Tide Company pays its sole shareholder, Nick Sabar, a salary of $108,000. At the

Question

Tide Company pays its sole shareholder, Nick Sabar, a salary of $108,000. At the end of each year, the company pays Nick a bonus equal to the difference between the corporation’s taxable income for the year (before the bonus) and $75,000. In this way, the company hopes to keep its taxable income at amounts that are taxed at either 15 percent or 25 percent. This year, Tide reported prebonus taxable income of $656,000 and paid Nick a bonus of $581,000. On audit, the IRS determined that individuals working in Nick’s position earned on average $290,000 per year. The company had no formal compensation policy and never paid a dividend. Assume Nick’s marginal ordinary rate is 35 percent and his rate on dividends is 15 percent. Refer Corporate tax table.

a. How much of Nick’s bonus might the IRS recharacterize as a dividend?

b. Assuming the IRS recharacterizes $199,500 of Nick’s bonus as a dividend, what additional income tax liability does Tide Company face?

Explanation / Answer

(a) Excess compensation is the Nick's bonus recharacterized as a dividend = $108,000 + $581,000 - $290,000 = $399,000

(b) New company's taxable income = $75,000 + $199,500 = $274,500

Tax on $274,500 = ($274,500 - $100,000) * 39% = $68,055 + $22,250 = $90,305

Tax on $75,000 = $(75,000 - 20,000) * 25% = $13,750

Increase in tax liability = $90,305 - $13,750 = $76,555

* Please note that the corporate tax table is not provided, so if there is a change in tax rate used above. Please update it accordingly. The approach is the same. (Only the tax rate might change)

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