Tax Research on Mr. Jones

Tax Research Memorandum

To: Mr. Jones, President of the Corporation

From:

Date: September 9, 2012

Re: The pension plan contribution should be account on Mr. Jones Salary.

Facts

Mr. Jones, you are the president of a corporation that is owned by you and your family. The corporation has paid you a salary of $48,000 during a tax year under audit and you have also received a contribution made by the corporation on your behalf of $12,000 to a pension plan. A dispute has come up over the compensation paid to you in that tax year. The corporation has requested for me to research and determine whether the pension plan contributions must be taken into account in determining whether the compensation is reasonable.

Issue

The issue is that the IRS agent claims that both the salary paid to Mr. Jones and the pension plan contribution made on his behalf must be taken into account in determining whether the total compensation is reasonable in amount. The IRS agent is about to disallow a portion of the deduction for the compensation.

Rule

Self-employed individuals can establish a variety of retirement plans and make contributions for both themselves and their employees. Contributions made on behalf of the employees reduce business profits and contributions sole proprietors make to their own retirement plans reduce their income tax liability reported on their individual income tax returns, but they do not reduce net earnings from the business and, consequently, do not reduce a sole proprietor’s self-employment taxes. (CCH Group, 2011)

Analysis

Due to attractiveness of the tax deferral feature of retirement accounts, the code limits the amounts that can be contributed to retirement plans each year. The Code limits the maximum amount the that the employers can contribute on behalf of an employee to a defined contribution plan to the lesser of (1) 100 percent of a participants compensation or (2) a specified amount, which is adjusted annually for inflation. Code...