September 1st, 2012
Portfolio Project ACT400
I.Problem 1-Osprey Corporation
Dan and Patrick Zimbrick, sole shareholders of Osprey Corporation have been required to repay compensation to Osprey Corporation that was found by the IRS to be excessive. In order to determine how these repayments are to be treated for tax purposes, it is important to note that in 2006 the board of directors made up of Dan, Patrick and their uncle John, adopted a legally enforceable resolution. The resolution stipulated that any overpayment of salary disallowed as a deduction by the IRS would be repaid to the Osprey Corporation. In late 2010 during an audit by the IRS, $200,000 of Patrick’s compensation, and $150,000 of Dan’s compensation were recharacterized as constructive dividends. This was done because the salaries were found to be excessive. Reg §1.162-8 states excessive compensation will be disallowed to the corporation and treated as a constructive dividend to the shareholder. Because the agreement to the resolution was in place prior to their salary payments, the repayments were legally enforceable under state law. As stated by Hoffman, Raabe, Smith and Maloney “the constructive dividend serves as a substitute for actual distributions and is usually intended to accomplish some tax objective not available through the use of direct dividends. Alternatively the shareholders may be seeking benefits for themselves while avoiding the recognition of income”(2012, 5-16). Because the resolution did contain a repayment provision it should reduce the effect of the constructive dividends on Dan and Patrick. b. Issues
A corporation cannot take a deduction from the constructive dividend, and the shareholder must report the amount of the constructive dividend on their tax return. The IRS will recharacterize an item that has been deducted on the corporate tax return to a non-deductible dividend. Constructive dividends are double taxed, first on the corporate level and again at the shareholder level. This characterization results in the IRS denial of the deduction on the corporate level. To determine how the repayment by Dan and Patrick should be treated for tax purposes we must determine whether the repayment can, or should be treated as a deduction or as a credit. c. Discussion
In §162, it states compensation is deductible only to the extent that it is reasonable and is in fact payment purely for services. In a case similar to Dan and Patrick’s situation involving excessive compensation, Vincent E. Oswald v. Commissioner, 49 T.C. 645 (1968), the court found the repayments to be a deductible expense. In this case the question was whether, “under section 162 of the Code, the officers are entitled to a business expense deduction for the calendar year 1968 for the salaries repaid by them to the corporation” (Vincent E. Oswald. 49 T.C. 645 (1968)). The Section 1.162-1 of the Income Tax Regulations “provides, in part, that ordinary and necessary expenditures directly connected with or pertaining to the taxpayer's trade or business are deductible from gross income as business expenses” (Rev. Rul. 69-115, 1969-1 CB 50 -- IRC Sec(s). 162). According to the case, the court found that a deduction for ordinary and necessary business expenses would be allowed.
If Dan and Patrick sought a credit for the repayment of the taxes, the relief provision contained in IRC section 1341 suggest that a taxpayer may reduce its current years tax by the amount of the extra taxes paid by having to include the income in a previous year. The requirement that a taxpayer be entitled to this deduction has two subsets. One, there must be a deduction as the result of the restoration of income, and two, the deduction must occur under a code section other than section 1341. In a federal case Van Cleave v. U.S., the case involves “a claim of favorable income tax...