Topic: Section 162 Assignment
Sarais the principal shareholder in Mayfield Corporation with 60% of theshares, she is also an officer of the company and it director to. Thecompany pays tax annually using the method of accounting. Sarareceived the following amounts as salary and nontaxable fringebenefits from Mayfield:
Thischanged when Mayfield bylaws were amended on December 15, Year 2,andin Year 4, upon auditing Mayfield’s tax returns for Year 1 throughYear 3, a revenue agent determined that reasonable compensation forSara’s services is $110,000, $165,000, and $175,000, respectively.We are to determine what salary and fringe benefits are taxable toSara inthe period Year 1 through 3 and what reimbursements Saracan deduct during the period Year 5 through Year 9.
Sec162(a)(1) permits a taxpayer to deduct a reasonable allowance forsalaries or other compensation for personal services actuallyrendered that is paid or incurred during the tax year. RegulationSec. 1.162-8 holds that, “The income tax liability of the recipientin respect of an amount ostensibly paid to him as compensation, butnow allowed to be deducted as such by the pay or, will depend uponthe circumstances of each case.” Such amounts may be taxed to therecipient as a dividend. But, “in the absence of evidence tojustify other treatment, excessive payments for salaries or othercompensation for personal services will be included in gross incomeof the recipient.”
RevenueRuling 69-115, 1969-1 C.B. 50, holds that shareholder-employees of aclosely held corporation are entitled to deduct as a business expensein the year of repayment the portion of the salaries they receivedthat were declared unreasonable compensation. Only the amounts theywere legally obligated to repay under an agreement with thecorporation can be deducted. The obligation to repay the salariesmust be enforceable under state law. No deduction is available forany amounts that are voluntarily repaid. Also see Vincent E. Oswald,49 T.C. 645 (1968), act. 1968-2 C.B. 2, where the Tax Court held thata repayment was denied a deduction for amounts the shareholdervoluntarily repaid prior to the adoption of a by-laws amendmentrequiring such repayments. Amounts were deductible, however, whenpaid after the corporation adopted a by-laws agreement requiringrepayment of nondeductible compensation payments.
Inthe case at hand, The IRS (internal revenue rate) is unlikely toreclassify the excess compensation as a dividend because, undercurrent law, dividends for the years in question would be taxed atthe applicable capital gains rate.
Thereforeif the unreasonable compensation equals:
Thetaxable amount is
Totalunreasonable amount-deductable ($240,000-23,625) = 216,375
Thisis due to that all the compensation is taxed in the tax year in whichit is received. Only the portion of the compensation repaid after theadoption of the by-laws amendment on December 15, Year 2 can beducted. This amount should be: Year 1, $0 Year 2, $3,125 (1/24 x $75,000) and Year 3, $115,000. One could treat a ratable share ofthe repayment as being deductible in each of the five years in whicha payment is made so that one-fifth of the Year 2 and Year 3 amounts[$23,625 = 0.20 x ($3,125 + $115,000)] is deductible in Year 5through Year 9.