Question

Sonya owns 69 percent and her sister Karen owns 31 percent of the Tanglewood Group. They inherited their ownership from their mother, who died in 2018. Sonya is the president and chief financial officer of the corporation and receives a salary of $132,800, which is reasonable given her duties and responsibilities. Karen, who is vice president, is paid a salary of $55,500. She is not actively involved in the business and views her ownership as an investment.

Determine how the payments to Sonya and Karen are treated for tax purposes if:

a. Tanglewood is a corporation. The salary paid to Sonya should be deductible. The $ paid to Karen is not a deductible expense of the corporation.

b. Tanglewood is an S corporation. The salary paid to Sonya should be deductible. The $ paid to Karen is not a deductible expense of the corporation. Karen's income from the S corporation increases by $_________. Sonya's income increases by $_________.

Answer 1

a. If Tanglewood is a corporation:

Corporation pays its own taxes thus, revenue of corporation is taxed at corporate level. In the given case, the salary paid to Sonya should be deductible and $ paid to Karen is not a deductible expense of the corporation. Thus, the income of corporation shall be in increased by $55,500 and the corporation is liable to pay tax on such increased income. Sonya and Karen are required to report salary income in their individual tax returns and liable to pay tax on such salary income. Consequently, the salary paid to Karen will be taxed twice.

b. If Tanglewood is an S corporation:

S corporation enjoys pass through taxation. Thus, income is taxed at the shareholder level and not at the corporate level.In the given case the salary paid to Sonya should be deductible and the $ paid to Karen is not a deductible accordingly, $55,500 will be added to the income of corporation but the corporation is not liable to pay tax on such addition. Such increased income shall be distributed to the shareholders in their respective proportion of shareholding. Therefore, Karen's income from the S corporation increases by $17,205 and Sonya's income increases by $38295.