Question

Forward Corporation is owned by a group of 15 shareholders. During the current? year, ForwardForward pays $550,000 in salary and bonuses to AlvinAlvin?, its president and controlling shareholder. The? corporation's marginal tax rate is 34?%, and AlvinAlvin?'s marginal tax rate is 39.6?%. The IRS audits ForwardForward?'s tax return and determines that reasonable compensation for Alvin is $350,000. ForwardForward agrees to the adjustment.

What effect does the disallowance of part of the salary and bonus deduction have on Forward?'s and Alvin?'s respective tax? positions? Ignore payroll? taxes, such as FICA. ?(Assume a? 23.8% capital gains tax? rate, if?necessary.)

Answer 1

Since the reasonable compensation for Alvin is $350,000, thus the remaining amount $200,000 ($550,000 - $350,000) will be treated as disallowed salary and bonuses and will not be considered for the deductions by Forward Corporation and taxable as a dividend to Alvin. Also will lose the salary deduction for a tax cost of $68,000 ($200,000 * 0.34). If we assume a? 23.8% capital gains tax? rate Alvin will be saving $31,600 [= $200,000 * (39.6% -23.8%)] because of the difference between Alvin's applicable tax rate on the dividend income and the ordinary tax rate. Since Alvin falls in 39.6% tax bracket and the and the income is more than the $200,000 AGI threshold, thus will be triggering an additional tax at 3.8% on net investment income, and as a result net tax cost will be computed as $36,400 (=$68,000 -$31,600).