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Taxation Memo

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Write a memorandum addressing each of the three issues listed below.

Mr. Kim is the sole shareholder and CEO of KimTech, Inc., a technology company valued at approximately $5,000,000. KimTech is a C corporation for federal tax purposes. In 2007, KimTech had net pretax profits--before deducting Kim's compensation--of $1,000,000. After deducting Kim's base salary of $100,000 and bonus of $800,000, the company was left with a small after-tax profit, which was retained by KimTech (i.e., no dividends were paid to Kim). KimTech has two other officers, a CFO and a VP of Sales and Marketing, each of whom received salaries of $100,000 and no bonuses. Kim's bonus was awarded by the board of directors, which consists of three directors: Kim, who serves as Chairman, the CFO and the VP of Sales and Marketing. In determining Kim's bonus, the board multiplied pretax profits, before Kim's compensation, by 80% (i.e., $1,000,000 x .8 = $800,000 bonus). In recent years, KimTech's value has been appreciating at 7% per year. Assume that the average compensation for CEOs of similar-sized companies in the same industry is $500,000 (salary and bonus combined).

Use the typical tax resources both primary and secondary which include statutes, regulations, and court decisions to formulate your advice regarding each of the three issues listed below:


1. Assuming that 2007 is a typical year for KimTech, in terms of profitability and compensation practices, evaluate the reasonableness of Kim's compensation package in light of the five factors enumerated in the Elliotts case. If audited by the IRS, will Kim's compensation be deemed reasonable? Why or why not? What can KimTech do to show that Kim's compensation is reasonable?

2. Assuming that 2007 is a typical year for KimTech, in terms of profitability and compensation practices, evaluate the reasonableness of Kim's compensation using the independent investor/return on equity approach. Is Kim's compensation package reasonable under this test? Why or why not?

3. Is contingent compensation (e.g., a compensation package involving a significant bonus) more likely to result in a determination that compensation is unreasonable than a compensation package that is all, or primarily, a fixed salary?

Use the following heading and other specifics:

TO: Mr. Kim
FROM: Your Name
DATE: Today's Date
RE: Tax Memo #2-Executive Compensation

For each issue, begin by restating the issue. Then, explain and discuss the tax rules that apply to the issue, which you gleaned from the sources listed in the Applicable Law section above. Then, conclude with a definitive answer to the issue, supported by citations to the sources used. So, for each issue, you should:

1. State the issue,
2. Explain and discuss the applicable law (IRC sections, regulations, court decision, etc.), and
3. Present your answer in the form of a concluding paragraph that refers to specific language from the IRC sections, regulations, court decisions, and other sources (if applicable) to support the conclusion.

Citations are required. You must provide cites whenever you refer to the sources of tax law used in this memorandum. You may cite your sources in numbered footnotes, numbered endnotes, or in parentheses immediately after the sentence mentioning the cited source.

Solution Preview

The first issue is that the reasonableness of Kim's compensation package is to be evaluated in the light of the five factors enumerated in the Elliot's case. The issue is will IRS evaluate Kim's compensation to be reasonable and if Kim's compensation package is reasonable under the test.

The relevant case law is Elliotts, Inc. v. Commissioner (1983) that is used to ascertain reasonable compensation under section 162(a)(1). The five factors are employee's role in the company, external comparisons, character and condition of the company, conflict of interest, and internal consistency.

IRS will not deem Kim's compensation to be reasonable. The reason is that his bonus alone is 80% of the company's earning. Moreover, he has an additional fixed salary of $100,000. This makes his compensation equal to 90% of the net pretax compensation. The IRS will perceive the high compensation as an attempt to avoid paying taxes. However, Kim can defend himself using the five factors established in Elliott's case. With respect to employees role in the company, Kim can claim that he is instrumental in getting all the business, he has established relationships with customers, and is the ...

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