.
7. [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 (non-performance
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.
8. [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 company’s 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.
9. [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 employee’s 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.
10. [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 employer’s
marginal rate is 0 percent) nonqualified options over an equivalent number of incentive
stock options.
11. [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
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be superior to salary in terms of motivating employees to behave more like owners—

stock 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.
12. [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 ISO’s 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.
13. [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 tax purposes,
employers expense the bargain element when nonqualified options are exercised.
However, employers never receive a tax deduction for incentive stock options.
14. [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.
15. [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 Zoom’s stock price to increase dramatically. In
addition to his salary, Matt received Boom Zoom restricted stock. How will Matt’s
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?
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If Matt doesn’t make the §83(b) election, the fair market value of the stock on the vesting
date will be included in Matt’s 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 a §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, a §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.
16. [LO 2] What risks do employees making a §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 doesn’t become vested subsequent to the §83(b) election,
employees will have reported income that they did not actually receive (phantom
income).
17. [LO 3] Explain the differences and similarities between a fringe benefit as a form
of compensation and salary.
A fringe benefit is 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.
18. [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 employee’s 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. Group-term life premiums are always deductible by the
employer.
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19. [LO 3] Compare and contrast the employer’s 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 benefit.
This lowers the actual cost of compensating employees which is possible through an
indirect government subsidy.
20. [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.
21. [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 employee’s taxable income.
An employer can provide a qualified employee discount from an employee’s 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 actual cost to manufacture the
vehicle. The remaining value of the vehicle may be received as a nontaxable fringe
benefit.
22. [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
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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.
23. [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 offered 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 doesn’t 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 health single insurance
and receive cash or another benefit with the difference.
24. [LO 3] Explain why Congress allows employees to receive certain fringe benefits
tax-free but others are taxable?
Congress subsidizes, through excluding them from employee’s income, benefits that are
considered essential (e.g., health insurance) or that are considered to be in the public
interest (e.g., mass transit passes). 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.
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 public’s
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.
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25. [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 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 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
26. [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 taxpayer’s spouse receives an
incredible health insurance package then the employee probably doesn’t 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
27. [LO 1] {Research} Anna is single with one four-year-old child. She earns a monthly
salary in 2010 of $5,000.
a. If she claims two withholding allowances, how much will her employer
withhold from her monthly paycheck? Refer to IRS Publication 15 and use the
wage bracket method.
b. If she claims four withholding allowances, how much will her employer
withhold from her monthly paycheck? Refer to IRS Publication 15 and use
the wage bracket method.
c. Assuming that she has no other income, claims the standard deduction, and
claims one personal and one dependency deduction, what is Anna’s tax
liability for the year? How many withholding allowances should she claim to
equalize (approximately) her withholding and her tax liability?
a) Publication 15 (see IRS.gov) has withholding tables for taxpayers using the
wage bracket method to compute their withholding.. The table on page54
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 $709
withheld each month.
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b) Publication 15 (see IRS.gov) has withholding tables for taxpayers using the
wage bracket method to compute their withholding. The table on page 54
indicates that a single taxpayer, like Anna, claiming 4 allowances and
receiving salary between $5,000, and $5,040 per month, will have $557
withheld each month.2
c) Anna’s filing status will be Head of Household. Using the 2010 Tax Rate
Schedule (not the Tax Table).
AGI $60,000
Standard
Deduction $8,400
Personal
Exemption
s $7,300
Taxable
Income $44,300
Tax $6,048
Anna’s tax is $6,048 which is $4,853 [($44,300 - $11,950) × 15%] + $1,195

($11,950 × 10%).
On a monthly basis, Anna should have $504 withheld ($6,048 / 12). Using the
table, if Anna claims 4 withholding allowances her monthly withholding would
be $557. Alternatively, if Anna claims 5 allowances her monthly withholding
would be $481. If Anna claims 4 allowances, she will be over withheld. If she
claims 5 allowances she will be under withheld..
28. [LO 1] Baker works for Company ATT for all of 2010. What is his FICA obligation
under the following circumstances:
a. Baker is single and earns a salary of $50,000.
b. Baker is single and earns a salary of $110,000.
c. Baker is married and earns a salary of $50,000. His spouse earns $25,000
year.
d. Baker is married and earns a salary of $50,000. His spouse earns $55,000 per
year.
a. $3,825 in FICA tax, computed as follows:
(1) Compensation $50,000

(2) Social Security $3,100 (1) x 6.2%
(3) Medicare taxes $725 (1) x 1.45%
FICA tax $3,825 (2) + (3)
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b. $8,217 in FICA tax, computed as follows:
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(2) Social Security* $6,622 $106,800 x 6.2%
(3) Medicare taxes $1,595 (1) x 1.45%
FICA tax $8,217 (2) + (3)
*For Social Security, compensation has a ceiling of
$106,800 in 2010.
c. Same as part a; FICA tax is computed individually and the spouses earnings do not
affect Baker’s computation.
d. Same as part a; FICA tax is computed individually and the spouses earnings do not
affect Baker’s computation.
29. [LO 1] Rasheed works for AD Company and earns $350,000 in salary during 2010.
Assuming he has no other sources of income, what amount of Social Security taxes
and what amount of Medicare taxes will Rasheed pay for the year?
Rasheed owes $11,697 in FICA tax, computed as follows:

