According to Internal Revenue Code (IRC), a number of factors are used to determine whether the compensation is reasonable or unreasonable. Some of the factors are; the first is the qualification of the employee. Second are the scope, nature, and extent of employees work, third is the complexity and size of the firm and fourth is general economic status (Kenneth 356). The relationship between the employee and the firm is also need to be known to establish any form of disguise. For compensation to be considered reasonable there must be test on the amount being paid. Amount to be paid must be reasonable to the state of the firm and economic status the company and the employee each need to be considered. The purpose for compensation is also very important when determining reasonability of compensation (Kenneth 370). All forms of compensation such as salary or wages, pensions, payment for expenses, royalties, and the similar kind should be taken into account when examining reasonable compensation.
Looking into the client’s case, the president earns a salary of $10 million of which $5 million is basic salary and 5 percent on the company’s gross receipt that does not exceed $5 million. The $5 million on the grows income of the firm is not show its basis and it falls under constructive dividend. This is because this payment results benefits the president and the formal dividends have not been declared. This is an informal dealing between the organization and the employee.
Recommendation is for the client to accept the adjustment as proposed by the IRS. Assuming this may end him up with a legal problem that may be very expensive for the firm in the end.
Stock redemption can be treated as sales or as dividend. In the case that the stock is treated as sales, the earnings are not taxed unless stated otherwise (Porter 654). For the redemption to be considered a sale, it must meet some conditions some of which are, substantially disproportionate, partial liquidation, and not equivalent to dividend. In the case of the client, the redemption is 50 percent for the client and the son each. After the redemption, the client remains with 50 percent of the total which is less than 80 percent of what was owned before (Kenneth 384). This shows that the redemption did not qualify for stock redemption as a sale.This is falling under substantially disproportionate type of redemption.
Recommendation to the client will be to accept the recommendation on notice of proposed adjustment by the IRS and make the necessary changes as challenging the case will not be profitable to the business as the provisions that the redemption was a distribution as recommended.
According to IRS rules, the rental can be treated us passive activities. IRC 469(c) (2) explains that passive activities are not deductible except for; when there is passive income; when the rental is a real estate professional, and some disqualify dispositions exist (Berlet 2012). Recommendation to the client and his son is to claim the $25000 allowance that is given to offset losses as provided for in IRC 469(I) (8).
A tax plan for the in future will be on the stock will be assuming that the president has a tax rate of 25 percent and the son has the tax rate reduced to 5 percent. This can be calculated as ($ 300mil × 30%) this will give $90mil tax exception in the future particularly on the stock. The tax on the client will be (15% ×5mil) which is o.75 mil tax exception. On the rental, the tax exception will be $250000 if single but when two the exception goes to $500000.
If the client wants to receive the similar amount of compensation on the salary then the provision is that there must be records in the past that shows that the compensation had been approved. With the signed document, the client has the ability to show that the compensation is informal payment but an authorized payment as required by the IRC (Berlet 317). Under this defense, the client will be able to show that there is internal consistency on how the company treats his payment. The papers will also be able to explain that the extra payment is either a bonus or regular payment that has a long stand history. On the stock redemption, the client can be advised to reduce the stock redemption to a relatively lower percentage so that after the redemption the client can still have a stock not less than 80 percent of what he originally owned (Porter 715). This will enable the client to have the opportunity to avoid tax, as redemption treated as sales does not attract any sale. The client must ensure that the stock is not equivalent to dividend, ensure that that there is substantially disproportionate, in complete termination of interest of the shareholder, and finally ensure that there is liquidation as required by the IRC 302(b).
The findings shows that the suggested recommendations by the IRS were relevant and the relevant corrective measures to avoid loss of finances on the legal matters need to be employed.
Kenneth, A. Federal Taxation. New York: Pantheon, 2013. Print.
Berlet, B. Constructive Dividends: Reasonable and Unreasonable Redemption. London: Oxford UP, 2012.
Porter, M. Stock Redemption Categories. New York, 2010. Free Press.