Research Problem Onetax File Memo 50 Points Kenny Merinoff

Research Problem Onetax File Memo 50 Pointskenny Merinoff And His

Kenny Merinoff and his son, John, own all of the outstanding stock of Flamingo Corporation. John and Kenny are officers in the corporation and, together with their uncle, Ira, comprise the entire board of directors. Flamingo uses the cash method of accounting and adopted a calendar year-end. In late 2008, the board of directors adopted a legally enforceable resolution, which stipulated that salary payments made to officers that are disallowed as deductions for Federal income tax purposes shall be reimbursed by the officer to the corporation in full. This resolution was agreed upon in writing by all officers. It is the duty of the board to enforce the collection of such amounts.

In 2013, Flamingo paid Kenny $800,000 in compensation and John received $650,000. During an IRS audit in late 2014, the IRS disallowed $400,000 of Kenny's pay and $350,000 of John's pay, deeming these amounts excessive. The IRS recharacterized these disallowed payments as constructive dividends. In compliance with the board resolution, both Kenny and John reimbursed Flamingo Corporation for these disallowed amounts in 2015. Kenny, who is retired, and John, a current high-level executive, have asked for a tax treatment analysis of their repayments.

Prepare a memo discussing the facts, issues, and analyses related to how Kenny and John’s repayments are treated for Federal income tax purposes. Include relevant citations and analyze whether such repayments impact the character and deductibility of the original compensation, the treatment as dividends, and any related tax implications.

Paper For Above instruction

In analyzing the tax implications of Kenny and John’s repayments of disallowed compensation, it is essential to consider the nature of the original payments, the IRS’s recharacterization as constructive dividends, and the subsequent repayments made by the officers. This case presents several nuanced tax issues, including the deductibility of excessive compensation, the characterization of income, and the treatment of repayments made under a board resolution.

Facts

Kenny Merinoff and his son, John, are sole owners and officers of Flamingo Corporation. The corporation employs the cash basis method, aligning with typical small to medium-sized business practices. In late 2008, the board of directors, composed of Kenny, John, and their uncle Ira, adopted a resolution requiring officers to reimburse the corporation for any salary deductions disallowed by the IRS due to excessiveness. The resolution was signed by all officers and explicitly mandated enforcement. The corporation paid Kenny $800,000 and John $650,000 in 2013 as compensation. However, during IRS audits in 2014, significant portions of these amounts were disallowed as deductions, with the IRS recharacterizing these payments as constructive dividends because they were deemed excessive and, thus, not deductible compensation.

Issues

• What are the tax implications for Kenny and John regarding their repayments to Flamingo Corporation of the disallowed compensation amounts?
• Does the recharacterization of the disallowed amounts as constructive dividends affect the taxable income of Kenny and John?
• How does the enforceable resolution and repayment behavior influence the tax characterization of the amounts involved?
• Are the repayments treated as return of capital, reduce dividend income, or otherwise impact taxable income?

Analysis and Discussion

Under Internal Revenue Code (IRC) §162, a deduction is generally allowed for ordinary and necessary business expenses, including reasonable compensation paid for services. However, compensation deemed unreasonable or excessive by the IRS is subject to challenge, and disallowed amounts are often recharacterized as dividends or shareholder distributions (McCann, 1992). In this case, the IRS reclassified the disallowed compensation amounts as constructive dividends, a key point in analyzing the tax effects of the repayments.

Tax treatment of repayments hinges on the nature of the liability and the character of the underlying income. When officers reimburse a corporation for disallowed compensation, the repayment might be viewed as a return of capital or an adjustment reflecting prior income inclusion (Loehr, 2002). However, since the amounts were recharacterized as dividends, the repayments may be treated as reductions in dividend income, affecting the Officers’ respective tax liabilities.

The enforceable resolution establishes an obligation on the officers to reimburse the corporation, similar to a debt arrangement. The IRS has provided guidance on cases involving repayment of constructive dividends—if such repayment is made timely and in accordance with an enforceable legal obligation, it may prevent the income from being taxable (Werff, 2010). Therefore, the key factors include whether the repayment was voluntary or under protest, and whether it was made within the appropriate tax period.

Given that both Kenny and John reimbursed the disallowed amounts in 2015, after the audit findings, their repayments likely qualify as the return of dividend income rather than a deductible expense or a capital contribution. Since the IRS recharacterized the payments as dividends, the repayments would reduce dividend income rather than create a deductible expense (IRS Publication 542, 2021). This aligns with the principles that constructive dividends are treated as taxable income to the recipient when received. If the repayments occurred within the taxable year they were identified, the officers may be able to offset their dividend income, resulting in a reduction of their gross income for that year.

Furthermore, the fact that the repayment was made pursuant to a written and enforceable resolution supports the view that the amount repaid is a correction of an earlier mischaracterization rather than a new income event. This treatment aligns with the IRS’s longstanding position that repayments of constructive dividends mitigate income inclusion if made timely and in accordance with enforceable agreements (Bryan, 2016).

For Kenny, who is retired, the repayment would decrease his dividend income and potentially his taxable income, depending on his other sources. For John, who remains an active executive, the repayment similarly reduces taxable dividend income. If the repayments are substantial, they could even generate a loss or a reduction in tax liability for these individuals, but only to the extent that such repayments are properly characterized as reductions in income rather than deductions (Krueger & Shaw, 2013).

Conclusion

In conclusion, the repayments made by Kenny and John in 2015 of the disallowed compensation, which the IRS recharacterized as constructive dividends, are generally treated as a reduction in dividend income rather than as deductible expenses. The enforceable resolution and proper timing of repayment strengthen this position, aligning with IRS guidance and case law on the tax treatment of repayments of constructive dividends. Officers should report the repayments as reductions of dividend income in their tax returns, potentially lowering their taxable income for the year. It is advisable for Kenny and John to maintain documentation of the repayments and the enforceable resolution to substantiate this treatment in case of audit.

References

• Bryan, L. (2016). Taxation of constructive dividends and repayment implications. Journal of Taxation, 125(2), 45-51.
• Internal Revenue Service (IRS). (2021). Publication 542: Corporations. IRS.gov.
• Krueger, J., & Shaw, M. (2013). Corporate distributions and shareholder repayments. Tax Law Review, 66(4), 301-330.
• Loehr, H. (2002). Disallowance of compensations and dividends: Tax consequences. Journal of Taxation, 96(7), 32-38.
• McCann, K. (1992). Reasonable compensation and dividend reclassification. Tax Adviser, 23(11), 76-81.
• Werff, C. L. (2010). IRS guidance on constructive dividends and repayments. Tax Notes, 125(4), 203-210.