(2) Social Security* $6,622 $106,800 x 6.2%
(3) Medicare taxes $5,075 (1) x 1.45%
FICA tax $11,697 (2) + (3)
*For Social Security, compensation has a ceiling of
$106,800 in 2010.
30. [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 other’s stock in
North.
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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 other’s stock in
North.
a. North may deduct $35,000 in year 1 because they were paid within 2 ½ 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
b. North may not deduct any of the bonus in year 1 because the bonuses were not paid
within 2 ½ months of year end. It may deduct the $35,000 of bonuses in year 2.
Lisa Tanaka $7,500
$35,000
c. North may deduct $17,500 in both year 1 and year 2. Helen and Steve’s bonuses are
deductible in year 1 because they were paid within 2 ½ months of year end. Lisa and
Jared’s bonuses are deductible in year 2 which is the year they take the bonuses into
income—since they are related parties (own greater than 50 percent).
Lisa Tanaka $7,500
$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 ½ 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..
Lisa Tanaka $7,500
$35,000
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31. [LO 1] Lynette is the CEO of publicly traded TTT Corporation and earns a salary of
$200,000 in 2010. Assume TTT has a 35 percent marginal tax rate.
a. What is TTT Corporation’s after-tax cost of paying Lynette’s salary excluding
FICA taxes?
b. What is TTT Corporation’s after-tax cost of paying Lynette’s salary including
FICA taxes?
a. TTT’s 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)
b. TTT’s after-tax cost is $136,189, calculated as follows:

(1) Salary $200,000
(2) Social Security taxes* $6,622 $106,800 x 6.2%
(3) Medicare taxes $2,900 $200,000 × 1.45%
(4) Total before-tax cost $209,522 (1) – ((2) + (3))
(5) (1 – marginal tax rate) × 65% (1 – 35%)
After tax cost of salary $136,189 (4) × (5)
*For Social Security, compensation has a ceiling of $106,800 in 2010.
32. [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 ABC’s after-tax cost of paying Marcus’s salary (excluding FICA
taxes)?
b. Now assume that Marcus, in addition to the $1.5 million salary, earns a
performance-based bonus of $500,000. What is ABC’s after-tax cost of paying
Marcus’s salary (excluding FICA taxes)?
a. ABC’s after-tax cost is $1,150,000, calculated as follows:

(1) Salary $1,500,000
(2) Deductible portion $1,000,000 Maximum deduction
(3) Marginal tax rate x 35% Given
(4)Tax deduction $350,000 (2) × (3)
After tax cost of salary $1,150,000 (1) – (4)
b. ABC’s after-tax cost is $1,475,000, calculated as follows:
12-15

(1) Salary $1,500,000
(2) Deductible base salary $1,000,000 Maximum deduction
(3) Performance-based bonus $500,000
(4) Deductible pay $1,500,000 (2) + (3)
(5) Marginal tax rate × 35% Given
(6)Tax deduction $525,000 (4) × (5)
After tax cost of salary $1,475,000 (1) + (3) – (6)
33. [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 MMM’s after-tax cost of providing Ramon with Option 1?
d. What is MMM’s expected after-tax cost of providing Ramon with Option 2 if
it believes there is a 40 percent chance Ramon will qualify for the
performance-based compensation?
a. Option 2 has a higher expected value:

a) Option 1: $2,500,000 x (1-.4) = $1,500,000
Option 2: $3,000,000 x (1-.4) = $1,800,000
Option 2 would be better from an expected value standpoint.
b) 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
Option 1 would be better from an expected value standpoint.
c) Option 1: ($1,000,000 x (1-.35)) + ($1,500,000 x (1-.0)) = $2,150,000
d) Option 2: ($1,000,000 x (1-.35)) + ($2,000,000 x (1-.35) x 40%) = $1,170,000
12-16
34. [LO 2] 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 MNL’s stock price was $8 per share. Now that
MNL’s 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 Cammie’s 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 Corporation’s tax consequences on grant date, exercise date,
and date of sale assuming its marginal tax rate is 35 percent?
a. Cammie recognizes $30,000 of ordinary income and pays tax of $9,000 in

the year of exercise, the calculations are as follows:

(1) Shares acquired 1,000 (100 × 10 shares)
(2) Exercise price $10.00
(3) Cash needed to exercise $10,000 (1) x (2)
(4) Market price $40
(5) Market value of shares $40,000 (1) × (4)
(6) Bargain Element (ordinary income) $30,000 (5) – (3)
(7) Marginal Tax Rate 30%
Tax due in year of exercise $9,000 (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:

