Tax Memorandum2 - Tax Memorandum Question 1 Issue Was the...

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Tax Memorandum Question 1 Issue: Was the compensation package paid to Mr. Kim for the 2007 tax year reasonable? Rule: IRC section 162(a) governs the deductibility of trade or business expenses. In general there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including - the reasonable allowance for salaries and other compensation for personal services actually rendered, (Ephraim P. Smith, 2010). This is a two-prong test to determine if compensation is first reasonable and second for services actually rendered. The Tax Court has developed a seven-factor test for determining whether compensation is reasonable, which generally considers the following factors: 1. the type and extent of the services rendered; 2. the scarcity of qualified employees; 3. the qualifications and prior earning capacity of the employee; 4. the contributions of the employee to the business venture; 5. the net earnings of the employer; 6. the prevailing compensation paid to employees with comparable jobs; and 7. the peculiar characteristics of the employer's business, (Vincent, 2000). In Elliotts Inc. v. Commissioner five broad factors were established to help determine reasonableness of pay. No single factor is decisive and they should be applied using the independent investor view point. The five factors are as follows: 1. the employees role in the company; 2. the comparison of the employee’s salary with those paid by similar companies for similar services; 3. the character and condition of the company; 4. the potential conflicts of interest; and 5. the evidence of an internal inconsistency in a company’s treatment of payment to employees, (business, 2000). When considering compensation it is important that potential conflicts of interest are avoided by conducting arm’s length by an independent, profit-maximizing board. “Compensation based upon formulas is specifically recognized as acceptable under Regulations Section 1.162-7(b) (2). If such formulas are negotiated at arm’s-length, then such formulas will normally be upheld and the compensation paid under them will be deemed to be reasonable,” (Burton). Application: One of the pervasive tax issues in C corps is that of reasonable compensation. The IRS questions compensation because “many businesses organized as C corporations pay owners and other key employees the highest ‘reasonable’ compensation possible, in order to maximize corporate level deductions and minimize the "double tax" effect of being a C corporation,” (Vincent, 2000). The key to applying the factors above is to determine if an independent investor would be willing to compensate the employee as he was actually compensated. Using the seven-factor test mentioned above you would need
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to analyze Mr. Kim’s contributions from the standpoint of an independent investor in each category to determine if his pay was reasonable or not.
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