Line Items

IRC section 162(m)(1) imposes a $1 million limit on the amount a publicly held corporation can deduct for remuneration paid to one of its “covered employees.” A “covered employee” is defined as the corporation’s chief executive officer or its four most highly compensated officers as reported on the “summary compensation table” filed with the SEC. That person also must be employed as an executive officer on the last day of the taxable year.

However, what happens if the corporation is acquired and one of these officers resigns but continues to work as a consultant or as an employee of a member of the acquiring company’s controlled group?

According to the IRS, if the officer resigns before the last day of the tax year, with no intent to resume his or her duties in the foreseeable future, and if the acquired corporation will not file a “summary compensation table” (for example, it no longer has publicly traded equity securities or is no longer an SEC reporting entity) then the corporation will not be subject to the $1 million deduction limitation for compensation paid to that officer in the resignation year (letter rulings 200039028 and 200042016).

OK to Base Performance Bonuses on Shorter Year

Generally, a corporation can deduct only $1 million in compensation paid to its CEO or top four executives. However, IRC section 162(m)(4) provides an exception to the rule by allowing a corporation to deduct additional compensation based on clearly articulated performance goals. A compensation committee, comprising solely two or more outside directors, and disclosed to the employer’s shareholders, must set the goals. Also, before any covered employees are paid, a majority of the shareholders must approve the goals and the compensation committee must certify that the goals were met.

Recently, a publicly held corporation had such a plan. However, immediately after the committee established the goals for the year, the company decided to change its yearend to conform to that of its major competitors. Since the change resulted in a shorter tax year, the company also reduced the performance goals.

According to the IRS, the bonuses paid to the top executives based on the shorter tax year will be qualified performance-based compensation as long as the original full-year performance goals are also met by the end of the initial full year, and the compensation committee certifies this (letter ruling 200044007).

Gifts to Children’s Spouses Considered Gifts to Children

A taxpayer owned stock in a closely held corporation that operated a funeral home. Her two sons and a grandson were licensed funeral directors and actively involved in the business. Her attorney advised her to begin giving stock to family members in order to save estate taxes and to ensure the family succession of the business. So, from 1985 until her death in 1995, the taxpayer made annual gifts of shares valued at $10,000 to each of the three licensed directors and their wives. However, immediately thereafter, the wives transferred their shares over to their husbands. The taxpayer also had two daughters. Since they were not active in the business, they were not given any shares in the funeral home.

The IRS argued that the gifts to the wives were really additional gifts to the husbands and subject to the gift tax because the taxpayer’s will stated that, if one of her sons predeceased her, the surviving spouse would not receive any shares. The Tax Court agreed. According to the court, the transfers to the wives were all part of a prearranged plan to obtain additional annual gift tax exclusions for the taxpayer. ( Estate of Marie A. Bies v. Commissioner, TC Memo 2000-338).

Accountant’s Advice Is Reasonable Cause for Late Payment

Taxpayers who do not pay their taxes on time are subject to a mandatory penalty for late payment of taxes unless they can prove the failure was due to “reasonable cause” not to “willful neglect.” Reasonable cause means a taxpayer exercised ordinary business care and prudence in attempting to pay a tax liability, but either was unable to pay or would suffer an undue hardship if he or she paid on time. Willful neglect is reckless indifference or an intentional failure to pay.

In a recent case, a taxpayer redeemed his interests in two limited partnerships. Since he had not received any K-1 forms, he extended his due date from April 15 to October 15. In the past both partnerships had generated substantial losses. However, in the current year, one of the partnership losses was recaptured, resulting in a substantial long-term capital gain for the taxpayer. But the taxpayer made no estimated tax payments because his accountant told him the unforeseen tax liability could be offset by credits and loss carryforwards. Immediately before the October 15 deadline, however, the taxpayer was informed that the other partnership had also generated a gain for the year in question, and therefore he still would owe taxes.

When October 15 arrived, the taxpayer had no liquid assets. A recent divorce had left him cash poor and unable to pay his taxes. He attempted to obtain a bank loan, but the collateral requirements delayed the issuance of the funds.

The IRS assessed a late payment penalty but a district court found his reliance on the accountant’s advice was reasonable cause for not paying ( Broker v. United States, ED PA (10-26-2000)).

Floor Installer Must Use Accrual Method

A taxpayer owned and operated an S corporation that installed floors. The corporation considered itself to be a service provider and purchased the flooring materials for specific jobs as an accommodation for customers. Therefore, it used the cash method of accounting to prepare its federal income tax return because it did not consider the flooring materials on hand at the end of the year to be inventory. However, the IRS considered the materials merchandise and, thus, inventory held by the taxpayer. Under IRC section 446, businesses with inventory must use the accrual accounting method, and therefore, the IRS required the corporation to use the accrual not the cash method of accounting.

The Tax Court agreed with the taxpayer, holding that it was not in the business of selling flooring materials. According to the court, the corporation was a service provider and the flooring materials were an indispensable and inseparable part of rendering those services ( Edward G. Smith v. Commissioner, TC Memo 2000-353).

—Michael Lynch, Esq., professor of tax accounting at
Bryant College, Smithfield, Rhode Island.