(7) Shares acquired with NQOs 1,000 (1)
(8) Market price at sale $60.00
(9) Amount Realized $60,000 (7) x (8)
(10) Basis $40,000 (5)
(11) Long-term capital gain $20,000 (9) - (10)
Tax due in year of exercise $3,000 (11) x (12)
12-17
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 MNL’s tax burden by
$10,500.
35. [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. Cutter’s 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 Yost’s 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
long-term capital gains rate is 15 percent?
b. What are Cutter Corporation’s 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 Yost’s 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 Yost’s 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:

(1) Shares acquired 3,000 (300 x 10 shares)
(3) Cash needed to exercise $45,000 (1) × (2)
12-18

(8) Tax due in year of exercise $11,550 (6) x (7)
He also recognizes $63,000 of capital gain and pays tax of $9,450 in the year of
sale, the calculations are as follows:

(11) Amount Realized $141,000 (9) × (10)
(12) Basis $78,000 (5)
Tax due in year of sale $9,450 (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. Cutter’s taxes are reduced
by $8,250.
(1) Bargain Element (ordinary income) $33,000 (6) above

(3) Tax benefit in year of exercise $8,250 (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:

(1) Cash needed to exercise $45,000 (3) from part a
(2) Tax due at exercise $11,550 (8) from part a
(3) Cash needed for same-day sale $56,550 (1) + (2)
(5) Shares needed to be sold 2,175 (3) / (4)
12-19
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.
36. [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 Barlow’s 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 cash flow effects 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 cash flow effects for Barlow Corporation resulting from Haven’s
option exercise if Barlow’s marginal tax rate is 35 percent?
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:

(1) Shares acquired 4,000 (200 x 20 shares)
(2) Strike price $7.00
Tax due in year of exercise $51,600 (6) × (7)
He also recognizes $100,000 of capital gain and pays tax of $15,000 in the year
of sale, the calculations are as follows:

12-20

(11) Amount Realized $300,000 (9) × (10)
(12) Basis $200,000 (5)
Tax due in year of sale $15,000 (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.
(1) Bargain Element (ordinary income) $172,000 (6) above

(3) Tax benefit in year of exercise $60,200 (1) × (2)
37. [LO 2] Mark received 10 ISOs at the time he started working for Hendricks
Corporation five years ago when Hendricks’s 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 Hendricks’s 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 Mark’s 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 Hendricks’s 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:

(1) Shares acquired 100 (10 x 10 shares)
(3) Cash needed to exercise $500 (1) × (2)
12-21

(6) Bargain Element (AMT $3,000 (5) – (3)
preference)*
*The bargain element is includable in AMTI, which may cause Mark to pay AMT.
In the year of sale, Mark recognizes $3,000 of long-term capital gain and pays
tax of $450, the calculations are as follows:

(7) Shares acquired with NQOs 100 (1)
(9) Amount Realized $3,500 (7) × (8)
(10) Basis $500 (3) above
Tax due in year of sale $450 (11) × (12)
b. Hendricks has no tax consequences on the grant date, exercise, or sale date
because the options are ISOs.
38. [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)v. Zorro’s share price was $3 per share at the time. Now
that Zorro’s 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 Antonio’s 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 long-term capital gains rate is 15 percent?
b. What are Zorro’s 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 Antonio’s
option exercise if Zorro’s marginal tax rate is 35 percent?
a. Antonio has no tax consequences on the grant date.
12-22
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

(5) Amount Realized $40,000 (1) × (4)
(6) Basis $2,400 (3) above
(7) Bargain Element/Ordinary Income $37,600 (5) - (6)
Tax paid in year of sale $11,280 (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:

(1) Bargain Element $37,600 From line 7 above
(4) Ordinary Marginal Tax Rate 25%
Tax benefit when shares vest $9,400 (3) × (4)
c. Antonio’s has no cash flow consequences on the grant date.
Antonio’s cash flow consequences on the exercise/sale date are an outflow of

$2,400 (from line 3 above) to exercise the options, an inflow of $40,000 of the
amount realized on the sale of the shares and an outflow of 11,280 for the tax
paid on the bargain element (from part a above)).
d. Zorro receives a cash inflow of $2,400 from Antonio’s exercise of the options
and receives a tax benefit/cash inflow of $9,400 from the compensation
deduction.
39. [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
12-23
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 (disregard FICA taxes in your analysis):
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 Harmer’s 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 Harmer’s employees prefer?
e. What is the present value of each employee’s after-tax cash flows from
year 1 through year 5 if the employees receive ISOs?
f. What is the present value of each employee’s 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 employee’s bargain element upon exercise. In
contrast, Harmer receives no tax benefit if ISOs are used.
b. Harmer’s per employee tax benefit upon exercise of the NQOs is $126,
calculated as follows:
12-24

