Options
abound when considering forms of compensation
Now is the best time for you to revisit your business’s
compensation package and plan for the coming year. Besides
traditional offerings such as salary, bonuses and fringe
benefits, consider offering your employees compensation in
other, more creative forms, such as nonqualified deferred
compensation, incentive stock options or an equity interest
in the business.
Traditional but tricky
Tax treatment of traditional salaries is usually simple. But
watch out: The IRS can question salary paid to business
owners if it’s deemed unreasonable — either too high or too
low. Salaries may be considered too high in the case of
corporations that pay out profits as deductible compensation
rather than as dividends (to avoid double taxation). With S
corporations, the IRS worries that salaries of
owner-employees may be artificially low to avoid payroll
tax.
Because companies typically pay out bonuses close to year
end — after profits for the year have been determined — they
may garner more scrutiny. You can protect and justify your
compensation amounts by:
-
Documenting compensation decisions,
-
Comparing your bonuses with those of similar businesses,
-
Setting
objective criteria for determining salary and bonuses,
and
-
Ensuring that employees, other than owners, share in
lucrative salaries and bonuses.
While
making sure you have your “ducks in a row” may be
time-consuming, the result will be compensation levels that
pass IRS scrutiny.
Creative and tax favored
Compensation can also take the form of stock options or
other equity-based pay. Incentive stock options (ISOs)
receive tax-favored treatment if certain requirements are
met. With an ISO, you grant an employee a right to buy
company stock at a fixed price in the future. The employee
can exercise the option and buy the stock after meeting a
holding period requirement.
If all requirements are met, ISOs create no income tax
either at grant or upon exercise. Employers deduct the
compensation when the employee recognizes income, not when
the option is exercised.
In contrast, nonqualified stock options generate
compensation income in the year of exercise, and the company
gets a compensation deduction at that time. With no holding
period requirement, the employee can sell some of the newly
acquired stock immediately to pay the tax, and incur no
additional tax cost.
Also consider phantom stock or actual equity ownership.
Crucial and for everyone
Fringe benefits should be part of your overall compensation
package — both to attract and retain employees. With some
statutorily defined fringe benefits, such as group-term life
insurance (up to $50,000), health insurance, parking and
employee discounts, the company gets a deduction, but the
value of the benefit isn’t included in the employee’s
income. Moreover, the business usually avoids payroll taxes
on these amounts. Keep in mind that these fringe benefits
cannot discriminate in favor of a select group of employees.
De minimis benefits and working condition fringes that may
be excluded from the employee’s income include company
parties and noncash holiday gifts, and occasional tickets to
entertainment or sporting events. Employee discounts and “no
additional cost” services are other benefits that can be
excluded from income.
Be aware that the benefits available to owners may be
limited, or tax treatment may differ, based on the type of
entity. Partnerships and S corporations will be somewhat
limited in providing nontaxable fringe benefits to owners.
Retiring but essential
Retirement plans fall into two categories: qualified and
nonqualified. Qualified plans are traditional plans, such as
401(k)s, that qualify for special treatment under tax and
employment law, including an immediate deduction for
employer contributions and deferred income for employees.
Nonqualified plans are contractual arrangements between the
employer and employee that don’t meet the “qualified”
requirements. Nonqualified deferred compensation plans
typically benefit only a select group of key employees. If
properly set up, the employee doesn’t pay income tax (and
the business doesn’t receive a deduction) until the amounts
are received at some point in the future. Note, however,
that the rules got tougher under the American Jobs Creation
Act for compensation deferred after 2004.
Pay well and keep them happy
Quality employees can make a huge difference to any company.
And a well-thought-out compensation package can make a huge
difference between a happy employee and one who’s ready to
walk. Make sure your compensation package fills the bill.
Back to top
Phishing got you down?
Develop an information security policy
The same technology revolution that ushered in the Internet
has also introduced many new security risks. To thwart
potential risks to your business, personnel, suppliers and
customers, understand what you’re up against and put a
protective policy in place.
