Question

Maria Garcia is a CPA whose firm has prepared the tax returns of Stanley Corporation for many years. A review of Stanley’s last three tax returns by a new staff accountant, who has been assigned to the client for the first time, reveals that the corporation may be paying excessive compensation to one of its key officers. The staff accountant feels that the firm should inform the IRS and/or report the excess amount as a nondeductible dividend. Although the facts are ambiguous, they tend to support the contention that the compensation paid in current and prior years is reasonable.

Required: In a client letter, discuss Maria’s role as an advocate for Stanley, and discuss the possible tax consequences resulting from a subsequent audit.

Answer 1

To

The Directors

Stanley Corporation,

As per the latest changes in US tax reform law, there have been some changes in the tax treatment of compensation paid to top executives or key employees. One of them is the wider application of tax code section 162(m) under new law. As per this section, deduction limit has been placed for public companies in respect of compensation exceeding $1 million paid yearly to a covered employee, but now the term covered employee will also cover CEO,CFO and three most highly compensated officers. Consequently, companies which were earlier exempted from section 162(m) deduction limits will now be covered under new law. In nutshell, it can be said that any compensation exceeding $1 million yearly paid to a covered employee will no longer be deductible, resulting in more disallowed expenses and ultimately higher taxable profits and tax. Under previous law, CFO was clearly exempted from the status of covered employee. Also,under the new law, there will be no exemption in respect of compensation on the basis of performance. There is also a provision where once a person is identified as covered employee, he/she or his/her beneficiaries will continue to remain covered employees even if they leave the company.