Question

Martin Martindale, the 40-year-old founder and president of Martindale Corporation (an accrual-basis, calendar-year C corporation), owns 60 percent of the stock and receives a salary of $600,000. Four unrelated shareholders own the rest of the stock equally. The corporation has paid dividends regularly to the shareholders and plans to continue to do so in the future. Martin plans to recommend that the board of directors authorize the payment of a bonus to himself and two other employees (all cash-basis, calendar-year individuals). The first employee is the vice president, who owns 10 percent of the corporation and receives a salary of $400,000. The other employee is the controller, who is not currently a shareholder in the corporation and receives a salary of $200,000. Martin would like the bonus to equal 75 percent of each recipient’s current salary. Martin believes that the total compensation is probably a little high when compared to the corporation’s competitors but Martindale is much more profitable. Martindale’s profits have increased by more than 20 percent in the last two years due to the efforts of the individuals who will receive the bonuses, while other businesses in the same industry showed an increase in profits of less than 10 percent. Martin asks you, as the corporation’s tax advisor, to recommend what the corporation needs to do so that it gets a deduction for the planned bonuses. Martin would prefer to pay the bonuses next year but deduct them this year.

1. Locate and read Mayson Manufacturing Co., 178 F.2d 115, 38 AFTR 1028, 49–2 USTC 9467 (CA6, 1949) and Elliotts Inc. 716 F.2d 1241, 52 AFTR 2d 83-5976, 83-2 USTC ¶9610 (CA9, 1985). Summarize the important points of these cases as they relate to Martindale.
2. Prepare a summary of the relevant Code and regulation sections as they apply to Martindale.
3. Prepare a one-paragraph summary for Martin on what the corporation needs to do to qualify for a deduction for the planned bonuses.

Answer 1

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Locate and read Mayson Manufacturing Co., 178 F.2d 115, 38 AFTR 1028, 49–2 USTC 9467 (CA6, 1949) and Elliotts Inc. 716 F.2d 1241, 52 AFTR 2d 83-5976, 83-2 USTC ¶9610 (CA9, 1985). Summarize the important points of these cases as they relate to Martindale.

In the case of Mayson Manufacturing, the IRS disallowed a portion of the compensation paid to three officers as being unreasonable in amount. The facts state that the Petitioner felt that the company would prosper more if a bonus system was established for Mayson Manufacturing Co. In this case, the board agreed to bonuses based on a percentage of the net profits and a percentage of gross sales. The Tax Court ruled in favor of the IRS. The Tax Court’s ruling was based in part upon its finding that the compensation, including the basic salary and bonus, paid to Mayson’s officers did not result from an arm’s length transaction. The Appellate Court stated that each case of this kind must be based on the individual company’s facts and circumstances. Some of the factors to be considered include

• The employee’s qualifications
• The nature, extent and scope of the employee’s work
• The size and complexities of the business
• A comparison of salaries paid with the gross and net income of the business
• The prevailing general economic conditions
• A comparison of salaries with distributions to stockholders
• The prevailing rates of compensation for comparable positions
• The amount of compensation paid to the employee in previous years
• The salary policy of the corporation

The Appellate Court found that the basic salary and bonus plan was, in fact, made in good faith. Furthermore, no evidence was introduced by either party in regard to what compensation other companies engaged in the same type of work paid for comparable services during the year in question. Such evidence, if available would have a bearing upon the issue. The Appellate Court held that the facts in Mayson suggested the amounts paid as compensation were reasonable.

Prepare a summary of the relevant Code and regulation sections as they apply to Martindale.

Sec. 162(a)(1) allows a reasonable deduction for salaries or other compensation.

Sec. 267 states that a deduction is not allowed for compensation accrued to a "related party" until the payment is made. This section defines a "related" taxpayer to include a shareholder owning more than 50% of the corporation (Martin).

Reg. Sec. 1.404(a)-1(b) states that in determining what is considered reasonable compensation, personal services actually rendered in prior years as well as the current year and all compensation paid to the employee should be considered.

Reg. Sec. 1.404(b)-1T(b)(1) states that payment made after the fifteenth day of the third calendar month after the employer's taxable year in which the services are rendered will be considered deferred compensation. This means it will not be deductible until the year paid and included in the income of the employee.

Prepare a one-paragraph summary for Martin on what the corporation needs to do to qualify for a deduction for the planned bonuses.

a. In order to qualify for a deduction for the planned bonuses, the bonus plan must be considered reasonable. The factors to consider as to reasonableness are those listed in the Mayson Manufacturing case. The corporation will need to be able to justify the reasoning for salaries that exceed the norm in the industry. Rather than base the bonus plan on a percentage of the employee’s salaries, it might be better to pay a bonus based on the percentage of income or sales of the company. In addition, Martindale Corporation must pay the bonus to Martin before December 31 if it wants to deduct his bonus in the current year. For the other two employees, the liability for their bonuses must be determined by December 31 and then paid by March 15th next year if it wants to deduct these bonuses in the current year.