Know the risks
Information security breaches cost companies dearly in
personal computer (PC) and network system repairs, lost
worker productivity, potential business, and the theft or
loss of valuable and proprietary company data, such as
financials, personnel data, product research and
development, and market intelligence.
Along with the ever-present threats caused by computer
viruses, worms and Trojan horses, here are some other
technology breaches to prepare for:
Hacking. Hackers use special search tools to target
unprotected PCs for the purpose of damaging or stealing
data. Bigger scale hacking schemes, known as “denial of
service” attacks, are designed to bombard and shut down
company computer networks.
Phishing. This security breach involves spam e-mails
or pop-up messages created by fraudsters that are linked to
phony Web sites. The purpose is to steal people’s identities
and money by tricking them into responding to phony offers,
such as loan or credit card applications.
Cyber terrorism. Online “terrorists” use computing
technologies to threaten, with vengeful harm, a group or
organization of people into acting a certain way.
With an awareness of these possible risks, you can put a
plan in place to protect your organization.
Develop an information security policy
Start by assessing the risks specific to your company’s
computer systems and prioritize the need to address each
based on standards and compliance requirements for your
industry. For example, special compliance requirements may
apply for financial services or health care companies
dealing with highly confidential information.
As you develop your policy, make sure it’s realistic by
balancing it against the estimated resources required, costs
and timeline as well as any impact on company productivity
and revenue.
Your plan should address implementing protective programs,
including antivirus software to inoculate against and
eradicate viruses; firewall software to examine all incoming
and outgoing messages and block unauthorized access to your
company network; and monitoring software to watch over
company computer systems and data, including e-mail and
Internet activity.
Other important preventive measures include:
-
Requiring employees to use more difficult PC passwords
and to change them often,
-
Advising workers against opening unsolicited or
strangely named attachments with unfamiliar file
extensions received via e-mail or instant messaging,
-
Exercising caution when using portable floppies and
flash drives to transfer information between computers,
unless you know they are protected,
-
Watching for signs of possible PC system tampering, such
as slower operation, disappearing programs, and unusual
disk or screen activity, and
-
Performing regular backups to facilitate the recovery of
data, including company files, e-mail and address books,
in the event of a breach.
An
important part of your security policy is a program that
continuously measures policy effectiveness and reassesses
risks and priorities based on changing business needs.
Manufacturers often close security breaches with patches or
new versions of software. So stay current by regularly
downloading software updates to protect against new threats.
Companywide participation is key
You may go to great lengths to protect your business from
information security breaches. But computer security is not
a “set it and forget it” proposition. It
requires constant vigilance. To help ensure success, involve
your management members and staff throughout the policy
development process to secure and maintain their support
from the outset.
Back to Top
Capital ideas
Year end tax strategies for investors
As the year winds down, it’s a good time to review your
portfolio and consider investment moves you can make before
Dec. 31 to cut your tax bill. But be sure to keep your
overall financial picture in mind. Your decision to buy,
sell or hold investments should never be based on tax
savings alone.
Take stock of your gains and losses
Review your portfolio’s “paper” capital gains and losses,
and consider selling some of the losers to offset gains
you’ve recognized. If your losses for the year exceed your
gains, you can use the net loss to offset up to $3,000 of
ordinary income. You may also carry over unused losses
indefinitely to offset gains — and up to $3,000 of ordinary
income — in future years.
Even if you haven’t sold any securities this year, you may
have received capital gains distributions from mutual funds.
These gains must be reported on your tax return even if they
were automatically reinvested in more of the mutual funds’
shares.
Have your cake and eat it, too
A popular strategy is to sell stock or other securities at a
loss and then replace them with the same securities. This
technique allows you to generate a tax deduction while
keeping your portfolio intact.
But watch out for the “wash sale rule,” which prohibits you
from deducting a loss on the sale of a security if you
acquire substantially the same security within 30 days
before or after the sale. Fortunately, if the wash sale rule
applies, you don’t lose the deduction permanently. Instead,
the loss increases your cost basis in the replacement
securities, so it reduces your gain later when you sell
those securities.