(3) Cash needed to exercise $140 (1) × (2)
(5) Market value of shares $500 (1) × (4)
(6) Bargain Element $360 (5) – (3)
Tax benefit in year of exercise $126 (6) × (7)
c. Harmer’s per employee tax benefit upon exercise of the ISOs is $0,
because employers receive no deduction upon an ISO exercise.
d. Harmer’s employees would prefer ISOs because the bargain element isn’t
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:
(3) Cash needed to exercise $140 (1) x (2)
(4)Present Value Factor .751 10% discount rate for 3 years
(5) Present Value of Cash to Exercise $105.14 (3) x (4)

(7) Market Price at Sale $35.00
(8) Amount Realized $700 (6) x (7)
(9) Basis in Stock $140 (3)
(10) Long-term capital gain $560 (8) - (9)
(11)Marginal Tax Rate 15%
12-25
(12) Tax paid on capital gain in year of $84 (10) x (11)

sale
(13) Net cash inflow at sale $616 (8) - (12)
(15) Present Value of Sale Proceeds $382.54 (13) x (14)
Present Value of ISOs $277.40 (15)- (5)
f. The present value of NQOs to each employee is $202.79, calculated as

follows:

(5) Market value of shares $500 (1) x (4)
(6) Bargain Element $360 (5) – (3)
(8) Tax paid on bargain element in year $144 (6) x (7)
of exercise
(9) Cash outflows at exercise date $284 (3)+(8)
(11) Present Value of Cash to Exercise $213.28 (9) x (10)

(13) Market Price at Sale $35.00
(14) Amount Realized $700 (6) x (7)
(15) Basis in stock $500 from (5) above
(16) Long-term capital gain $200 (14)-(15)
12-26
(18) Tax paid on capital gain in year of $30 (16) x (17)

sale
(19) Net cash inflow at sale $670 (14) - (18)
(21) Present Value of Sale Proceeds $416.07 (19) x (20)
Present Value of NQOs $202.79 (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:
(1) PV of ISOs $277.40 Part e, line 16
(2) PV of NQOs $202.79 Part f, line 22
(3) Ratio 1.368 (1) / (2)
(4)ISOs received 20
(5) NQOs to break even with ISOs $27.36 (3) x (4)
NQOs to be received 28 Line 5 rounded up to nearest
whole option
Alternatively, the solution can be obtained algebraically as follows:

First, let’s find out how many additional NQOs Harmer would have to grant to their
employees to keep them indifferent between receiving ISOs and NQO’s.
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 NQO’s 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:
12-27
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 Selling Price Capital Gains Taxes

Element
What? You thought the algebra you learned back in high school would never be good for
anything?
Solving for X:
X = 27.37 NQOs. We’ll assume Harmer does not want to issue fractional shares, so we’ll
round up to 28 NQOs. So, Harmer will have to give each employee 8 more NQOs than
ISOs to keep them indifferent.
40. [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.
Dave’s 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 Dave’s 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
long-term capital gains rate is 15 percent?
b. If Dave’s stock price predictions are correct, what are the tax consequences of
these transactions to RRK if its marginal rate is 35 percent?
a. Dave’s tax consequences on the vesting date is that he will recognize is
$30,000 and pay taxes of $9,000, which is calculated as follows:
12-28
b.
(1) Shares acquired 1,000
(2) FMV at vesting date $30.00
(3) Ordinary income on vesting date $30,000 (1) x (2)
(5) Tax due when shares vest $9,000 (3) x (4)
Dave’s will owe $1,500 on the sale date, which is calculated as follows:
(6) Amount realized $40,000 1,000 shares x $40 per share
(7) Adjusted basis 30,000 From line 3 above.
(8) Long-term capital gain $10,000 (6) – (7)
(9) Preferential Marginal Tax Rate 15%
Tax due when shares sold $1,500 (8) x (9)
c. RRK will receive a tax benefit of $10,500 on the vesting date, which is
(3) Ordinary deduction on vesting date $30,000 (1) x (2)
Tax benefit when shares vest $10,500 (3) x (4)
RRK receives no benefit when Dave sells the shares.
41. [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. Dave’s 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
12-29
per share when he sells them. Assume that Dave’s 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?
a. Dave’s 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:
(2) FMV at grant date $7.00
(3) Ordinary income on grant date $7,000 (1) x (2)
(5) Tax due on grant dates vest $2,100 (3) x (4)
Dave will owe no tax on the vesting date since he made the §83(b) election.
Dave’s will owe $4,950 on the sale, which is calculated as follows:
(6) Amount realized $40,000 1,000 shares x $40 per share
(7) Adjusted basis 7,000 From line 3 above.
Tax due when shares sold $4,950 (8) x (9)
b. RRK will receive a tax benefit of $2,450 on the grant date, which is calculated
as follows:
(3) Ordinary deduction on vesting date $7,000 (1) x (2)
Tax benefit when shares vest $2,450 (3) x (4)
12-30
RRK receives no benefit on the vesting date or when Dave sells the shares.
42. [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.
Jessica’s 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 couldn’t 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:
(2) FMV at section 83(b) election $10.00
(3) Ordinary income on election date $100,000 (1) x (2)
Tax due at election $33,000 (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).
43. [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. Anna’s 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
12-31
d. What are the tax consequences of these transactions to Anna in year 3 if the
a. If Anna makes the section 83(b) election, she will recognize $25,000 on the
election date which is calculated as follows:
(2) FMV at section 83(b) election $5.00
Ordinary income on election date $25,000 (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 short-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 short-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.
44. [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. Hatch’s stock price is $5 on Tyra’s 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. Tyra’s
marginal tax rate is 30 percent and her long-term capital gains rate is 15 percent.
Assume that Tyra’s 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?
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. Tyra net cash flow for the NQOs is $1,085, which calculated as follows:
12-32

