Nittany Company pays its sole shareholder, Tammy Lion, a salary of $100,000. At the end of each year, the company pays Tammy a “bonus” equal to the difference between the corporation’s taxable income for the year (before the bonus) and $75,000. In this way, the company hopes to keep its taxable income at amounts that are taxed at either 15 percent or 25 percent. This year Nittany reported pre-bonus taxable income of $675,000 and paid Tammy a bonus of $600,000. On audit, the IRS determined that individuals working in Tammy’s position earned on average $300,000 per year. The company had no formal compensation policy and never paid a dividend.
a) How much of Tammy’s bonus might the IRS recharacterize as a dividend?
b) What arguments might Tammy make to counter this assertion?
c) Assuming the IRS recharacterizes $200,000 of Tammy’s bonus as a dividend, what additional income tax liability does Nittany Company face?