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Use a hands-on approach to tackle key business tax issues including the latest business tax developments. Apply the latest changes when preparing federal income tax returns and advise clients on new developments and tax-saving ideas for C Corporations. As a perfect companion to the related pass-through entities course in this series, many key tax return issues are covered.
Objectives:
TOC from previous edition. Please check back for updates.
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Excerpt from previous edition. Please check back for updates.
Chapter 3
C Corporation Items of Deduction
Learning Objectives
After completing this chapter, you should be
Salaries and Wages
Overview
Salaries, wages, and other payments to employees normally are deductible business expenses (Reg. ~§~1.162-7). However, four tests must be met:
Test 1 - Ordinary and Necessary
Comment: Taxpayers must show that salaries, wages, and other payments for employees' services, like any other business expenses, are ordinary and necessary expenditures directly connected with or pertaining to the taxpayers' trade or business.
Test 2 - Reasonable
Comment: Reasonableness of compensation is almost never questioned by the IRS unless the employee recipient is somehow "related" to the payor-taxpayer. For a corporate payor, a related recipient employee would be a stockholder or a member of a stockholder's family in a closelyheld corporation. In determining if compensation for a year is reasonable, all compensation is considered: the employee's salary, bonus, commissions, deferred compensation, fringe benefits, etc.
Test 3 - Services Rendered
Comment: A deduction is allowed only with respect to compensation for services actually rendered. Neither a cash- nor an accrual-method taxpayer can deduct amounts in years before services are performed.
Example 3-1 / Payment Before Services are Performed
If a payment is made in 2008 for services performed partly in 2008 and partly to be performed in 2009, the deduction is taken partly in each year. However, a cash-basistaxpayer can deduct in 2008 payments made in 2008 for services performed in 2008 or any earlier year.
Test 4 - Paid or Incurred
Comment: The taxpayer must have actually made the payments or incurred the expense during the tax year.
Severance Payments
Severance payments to employees are generally deductible as business expenses. Although these payments made in connection with a business downsizing may produce some future benefits, such as reducing operating costs and increasing efficiencies, they principally relate to previously rendered services of those employees and, therefore, are generally currently deductible as business expenses (Rev. Rul. 94-77, 1994-2 CB 19). The INDOPCO decision [92-1 USTC ~¶~50,113 (Sup. Ct. 1992)] does not affect the treatment of these payments. In that case, the U.S. Supreme Court concluded that certain legal and professional fees incurred by a target corporation to facilitate a friendly merger created significant long-term benefits for the taxpayer and, therefore, were capital expenditures.
The Federal Circuit affirmed three lower court decisions holding that early termination payments to departing employees represented wages and thus were subject to FICA tax. The termination payments were based on a formula using salary and years of service, so the court determined the payments could be directly connected to the employer-employee relationship and accordingly were subject to FICA (Associated Electric Cooperative, Inc. v. U.S., CA-FC, 9/28/2000; Abrahamsen v. U.S., CA-FC, 9/28/2000; Cook v. U.S., CA-FC, 10/2/2000). For additional cases and rulings on this subject see Abbott v. U.S. 2000-2 USTC ~¶~50,819, aff'g 2000-1 USTC ~¶~50,127 (U.S.D.C. NY 12/3/99).
v Development: In CSX Corporation, 518 F3d 1328 (Fed. Cir.), the corporation experienced financial difficulties and created programs with financial arrangements that encouraged employees to separate from the company. One type of payment was for layoffs and was a percentage of monthly compensation. A second type of payment was for reserve pools of employees who were eliminated as full-time but received a guaranteed minimum for each pay period adjusted for work performed as needed. A third type of payment was offered to nonmanagerial employees in exchange for agreeing to terminate employment, some of which were voluntary and some involuntary. The appellate court found that all four types of payments were wages or compensation for FICA and RRTA purposes.
Reasonable Compensation
Tax Planning the Compensation of a Stockholder-Employee
In the case of a closely-held corporation, the corporate tax rate structure is often a major influence in determining the amount of compensation that will be paid to stockholder-employees. Owner salaries and year-end bonuses are often used to reduce the corporate taxable income to an efficient level, giving consideration to both the corporate tax rates and the marginal rate of the individual shareholders.
In view of the fact that personal income tax rates now top out at 35%, a review of the corporate tax rate schedule indicates that most closely-held corporations would not retain annual taxable income above $75,000 or $100,000 (see a reproduction of the corporate tax rate schedule near the end of Chapter 5). Above $100,000, the corporate marginal rate is 39% on all taxable income to $335,000, and then drops back to a flat 34% until $10 million of taxable income. Even though some individuals will have marginal tax rates slightly greater than 35% because of the phase-out of itemized deductions and the phase-out exemptions1, the fact that earnings retained within the corporation will at some point be taxed again (in the form of increased value of the corporation at sale or liquidation, albeit generally at capital gain rates) suggests that when personal and corporate rates are nearly equal, the income should be moved to the personal return as long as the amount represents reasonable compensation for the services performed.2
Taxes, of course, are not the only influence on the retention of corporate earnings. A corporation must first consider its cash flow needs, and determine how much capital is appropriate to retain within the corporation for its reasonable business needs. The balance can be distributed as compensation to stockholder-employees, to the extent that it represents reasonable compensation in view of the value of their services. If the corporation has need for earnings beyond the $75,000 or $100,000 taxable income level, and if the reasonableness of compensation is not an issue, the shareholders should consider extracting the funds as salaries to reduce the corporate taxable income to an efficient level and then personally loan back to the corporation the portion of funds needed for business uses.
Note. The Medicare portion of the Social Security tax (1.45% each for employee and employer, total 2.90%) is applicable to the portion of the employee's salary exceeding the Social Security wage base ($102,000 for 2008). Thus, if Executive X is paid $300,000, X will pay a Medicare tax of $2,871, and the employer will pay an additional $2,871 on the $198,000 that exceeds the $102,000 Social Security 2008 wage base, for a total of $5,742 in extra Medicare tax. This should be taken into consideration in determining the best salary tax-wise for a C corporation's executives. (Of course, the corporation's share of the extra Medicare tax is deductible by the corporation.)
Reasonableness of Compensation
The reasonableness of compensation is a question of fact. Case law has provided an extensive list of factors that are relevant in determining the reasonableness of compensation (Comtec Systems, Inc. v. Comm., TC Memo 1995-4; Acme Construction Co., Inc. v. Comm., TC Memo 1995-6). Twelve factors have frequently been used by the Tax Court:
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