(1) Amount Realized $1,750 Line 11 from table below
(2) Cash outflow for shares at exercise $350 Line 3 from table below
(3) Cash outflow for taxes at exercise $210 Line 8 from table below
(4) Cash outflow for taxes at sale $105 Line 15 from table below
Net cash flow $1,085 (1)-(2)-(3)-(4)
She must pay $350 for the shares on the exercise and pay $210 in taxes, the

(5) Market value of shares $1,050 (1) x (4)
(6) Bargain Element (ordinary income) $700 (5) – (3)
Tax due in year of exercise $210 (6) x (7)
She realizes $1,750 on the sale and pays $105 in taxes on the sale, the

(9) Shares acquired with NQOs 70 (1)
(11) Amount Realized $1,750 (9) x (10)
(12) Basis $1,050 (5)
(13) Long-term capital gain $700 (11) - (12)
Tax due in year of exercise $105 (13) x (14)
b. Tyra net cash flow for the restricted stock is $950, which calculated as
follows:
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(2) Cash outflow for taxes at exercise $225 Line 5 from table below
Net cash flow $950 (1)-(2)-(3)
Tyra will owe $225 of taxes on the vesting date.

(1) Shares acquired 50
(3) Ordinary income on vesting date $750 (1) x (2)
Tax due when shares vest $225 (3) x (4)
She realizes $1,250 on the sale and pays $75 in taxes on the sale, the calculations
are as follows:

(6) Amount realized $1,250 50 shares x $25 per share
(7) Adjusted basis 750 From line 3 above.
(8) Long-term capital gain $500 (6) – (7)
Tax due when shares sold $75 (8) x (9)
c. Tyra net cash flow for the restricted stock is $1,025, which calculated as
follows:

(2) Cash outflow for taxes at election $75 Line 5 from table below
Net cash flow $1,025 (1)-(2)-(3)
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Tyra will owe $75 of taxes on the vesting date.

(1) Shares acquired 50
(2) FMV at election date $5.00
(3) Ordinary income on election date $250 (1) x (2)
Tax due when election is made $75 (3) x (4)
She realizes $1,250 on the sale and pays $150 in taxes on the sale, the

(6) Amount realized $1,250 50 shares x $25 per share
(7) Adjusted basis 250 From line 3 above.
Tax due when shares sold $150 (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.
45. [LO 3] Nicole’s 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 Nicole’s after-tax benefit if she receives the allowance this year
(ignore FICA taxes)?
b. What is Poe’s after-tax cost of providing the auto allowance (ignore FICA
taxes)?
c. What is Nicole’s after-tax benefit if she receives the allowance this year, and
her salary is below the Social Security wage base limit (include FICA taxes in
your analysis)?
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d.
e. What is Poe’s after-tax cost of providing the auto allowance, and Nicole’s
salary is under the Social Security wage base limit (include FICA taxes in
your analysis)?
f. What is Nicole’s after-tax benefit if she receives the allowance this year, and
her salary is over the Social Security wage base (include FICA taxes in your
analysis)?
g. What is Poe’s after-tax cost of providing the auto allowance if Nicole’s salary
is over the Social Security wage base (include FICA taxes in your analysis)?
a. Nicole’s after tax benefit is $12,000, calculated as follows:
(1) Automobile allowance $20,000 Taxable fringe benefit
(2) Marginal tax rate 40%
(3) Income tax on allowance $8,000 (1) x (2)
Total after-tax benefit $12,000 (1) - (3)
b. Poe’s after tax cost is $13,000, calculated as follows:

(3) Tax benefit of allowance $7,000 (1) x (2)
Total after-tax cost $13,000 (1) - (3)
c. Nicole’s after tax benefit is $12,470, calculated as follows:

(4) FICA taxes on automobile $1,530 (1) x 7.65% (Nicole is not over the
allowance Social Security wage base)
(5) Total taxes paid $7,530 (3) + (4)
d. Poe’s after tax cost is $13,994.50, calculated as follows:

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(4) FICA taxes on automobile $1,530 (1) x 7.65% (Nicole is not over the
allowance Social Security wage base)
(5) Tax benefit of FICA tax $535.50 (4) x 35%
Total after-tax cost $13,994.5 (1) - (3) + (4) – (5)
0
e. Nicole’s after tax benefit is $13,710, calculated as follows:

