1. Identify Effective Tax Strategy for Employee Compensation
2. Describe the Steps Utilized in Conducting Research:
3. List Tax Principles Used:
4. Assess the Likelihood of IRS Challenge
Mr. Whit is the sole shareholder and CEO of newly incorporated Talawanda Concepts.
He plans to pay himself a reasonable $100,000 annual salary. However, the
corporation will pay his first-year salary on a monthly basis and the entire secondyear
salary on December 31. The corporation will pay nothing to him during the second
calendar year, and then it will repeat the payment cycle in the third calendar year.
Talawanda will fund each year-end salary prepayment through short-term loans from
a local bank. The purpose of this odd payment schedule is to avoid Social Security tax
on Mr. Whit's base salary in alternating years. Will this strategy to minimize his payroll
tax actually work?
The problem is not quite as simple as it sounds because there are two variables which expand the options and the issues: the treatment is subject to different rules and limitations depending upon whether the corporation is an "S" or a "C".
1. The strategy was concocted to try to save social security tax which can be quantified for 2008 as $102,000 x 12.4% = $12,648. The 12.4% is the combined amount paid half by the employee and half by the employer. There is no limit for Medicare tax at 2.9% on the total amount paid (which includes employee and employer share). As a result, the individual could save $12,648 of FICA taxes in each of the four year strategy.
2. I conducted my research to include the following topics by type of corporation:
a. C Corporation
1. What factors constitute reasonable compensation
2. Application of the independent investor standard
3. Assessment of a successful IRS challenge
4. Penalties that might apply
5. Imposition of the Accumulated Earnings tax
6. Reclassification of wages as dividends and therefore double taxed
b. S Corporation
1. Compensation must be reasonable
2. Compensation must be treated as wages
3. Income-shifting purposes
4. Minimizing salaries to reduce payroll taxes
5. Recasting shareholder income as distributions, not wages
3. In ...
The tax savings for bunching two years' salary in one is calculated, but the real issue is an IRS challenge. The 800+ word solution explains how the IRS would challenge the issue and how they would assess tax, penalties and interest including the personal return. The solution diffentiates conclusions between a C and an S corporation, and also discusses planning that could have avoided the issue in the first place.