Corporate Income Taxes Issues and Facts of unreasonable compensation, stock redemptions treated as dividends and related party losses. Closely held companies pay compensation to employees and shareholders, instead of paying dividends since compensation is deductible. The Internal Revenue Service Audit of a company will disallow a portion of compensation deduction on the basis that it was unreasonably excessive; thus treated as nondeductible dividend. The impact of this adjustment has not been of concern since dividends have been taxed to individuals at a rate of 15% versus compensation, which is taxed at a maximum of 35%.
Besides, dividend distribution is not subject to employment taxes (Lassila & Kilpatrick, 2008). The shareholders transfers common stock to the issuing company in exchange for property or money. The transaction is likely to be either the sale of stock to the outsider or the receipt by the shareholder of dividend from the company. The sale of stock by a shareholder to his/her company is taxed as dividends, instead of being taxed as sales. Some of the issues facing the Congress, courts and treasury over the years is the determination of which transfers of stocks are supposed to be classified as sales and which of them should to be treated as sales.
But these parties do accept that transactions are treated as sales unless the transaction was equivalent to the distribution of taxable dividends. Taxes drive number decisions when it comes to owning rental properties. Therefore, landlords have a hard time in tax planning for rental properties. The largesse from the Treasury to the landlords does not have limits. After the deductions, IRS provides landlords with passive losses.
Those which exceeds Rent received cannot be used in offsetting ordinary income like salaries. Tax Law and its Implications to Businesses The compensation of the taxpayer from the gross receipt of the business is against IRS laws and regulations on compensation. The taxpayer pays himself very high compensation to reduce the amount of net income of the business; thus reducing dividends distributed among shareholders. Therefore, excess compensation should be treated as dividends and should be taxed differently. Dividends do undergo double taxation since they are taxed at the company level as income and also when being distributed to shareholders as the share of profit.
For tax planning purposes, the taxpayer should realize that dividends are taxed at the rate of 15%, compared to compensations, which are taxed at the rate 35% (Bankman, Griffith, & Pratt, 2008). Therefore, it is even worse for the taxpayer to pay himself/herself high compensation on the basis of trying to reduce tax burdens. In fact, high compensation increases the tax burden on the taxpayer. The general view of section 162(a)(1) of the Internal Revenue Code as contained in IRS allows publicly traded firms to deduct an unlimited amount of executive compensation for corporate tax purposes because salaries of senior employees are always negotiated at an arm’s length by the profit-maximizing board.
On the other hand, IRS uses section 162 (a) (1) to limit corporate deductions for the executive compensation paid by closely held companies because such companies lack enough finances to put in place checks and balances of publicly traded companies (Zelinsky, 2009). When family owned companies redeem shares, the purchase of those shares qualifies for capital gain treatment.
Precisely, the sale of shares should be treated as the distribution of dividends to shareholders. The most important result of dividend treatment relates mostly to the difference in tax rates applied to dividends and the long-term capital gains. The long-term capital gains recognized by shareholders who sell shares held for more than one year are taxed at the rate of 20% (Brody & Daiker, 2008). Therefore, the redemption of shares by the taxpayer and his son should be taxed at 20% federal rates since they have owned these shares for more than a year.
Since there are some differences in the treatment of capital gains and dividends, the taxpayer should in future attempt to structure the corporate distribution as share redemption, other than treating it as dividends in order to reduce its tax burden. Solving the Problem and Communicating the Findings The problem of the unreasonable contribution can be solved by the taxpayer by reducing his level of compensation based on the current level of 5% on the gross receipt. The IRS will treat excess compensation as constructive dividends, which are taxed at the rate of 35%, other than the 15 % tax rate for compensation.
As a result, the taxpayer would be forced to pay more taxes because of poor tax planning. In the case of stock redemptions in the construction company, taxes should be remitted at a rate of 20% on the redemption value as required by the federal tax laws. The rental loss from the construction company can neither be offset by tax liabilities for other companies of the taxpayer nor other income like the taxpayer’s salary (Hoffman, Raabe, Smith, & Maloney, 2007).
Therefore, based on the findings from unreasonable compensation, stock redemption, and rental losses, the client should accept Notice of the Proposed Amendment and adjust as per the requirement of the adjustments. This will relieve the taxpayer from future tax burdens resulting from failure to abide by the set federal tax laws. References Bankman, J., Griffith, T. D., & Pratt, K. (2008). Federal Income Tax: Examples & Explanations. London: Aspen Publishers Online. Brody, L., & Daiker, S. B. (2008). The Insured Stock Purchase Agreement with Sample Forms.
Washington D. C: American Bar Association. Hoffman, W., Raabe, W., Smith, J., & Maloney, D. (2007). West Federal Taxation 2008: Corporations, Partnerships, Estates, and Trusts, Professional Edition. Stamford: Cengage Learning. Lassila, D. R., & Kilpatrick, B. G. (2008). U.S. Master Compensation Tax Guide (2008). Illinois: CCH. Zelinsky, A. S. (2009). Taxing Unreasonable Compensation: § 162(a)(1) and Managerial Power. The Yale Law Journal, 637-645.