(4) FICA taxes on automobile $290 (1) x 1.45% (Nicole is over the
allowance (Medicare) Social Security wage base)
(5) Total taxes paid $6,290 (3) + (4)
f. Poe’s after tax cost is $13,188.50, calculated as follows:

(4) FICA taxes on automobile $290 (1) x 1.45% (Nicole is over the
allowance (Medicare) Social Security wage base)
(5) Tax benefit of Medicare tax $101.50 (4) x 35%
Total after-tax cost $13,188.5 (1) - (3) + (4) – (5)
0
46. [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 employee’s 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 agent’s
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
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the meals as a de minimis fringe benefit because they were provided for the
employer’s convenience. One important fact is that Boyd Gaming had a policy
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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 (1999-2 CB 243). Bills Corporation should be
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.
47. [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 (Lars’s AGI is too high to receive any tax deduction
for the insurance as a medical expense). Volvo, Lars’s 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 Lars’s salary while agreeing to pay his life
insurance?
d. Will Volvo and Lars be able to reach an agreement by which Volvo will
provide Lars’s 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 Lars’s 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.
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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.
48. [LO 3] {Tax Planning} Seiko’s currently has salary of $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 Seiko’s 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:

(1) Additional salary $10,000 Given
(2) Marginal tax rate 35% Given
(3) Income tax benefit $3,500 (1) x (2)
After-tax cost of additional salary $6,500 (1) - (3)
b. The after tax value to the employee of the current employer’s package is $66,500,
calculated as follows::
Salary with $10,000 raise $95,000

x (1-.30)
After-tax benefit from salary $66,500
The after-tax value to the employee of the car dealer’s package is $67,500, calculated as
follows:
Salary $75,000
x (1-.30)
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After-tax benefit $52,500

After-tax benefit of discount 15,000
After-tax value of second package $67,500
c. The current employer would have to offer her $96,429, because the after-tax
difference between the two packages offers is $1,000. Therefore, if Seiko’s 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)
After-tax benefit of extra salary $1,000
Salary (with $10,000 + 1,429 raise) $96,429

x (1-.30)
After-tax benefit from salary $67,500
49. [LO 1, 3] JDD Corporation provides the following benefits to its employee,
Ahmed (age 47):
 Salary $300,000
 Health insurance: $10,000
 Dental insurance: $2,000
 Life insurance: $3,000
 Dependent care: $5,000
 Professional dues: $500
 Personal use of company jet: $200,000
Assume the life insurance is a group-term life insurance policy that provides
$200,000 of coverage for Ahmed.
a. 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)?
b. Assuming Ahmed is subject to a marginal tax rate of 30 percent, what is his
after-tax benefit of receiving each of these benefits (including FICA taxes)?
c. Assuming JDD Corp.’s marginal tax rate is 35 percent, what is its after-tax
cost of providing these benefits to Ahmed ignoring FICA taxes (assume the
before tax cost of each benefit is equal to the values stated in the problem)?
d. Assuming JDD Corp.’s marginal tax rate is 35 percent, what is its after-tax
cost of providing these benefits to Ahmed including FICA taxes (assume the
before tax cost of each benefit is equal to the values stated in the problem)?
a. The after-tax benefit of Ahmed’s salary and benefits is $345,405, calculated as
follows:
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Taxable Benefits
(1) Salary $300,000
(2) Personal use of company jet $200,000
(3) Life Insurance (taxable portion) $270 ($150,000 x (.15 cents per
$1,000) x 12
(4) Taxable Total $500,270 (1) + (2) + (3)
(6) Income tax on benefits $175,095 (4) x (5)
(7) After-tax benefit of taxable items $325,175 (4) – (6)
Nontaxable Benefits
(8) Health Insurance $10,000
(9) Dental Insurance $2,000
(10) Life Insurance (nontaxable portion) $2,730 $3,000 – (3)
(11) Dependent Care $5,000
(12) Professional Dues $500
(13) Nontaxable Total $20,230 (8) + (9) + (10) + (11) +
(12)
After-tax benefit of salary and benefits $345,405 (7) + (13)
b. The after-tax benefit of Ahmed’s salary and benefits is $331,529, calculated as

follows:
Taxable Benefits
(1) Salary $300,000
$1,000) x 12
(4) Taxable Total $500,270 (1) + (2) + (3)
(6) Income tax on benefits $175,095 (4) x (5)
(7) FICA tax $6,622 ($106,800 x 6.2%)
(8) Medicare tax ($500,270 [from line 4]
$7,254 x.1.45%)
(9) Total taxes $188,971 (5) + (7) + (8)
(10) After-tax benefit of taxable items $311,299 (4) – (9)
Nontaxable Benefits
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(15)
After-tax benefit of salary and benefits $331,529 (10) + (16)
c. The after-tax cost of providing the Ahmed’s salary and benefits is $338,325,