Nevertheless, there are ways to get around the wash sale
rule. The simplest is to sell securities at a loss and wait
31 days before you repurchase them. A safer option, if you
can afford it, is to “double up” on the securities and then
wait 31 days before unloading the original securities.
Let’s look at an example. Sandra owns 1,000 shares of stock
in Untapped Potential Inc. (UPI), which she bought on Oct.
31, 2004, for $100 per share ($100,000). On Nov. 30, 2005,
the market price dropped to $80 per share, for a paper loss
of $20,000. Sandra would like to recognize the loss to
offset gains on other stocks she sold earlier in the year,
but she’s not ready to give up on UPI, whose long-term
prospects look bright. Her solution is to buy another 1,000
shares of UPI stock on Nov. 30 for $80,000. On Dec. 31, when
the price has dipped to $75, Sandra sells her original UPI
shares, generating a $25,000 capital loss for 2005 without
changing her position in the stock.
Hold on to benefit from low rates
Qualified dividends and long-term capital gains are
currently taxed at a maximum rate of 15% (5% for taxpayers
in the two lowest tax brackets). With ordinary income tax
rates climbing to as high as 35%, qualifying income for the
15% rate can mean substantial savings. But plan carefully,
because not all dividends and capital gains are eligible for
the reduced rates.
You’re entitled to the lower tax rate on dividends you
receive from domestic corporations or qualified foreign
corporations. A qualified foreign corporation is one that’s
incorporated in a U.S. possession or in a country that has a
current tax treaty with the United States and meets certain
other requirements. To qualify for the reduced rate, you
must hold the stock for at least 61 days during the 121-day
period that begins 60 days before the ex-dividend date. The
ex-dividend date is the cutoff date on and after which stock
buyers are no longer entitled to receive a declared
dividend.
Favorable capital gains tax rates are limited to long-term
capital gains — that is, gains on securities held for more
than one year. Short-term gains are taxed as ordinary
income, so when possible wait until you’ve met the holding
requirement before selling appreciated securities. The
holding period for long-term gains is more than one year, so
if you acquired a security on Dec. 31, 2004, you’ll have to
wait until Jan. 1, 2006, to qualify for long-term capital
gains treatment.
Cover all your bases
When you sell shares of stock or mutual funds, the tax
impact can vary dramatically because of your basis in the
shares. And different shares of the same
security may have different bases, depending on when you
bought them. In most cases, if you’re selling less than all
your shares, you’ll want to sell the shares with the highest
basis to minimize gains or maximize losses.
Suppose John makes the following purchases of XYZ stock:
- Feb. 1, 2004: 1,000
shares for $10 per share,
- Mar. 1, 2004: 1,000
shares for $12 per share, and
- Sept. 1, 2004: 1,000
shares for $22 per share.
On Dec. 1, 2005, John sells
1,000 shares of XYZ for $20 per share. If he doesn’t specify
which shares he’s selling, the IRS will use the first-in,
first-out (FIFO) method as the default method. Under FIFO,
it’s presumed John sold the shares he bought on Feb. 1,
2004, for a capital gain of $10,000.
If John had elected to sell the Sept. 1 shares using the
“specific identification” method, he would have recognized a
$2,000 loss. (Keep in mind, if you elect to use the specific
identification method, you must identify the shares at the
time of the sale.)
For mutual funds, you have four options for calculating the
basis of shares you sell. In addition to FIFO and specific
identification, you may elect to use one of two average cost
methods: the double category method and the single category
method.
Many mutual funds facilitate the process by providing
average cost information, but compare all four methods and
choose the one that best meets your needs.
When calculating your basis in mutual funds, don’t forget to
include any reinvested dividends in your cost.
Plan for many happy returns
Investment decisions should be driven by long-term earnings,
but don’t overlook taxes. If you incorporate these
strategies into a sound wealth management plan, your tax
returns can significantly affect your investment returns.
Back to Top
