Executive Salaries - Deductible Compensation or non-Deductible Dividend - Case Study Example

Memo File Ali Yusuf RE: XXin Inc. (tax year Facts Simon Jones, our client and a citizen of the United States, is the company president for a C Corporation, the Xinn Inc. Because of the size and lack of proper review of the salaries paid to similar corporations, Xinn Inc. pays the president more than what other equivalent companies pay. It now considers deducting the salary. In the corporation (Xinn Inc.), the shareholders’ (Simon Jones-the father, James Brown-the son, and Janine White-the daughter) total income is $13,980,000 from gross sales or receipts, costs of goods sold, sales of trusts and estates, net farm profits, net gains, and other total incomes. Total deductions (expenses) are $4,872,000,000. Deductions include wages and salaries, payments to the partners, maintenance and repairs, bad debts, licenses and taxes, rent, interest on bank loans, depletion, less depreciation, and depreciation. From the $13.98 million income, the firm was compelled to pay $1.56 million fines the Indiana State EPA for violation of clean air laws. As a response to the fines charged by the EPA, Xinn Inc. paid $250,000 for legal representation of the company in the court of law. The company is itemizing the annual salary of Simon Jones as a mandatory deduction. The president is paid $2.6 million per annum. Each shareholder and the president file their deductions jointly. Issues and conclusions 1 Is Xinn Inc. permitted to deduct the extra salary paid to Simon Jones? No, Xinn Inc. cannot deduct the high salary of $2,600,000 paid to Simon Jones Analysis 1 The huge salary paid to Simon Jones cannot be deducted since the Xinn Inc. failed to record the ‘deferred compensation’ liability in its financial statements. For the compensation to be ordinary for deducting, John L. Ginger Masonry [TCM 1997-251] requires that a number of factors need consideration (Greenwald, 1). Some of the factors that favored the corporation president from being deducted were: 1) Company role-the president conducted all the managerial responsibilities with only normal support, working weekends and long hours; 2) External comparison-the compensation was not in excess comparing the salary with other similar firm’s compensation for the duties and activities successfully completed; 3) Company condition-basically due to the involvement and efforts initiated by the president of the company, the corporation in question had emerged one of the top performers in a very competitive industry was capable of weathering the recession in the early nineties; 4) lack of dividends-the lack of evidence that dividends had not been given does not necessarily imply that the compensation was unjustified, given the elements of the case; and 5) Internal consistency-incase the salary is much out place with dues given to other company employees, this implies that the pay in part illustrates a dividend paid to the shareholder officer (Greenwald, 1). Here, they failed to identify such inconsistencies. On a different note, independent investor examination may be used to determine whether the president’s salary is deductable or note. Exacto Spring Corp. v. Commisioner, 196 F.3d 833 [7th Cir. 1999] sought to render the various techniques for reasonable compensation into simpler test referred to as ‘independent investor’ (Greenwald, 1). Using this examination, the corporate-executive connection can be seen as contract where by the company hires the president to manage the assets. In this case, the executive strives to increase the corporate value of assets in exchange for the stated basic salary. When the executive attains higher rates of returns adjusted to projected risks, he is entitled to a higher or improved salary. The Exacto case stated above involved paying $1.3 million in 1993 and $1,000,000 in 1994 as the salary for its chief executive and co-founder. The corporation was manufacturing precision springs. The IRS cut the deductible sums to $0.38 million and $0.4 million correspondingly. The Tax Court decided that the logical compensation was midway between the value the IRS considered practical and the amount paid. Judge Posner indicated that the expert representing IRS testified at the hearing that shareholders or investors in a company of Exacto standard would anticipate a 13% ROI. However, the Tax Court noted that the actual ROI was 20%. Using these findings, Judge Posner decreed that the compensation (salary) was fully and reasonably deductible (Greenwald, 1). Issues and Conclusions 2 Can the $1.56 million fine needed for violating EPA regulations be deducted? Yes, deductions are allowed. Can the $0.25 million paid for legal representation in the court of law be deducted? Yes, it is deductable. Analysis 2 The amount paid for the legal representation against violation of government regulation is deductible because IRS Section 162(a) allows enterprise deductions for compensatory interest, fees, damages and other expenses in defending claims and lawsuit. Welch v. Helvering [290 U.S. 111 (1933)] argued that the words ‘necessary expense’ and ‘ordinary expense’ are words with different meanings (International