Tax Memo

November 8, 2015

Tax File Memorandum

From:

Subject: Hannah – Salary and Fringe Benefits

Summary of Facts:

Hannah received salary and fringe benefits from a closely-held corporation for her service. The amounts paid by the corporation exceeded the reasonable compensation for Hannah’s services. The corporation amended its bylaws to require any payments made to an officer which shall be disallowed as a deductible expense by the IRS, shall be reimbursed to the corporation to the full extent of such disallowance.

Issue 1: What salary and fringe benefits are taxable to Hannah in the period Year 1 through 3?

Sec. 162(a)(1) allows a deduction for “a reasonable allowance for salaries or other compensation for personal services actually rendered”. Excessive payments for compensation are not deductible. Reg.§1.162-8 states that, “The income tax liability of the recipient in respect of an amount ostensibly paid to him as compensation, but not allowed to be deducted as such by the payor, will depend upon the circumstances of each case.” “In the absence of evidence to justify other treatment, excessive payments for salaries or other compensation for personal services will be included in gross income of the recipient.”

In Sterno Sales Corp. v. U.S., 15 AFTR 2d 979, 65-1 USTC ¶9419 (Ct. Cl. 1965), the Court held that Compensation remains compensation even if it is held unreasonable in amount and, accordingly, not deductible as a business expense. The payment does not change in character solely because it is characterized as excessive or undue. The non-deductibility of the expense by the payer, because it is unreasonable in amount, does not transform the payment in the hands of the payee.

Conclusion:

Hannah is likely to include all the amounts received as compensation. All the compensation is taxed in the tax year in which it is received.

Issue 2: What reimbursements Hannah can deduct during the period Year 5 through Year 9?

Revenue Ruling 69-115, 1969-1...