Taxable Benefits
(1) Salary $300,000
$1,000) x 12
(4) Taxable Total $500,270 (1) + (2) + (3)
Nontaxable Benefits
(10) Nontaxable Total $20,230 (5) + (6) + (7) + (8) + (9)
(11) Total Salary and Benefits provided $520,500 (4) + (10)

(12) Tax rate 35%
After-tax cost of salary and benefits $338,325 (11) – (13)
provided
d. The after-tax cost of providing the Ahmed’s salary and benefits is $347,344

Taxable Benefits
(1) Salary $300,000
$1,000) x 12
(4) Taxable Total $500,270 (1) + (2) + (3)
(5) FICA tax $6,622 ($106,800 x 6.2%)
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(6) Medicare tax ($500,270 [from line 4]

$7,254 x.1.45%)
(7) Employment taxes paid $13,876 (5) + (6)
Nontaxable Benefits
(12)
(14) Salary and Benefits provided $534,376 (4) + (7) + (13)

(15) Tax rate 35%
After-tax cost of salary and benefits $347,344 (14) – (16)
provided
50. [LO3] Gray’s employer is now offering group-term life insurance. The company
will provide each employee with $100,000 of group-term life insurance. It costs
Gray’s 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 $100,000

(2) Tax free benefit limit ($50,000) Statutory limit
(3) Taxable Benefit $50,000 (1)-(2)
(4) Divide by 1,000 50
(4) Cost Per $1,000 0.23 Exhibit 12-11
Monthly Premium $11.50 (4) x (5)
51. [LO3] Brady graduated from SUNY New Paltz with his bachelor’s 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. Brady’s taxable amount is calculated as follows:
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(1) Tuition benefit $10,000

($5,250 Statutory limit
(2) Excludable amount )
Taxable amount $4,750 (1)-(2)
52. [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
use airline benefits from gross income.
53. [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 Shasta’s 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 doesn’t 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.
54. [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 2010, the amount is $230 for qualified transportation fringe as
described in Rev. Proc. 2009-50. LaMont must include $240 per year into taxable
income ($20 ($250 of benefits less $230 exclusion) per month into income).
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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 2010, the amount is $230 for qualified parking as described in
Rev. Proc. 2009-50. LaMont must include $240 per year into taxable income ($20
($250 of benefits less $230 exclusion) per month into income).
55. [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
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.
56. [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 Jarvie’s current
shop, Bad Dog Cycles, each employee is allowed to purchase four bicycles a year at a
discount. Because road bikes have higher profit margins, employees receive a 30
percent discount on road bikes. Employees also normally receive a 20 percent
discount on mountain bikes. 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?
12-46
a) Under §132(a)(2), an employer may exclude from an employee’s income

discounts that do not exceed the employer’s cost of goods it provides in
the ordinary course of its business. Therefore, Jarvie must include $270
into taxable income:
Description Cost Employee Price Income
Specialized road bike $2,000 $2,240 $0
Rocky Mountain mountain bike $3,200 $3,040 $160
Trek road bike $2,000 $1,890 $110
Yeti mountain bike $2,500 $2,800 $0
Income $270
b) Bad Dog is not allowed a deduction for the employee discounts it provides its
employees. It may include the cost of the goods sold to employees in its cost of
goods sold.
57. [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 $11,000
Dental and vision $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
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.
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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.
Comprehensive Problems
58. [LO 1, 2] {Planning} 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 Option 1 Option 2 Option 3 Option 4

Salary $60,000 $50,000 $45,000 $45,000
Health Insurance $0 $5,000 $5,000 $5,000
Restricted stock $0 $0 Yes $0
NQO’s $0 $0 $0 Yes
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 20 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 Pratt’s marginal tax rate is 35 percent.
Assume that Pratt spends $3,000 in after-tax dollars for health expenses when he
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doesn’t 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 Pratt’s sole consideration is maximizing after-tax value for year 1, which
option should he select?
a. The solution assumes that no §83(b) election is made for Option 3. Pratt’s
after-tax value for each of the options is $36,000, $32,500, $35,750, and
$30,750 respectively, calculated as follows:
Option 1
(1) Salary $60,000
(2) Restricted Stock $0
(3) Taxable Total $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) NQO’s $0
(8) Health care expenses $3,000
After-tax value $36,000 (6) + (7) – (8)
Option 2
(1) Salary $50,000
(2) Restricted Stock $0
(3) Taxable Total $50,000 (1) + (2)
(4) Tax Rate 35%
(5) Tax Paid $17,500 (3) x (4)
(7) NQO’s $0
(8) Health care expenses $0
After-tax value $32,500 (6) + (7) – (8)
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Option 3
(1) Salary $45,000
(2) Restricted Stock $ 10,000
(3) Taxable Total $55,000 (1) + (2)
(4) Tax Rate 35%
(5) Tax Paid $19,250 (3) x (4)
(7) NQO’s $0
After-tax value $35,750 (6) + (7) – (8)
Option 4
(1) Salary $45,000
(2) NQO’s $10,000
(3) Taxable Total $55,000 (1) + (2)
(4) Tax Rate 35%
(5) Tax Paid $19,250 (3) x (4)
(6) Cash paid at exercise $5,000 $5 x 1,000 shares
(7) After-tax cash value $30,750 (3) – (5) – (6)
After-tax value $30,750 (7) - (8)
b. Pratt should select Option 1 ($36,000) because it maximizes his after-tax