Tax Services, 1). These words need to be considered to ensure the taxpayer benefits from allowed deductions. In Welch’s case, the court stressed in the factual characteristic of section 162(a) and upheld the petitioner’s (commissioner) disallowance for deduction. Considering the needs for determining the ‘ordinary’ nature of the expense in this case, Justice Cardozo noted that the ordinary variables are strains of constancy affected by circumstance, place and time. He further notes that in this context, ordinary does not imply that the payments made for the representation must be normal or habitual in the design that same individual responsible for paying taxes will be required to make them. It is also important to note that the security of the business caused by a lawsuit may occur only once in a lifetime. Similar to Xinn Inc. case, fees charged by the counsel may be so much that it recurrence is unlikely. Current rulings and cases relating to section 162(a) differ with Welch v. Helvering considering how expenditure is connected to acquiring goodwill (International Tax Services, 1). These new rulings indicate that expenses catering for the promotion, protection, and retaining of goodwill of established enterprises are deducted as necessary and ordinary expenses. Therefore, the $0.25 million paid for legal representation in the court of law can be deducted. The amount paid as fine for violating EPA is deductible because IRS Section 162(f) does not allow for deductions for a penalty or similar fine paid to the government for violating the governing principles (Lowman and Jacobs, 1). Sometimes, a fine may not be meant to punish a corporation, and that it may render the issue at hand worth litigating. S. Clark Jenkins, et ux. V. Commissioner [TC Memo. 1996-539, Doc 96-32146, 96 TNT 242-12] indicates that the Tax Court ruled that the shareholder of the fertilizer manufacturer in question was allowed a deduction through S corporation (Robert, 3). He was allowed to deduct the amount paid to two governmental states fines for shortages in the company’s fertilizer production. The IRS, through the shareholder’s S corporation, passed the decline for deduction, stating that the payments signified nondeductible expenses. After analyzing the purpose of the government regulation, Tax Court found that the fine or penalty was imposed to compensate consumers of the manufactured products. Consequently, the penalty was not meant to punish the fertilizer manufacturer. It was noted, by The Tax Court, that the fine was determined by calculating the quantity of the lacking component that was paid by the consumers but was never received. This value was added to the amount required for the compensation for a higher yield in the cultivated crops. The Tax Court realized this fact for the taxpayer since it did appeared as a counteractive figure, not a malicious one. It is demonstrated (by Jenkins) that it is vital to look beyond the ordinary ‘penalty or fine’ language to understand the objective of the rules under which the penalties or fines are levied. The simple fact that a fine for violation is communal rather than illicit does not allow the taxpayer to escape taxation. In addition, Hawronsky v. Commissioner [TC. 94, Doc 95-7783, 95TNT 155-9 (1995] ruled that section 162(f) disallow the taxpayer from deductions related to a series of damages he was responsible for when he violated the contract on scholarship program (Robert, 4). After determining that the transaction was a communal (civil) punishment, The Tax Court ruled that section 162(f) is applicable to both civil penalties and criminal fines. This ruling from the Tax Court can be used to determine whether Xinn Inc. are allowed deductions on the amount paid as the penalty for violating environmental regulations in Indiana. In conclusion, there is an allowable deduction for the expenses paid for the legal representation for the lawsuit against the penalty imposed by EPA. However, the taxable amount depends with the representative’s compliance with consistent tax filings. On the other hand, the fines for violating the environment are not deductible. Finally, the president’s income may or may not be allowed for deductions depending on the factors for and approaches to determining deductibility. Works Cited Greenwald Michael. Executive Salaries: Deductible compensation or non-deductible dividend? 2002. Pg.1. Retrieved April 30, 2014, from http://www.bdo.com/publications/industry/real/re_summer02/ International Tax Services. Welch v. Helvering [290 U.S. 111 (1993)]: Deductibility of Reputation Payments. 2006. Pg.1. Retrieved April 30, 2014, from http://www.andrewmitchel.com/charts/welch.pdf. Lowman D. and Jacobs T. The IRS pre-filing agreement program and deducting government settlements. 2010. Pg.1-6. Retrieved April 30, 2014, from http://www.hunton.com/files/Publication/0754b60d-f32e-4d48-a0a2-1db1cd2d07a2/Presentation/PublicationAttachment/098ffbbf-2ab8-4b0d-a4d6-317b1f706e43/Financial_Fraud_Law_Report_Lowman-Jacobs_2.10.pdf Robert W. Wood. Tax Deductions for Damage Payments: What, Me Worry? 2006. Pg.1-7. Retrieved April 30, 2014, from http://woodporter.com/Publications/Articles/pdf/TN011606.pdf Read More