Accounting

1

Introduction

Thepaper aims at providing recommendations, creating a tax plan andproposing a strategy for a client who is currently underinvestigation by IRS. Internal Revenue Code, IRC, provides theguidelines to be followed in determining the allowable and disallowedamounts in determining taxable amounts.

Facts

  1. Unreasonable compensation, stock redemptions and rental losses are the main issues. The client received 5% of gross receipts and base salary of $10 million. However, the 5% of the gross receipts should not exceed $5 million.

  2. The client redeemed 50% of the outstanding stock in the construction company. The client’s son also redeemed similar proportion of shares. The redemption was treated as a distribution under Section 301 of the IRC.

  3. The company also recorded rental losses associated with a building owned by the client. The building was leased to the construction company.

Issues

Fromthe facts above, there are three main issues

  1. Whether the amount received by the client as salary should be allowable or treated as constructive dividends.

  2. Whether the redemption of shares in the construction company should be treated as a distribution

  3. How to treat the rental losses from the building leased to the construction company

Localeapplicable authorities

UnderIRC 162 (a), the allowable amount for taxation purposes is expectedto follow performance-based compensation for any amount above $1million. Any amount above $1 million should be conditioned on theexecutives’’ performance. Any compensation in excess of $1millionrequires special treatment.

Section303 of the IRC outlines the taxation criteria for stock redemptions.The amount redeemed is treated as a corporate distribution. Partialredemption is taxable. According to Section 301, the redemptionamount shall be treated as a distribution of the property, regardlessof whether it’s partial redemption. In case of family ownedcorporations, the extent of redemption will determine whether theproceeds will be treated as an ordinary sale or as dividends. Theextent of redemption can be substantially disproportionate, partialliquidation or complete termination [ CITATION Mar11 l 1033 ].

IRC1031 (f) highlights the tax related requirements for related parties’transactions. The code disallows any related party losses. Relatedparties transactions arise if the taxpayer controls, either directlyor indirectly, more than 50% of the entity under consideration.Related party includes the entity, family members and the tax payer.Related parties are not entitled to tax-deferred treatment underSection 1034 (f) (4).

Evaluationof the authorities

IRC162 (a) is applicable in solving the first issue on constructivedividends. Section 303 (a) outlines the tax treatment of stockredemptions, and Section 267 (a) outlines the tax treatment ofrelated parties’ transactions. The sections will help in makingrecommendations to the client on the issues highlighted above.

Analysisof the facts

Basedon IRC 162 (a), the clients’ base salary of $10 million should betreated as constructive dividends. The code states that any amount inexcess of $1 million should be based on performance for it to qualifyto be deductible. The amount received by the client cannot beconsidered to be “reasonable compensation.” Reasonablecompensation is determined by a corporations’ Return on Equity,ROE. This is as highlighted in ExactoSpring Corp. v. Commissioner (196F.3d 833 (7th Cir. 1999) [ CITATION Int09 l 1033 ].

Theclient and the son each redeemed 50% of their shareholding in theconstruction company. The construction company is still wholly ownedby the client and the client’s son. The redemption should,therefore, be treated as corporate distribution.

Therental losses arising from the building owned by the client and sondo not qualify for deductions.

Conclusions and recommendations

Basedon the issues and facts discussed above, the client should accept theproposed adjustments. However, changes in the shareholding of theconstruction company would help the client to appeal the proposedadjustments.

Tax plan for future redemption of shares

Redemptionproceeds can either be treated as a sale or as a dividend. In casethey are treated as a sale, they are non-taxable to the extent of theclients’ redeemed shares. The surplus amount is considered to be aninvestment gain.

Infuture, the client can adopt any of the following redemption methods

  • A partial liquidation where the redemption is subject to partial’s liquidation of the construction company such as sale of assets.

  • Complete redemption of shares. In this case, the client and the son relinquish their ownership in the construction company.

  • Substantially disproportionate redemption. The client and the son should own less than 50% of the outstanding voting rights in the construction company after redemption and / or less than 80% before redemption, combined (client and the son) [ CITATION CCH08 l 1033 ].

Strategy for receiving similar amount in future

Theclient should adopt a performance-based pay so that the base salaryand the 5% of gross receipts can be allowed. Sufficient explanationshould be given to ensure that the total salary of $10 million isconsidered as “reasonable compensation.” IRC 1062 (a) states that“reasonable compensation” should not exceed $1 million. Failureto explain the excess amount would lead to the amount being treatedas constructive dividends. The client should also take intoconsideration the value of the employees’ contributions. The valueis indicated by the company’s ROE.

References

CCH Tax Law Editors. (2008). Internal Revenue Code: Income, Estate, Gift, Employment and Excise Taxes, Including All 2007 Amendments. Riverwoods, Ill: Toolkit Media Group.

Fried, M. L. (2011). Taxation of Securities Transactions, Volume 1. Dayton, Ohio: LexisNexis.

International Business Publications, USA. (2009). United States: How to Convert Taxes Into Profit Professional Guide for Non Profits Organizations: Tax Management for Business Activities. Int`l Business Publications.