value.
59. Santini’s new contract for 2010 indicates the following compensation and
benefits:
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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 ($265 per month) $3,180
Santini is 54 years old at the end of 2010. He is single and has no dependents. The
restricted stock grant is 500 shares granted when the market price was $5 per share.
Assume that the stock vests on December 31, 2010, 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 2009. The group-term life policy gives him $150,000 of
coverage. Assume that Santini does not itemize deductions for the year. Determine
Santini’s taxable income, income tax liability, and FICA tax liability for 2010.
Santini’s taxable income is $132,846, his income tax liability is $30,906, and his
FICA tax liability is $8,684, each is calculated as follows:
Taxable Benefits
(1) Salary $130,000 $130,000 (given)
(2) Restricted stock grant $2,500 500 shares x $5 on grant
date with §83(b) election
(3) Bonus $5,000 Given
(4) Hawaii trip $4,000 Given
(5) Life Insurance (taxable portion) $276 $100,000 x (.23 cents per
$1,000) x 12 months
(6) Parking $420 $35 per month ($265 per
month - $230 (statutory
limit)) x 12 months
(7) AGI $142,196 Sum of items (1) through (6)
(8) Standard Deduction $5,700 2010 single standard
deduction
(9) Personal Exemption $3,650 2010 personal exemption
(10) Taxable Income $132,846 (7) – (8) – (9)
(11) Income Tax Liability $30,906 [((10) - $82,400) x 28%]+
$16,781.25
12-51
FICA Taxes
(12) FICA tax $6,622 ($106,800 x 6.2%)
(13) Medicare tax $2,062 (7) x.1.45%)
Total FICA Taxes $8,684 (12) + (13)
60. [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 chooses the second package,
she would purchase the health and life insurance benefits herself at a cost of $10,000
annually after taxes. Assume her marginal tax rate is 33 percent.
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 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 of 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 Option 2
$235,00
Salary $250,000 0
(1-.33) (1-.33)
$157,45
ATCF from salary $167,500 0
($10,000
Cost of benefits ) $0
$157,45
After tax dollars $157,500 0
b. Sylvana is better of 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.
Option 1 Option 2
$240,00
Salary $250,000 0
(1-.33) (1-.33)
$160,80
ATCF from salary $167,500 0
($10,000
Cost of benefits ) $0
12-52
$160,80
After tax dollars $157,500 0
12-53

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Chapter 12 - Compensation

First, he could immediately complete a new Form W4 to decrease the number of

Second, because tax withholding is generally treated as though it is made evenly

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

be superior to salary in terms of motivating employees to behave more like owners—

Anna’s tax is $6,048 which is $4,853 [($44,300 - $11,950) × 15%] + $1,195

a. $3,825 in FICA tax, computed as follows:

(1) Compensation $50,000

b. $8,217 in FICA tax, computed as follows:

(1) Compensation $110,000

(1) Compensation $350,000

a. TTT’s after-tax cost is $130,000, calculated as follows:

b. TTT’s after-tax cost is $136,189, calculated as follows:

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

b. ABC’s after-tax cost is $1,475,000, calculated as follows:

Description Amount Explanation

a. Option 2 has a higher expected value:

a. Cammie recognizes $30,000 of ordinary income and pays tax of $9,000 in

Description Amount Explanation

Description Amount Explanation

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

Description Amount Explanation

(7) Marginal Tax Rate 35%

Description Amount Explanation

(1) Bargain Element (ordinary income) $33,000 (6) above

Description Amount Explanation

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

Haven has an outflow of $28,000 on the exercise. Haven recognizes $172,000

Description Amount Explanation

Description Amount Explanation

(10) Market price at sale $75.00

(1) Bargain Element (ordinary income) $172,000 (6) above

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

Description Amount Explanation

(5) Market value of shares $3,500 (1) × (4)

Description Amount Explanation

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

Since Antonio exercises and sells the shares immediately he has a

Description Amount Explanation

Description Amount Explanation

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

Antonio’s cash flow consequences on the exercise/sale date are an outflow of

employees. Now Harmer is trying to decide whether to issue nonqualified options

Description Amount Explanation

Description Amount Explanation

(12) Tax paid on capital gain in year of $84 (10) x (11)

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

Description Amount Explanation

Description Amount Explanation

(18) Tax paid on capital gain in year of $30 (16) x (17)

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

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)

Strike Price Tax on Bargain Selling Price Capital Gains Taxes

RRK receives no benefit when Dave sells the shares.

Description Amount Explanation

Description Amount Explanation

Description Amount Explanation

Description Amount Explanation

Tyra will owe $225 of taxes on the vesting date.

Description Amount Explanation

Description Amount Explanation