Karl Stick is president of Stock Company. He also owns 100 percent of its stock. Karl's salary is $120,000. At the end of the year, Karl was paid a bonus of $100,000 because the firm had a good year. Stock Company deducted $220,000 as compensation expense for the year. Upon audit, $80,000 of the deduction was disallowed. How could this happen? How would you advise Stock Company?
The conclusion of the IRS auditor is not uncommon in this situation.
Here's the problem:
Karl is both an employee and a shareholder. He is rewarded for his efforts differently in the two capacities. As an employee he should be paid a reasonable compensation for services performed. As a shareholder, he should be rewarded with dividends which are really distributions of earnings (a return on investment).
The tax consequences of wages versus dividends are very different in a closely-held Sub chapter C corporation. Wages are fully deductible to the corporation, and FICA/Medicare taxes are withheld and matched by the company. The W-2 is prepared and treated as any ...
The solution explains the problem from the perspective of the IRS including the tax consequences of the reclassification of compension. Further, the problem gives a list of four actions a company might take to avoid the issue of disallowed compensation to the owner of a closely held corporation.