Question

Nittany Company pays its sole shareholder, Tammy Lion, a salary of $109,800. At the end of each year, the company pays Tammy a "bonus" equal to the difference between the corporation’s taxable income for the year (before the bonus) and $68,500. In this way, the company hopes to keep its taxable income at amounts that are taxed at either 15 percent or 25 percent. This year, Nittany reported pre-bonus taxable income of $738,500 and paid Tammy a bonus of $670,000. On audit, the IRS determined that individuals working in Tammy’s position earned on average $335,000 per year. The company had no formal compensation policy and never paid a dividend. Refer Corporate tax table.

a. How much of Tammy’s bonus might the IRS recharacterize as a dividend?

b. Assuming the IRS recharacterizes $222,400 of Tammy’s bonus as a dividend, what additional income tax liability does Nittany Company face?

Answer 1

AS NITTANY COMPANY IS PAYING TAX ON $68500(WRITTEN IN SECOND LINE OF QUESTION)

SO THE TAXABLE INCOME MUST BE $68500 , NOW WE WILL DO REVERSE CALCULATION

CORPORATE TAXABLE INCOME = $738500 (GIVEN)

LESS DIVIDEND = $444800 (WORKING NOTE 1)

CORPORATE INCOME BEFORE BONUS = $293700 ($738500-$444800)

LESS BONUS = $225200 (WORKING NOTE 2 )

CORPORATE TAXABLE INCOME = $68500 ($293700-$225200)

(i) SO OUT OF $670000, $444800 OF TANMAYS BONUS HAS BEEN PAID AS DIVIDEND

(ii) IF IRS RECHARACTERIZES $222400 AS DIVIDEND IT WILL RESULT IN INCREASE OF TAXABLE INCOME OF $ 222400

CORPORATE INCOME = $738500

LESS BONUS = $225200 (AS CALCULATED)

LESS DIVIDEND = $222400

NET INCOME = $290900

PREVIOUSLY NET INCOME WAS 68500 AND TAX LIABILITY WAS

15% OF $ 50000 + 25%OF $18500($68500-$50000) = $12125

NOW THE TAX LIABILITY AFTER ASSUMPTION WILL BE

15% OF $ 50000 + 25%OF $25000+ 34% OF $215900($290900-$75000 = $87156

HENCE INCREASE OF $ 75031 ($87156-$12125)

WORKING NOTES

1.  CALCULATION OF DIVIDEND  

AS TANMAY IS EARNING A SALARY OF $109800 AND SAME PERSON AT HIS POSITION EARNS $335000 SO MAXIMUM WE CAN PAY A BONUS OF $225200 TO TANMAY ()

AND TO GET A NET INCOME OF $68500 REVERSE CALCULATION WILL BE THERE

CORPORATE INCOME = $738500

LESS BONUS = $225200

LESS DIVIDEND = $444800(BALANCING FIGURE)

NET TAXABLE INCOME = $68500

WORKING NOTE 2

AS TANMAY IS EARNING A SALARY OF $109800 AND SAME PERSON AT HIS POSITION EARNS $335000 SO MAXIMUM WE CAN PAY A BONUS OF $225200 TO TANMAY ()