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.
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.
Prepare a summary of the relevant Code and regulation sections as they apply to Martindale.
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 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
2 Taxation for Decision Makers Research Solutions
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.
b. 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.
c. 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.
Martin Martindale, the 40-year-old founder and president of Martindale Corporation (an accrual-basis, calendar-year C corporation), owns...
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