Corporate Distributions:

A study of Canadian vs. U.S. income distribution tax planning techniques.* Copyright ©2005 by Mark T. Serbinski, M.B.A., C.A., C.P.A.. Mr. Serbinski is a Chartered Accountant licensed in Ontario and a partner in the firm of Serbinski Partners PC, Chartered Accountants, Toronto, Ontario as well as a Certified Public Accountant licensed in Illinois and a principal in the firm of Mark T. Serbinski , Certified Public Accountants in Chicago, Illinois.  Admitted to practice before the Internal Revenue Service, Mr. Serbinski practices international tax and acts as a consultant to the profession.

Tax Planning and the Income Distribution Issue:

In Canada, when income is earned by a small corporation, income tax planning techniques include the analysis of the overall income earned in the year, and the determination of the optimal distribution of that income between the shareholders in the current year, accrued as a bonus for the shareholders in the following tax year, or the payment of dividends from after tax corporate earnings. Normally, the order of operations includes the payment of compensation to shareholders until the low (small business deduction) corporate tax rate is reached, the payment of corporate tax at the small business deduction rate on the first $300,000 of corporate income (if available), and the payment of management or shareholder bonuses for income in excess of $300,000 to prevent double taxation and integration at rates higher than the top individual marginal rate of tax.

In the U.S., one of the major problems in this area is Internal Revenue Code section 267, which states:

267(a)(2) Matching of deduction and payee income item in the case of expenses and interest.--If--

 267(a)(2)(A) by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not (unless paid) includible in the gross income of such person, and

267(a)(2)(B) at the close of the taxable year of the taxpayer for which (but for this paragraph) the amount would be deductible under this chapter, both the taxpayer and the person to whom the payment is to be made are persons specified in any of the paragraphs of subsection (b),

then any deduction allowable under this chapter in respect of such amount shall be allowable as of the day as of which such amount is includible in the gross income of the person to whom the payment is made (or, if later, as of the day on which it would be so allowable but for this paragraph). For purposes of this paragraph, in the case of a personal service corporation (within the meaning of section 441(i)(2) ), such corporation and any employee-owner (within the meaning of section 269A(b)(2) , as modified by section 441(i)(2) ) shall be treated as persons specified in subsection (b).

What does this mean in English?

Accrual and deduction of liabilities incurred by accrual-basis taxpayers payable to related cash-basis taxpayers is not allowed unless certain conditions are satisfied. The amount must be actually paid and must be includable in the gross income of the cash-basis payee.

An accrual-basis taxpayer may deduct expenses and interest owed to a related cash-basis taxpayer only when the accrual-basis taxpayer makes the payment and the amount paid is includable in the gross income of the cash-basis payee (cash-basis rule). Thus, under the cash-basis rule an accrual-basis taxpayer is treated as if the taxpayer is on the cash receipts and disbursements method of accounting. An accrual-basis taxpayer may deduct expenses and interest as of the day that the related cash-basis taxpayer to whom payment is to be made includes the amounts in his income under the following conditions:

l The amounts are not includable in income by the payee unless paid because of the payee's method of accounting; and 

l The accrual-basis taxpayer and the payee are related as of the close of the tax year for which the expenses or interest would otherwise be deductible.

In general, the cash-basis rule applies to all deductible expenses as long as the timing of the deduction is governed by the taxpayer's method of accounting or by the taxpayer's making an election to expense the item, even if the item is not deductible as a trade or business expense interest, or an income-producing expense.

Sec. 482.- Allocation of Income and Deductions Among Taxpayers—

In considering the method by which income and expenses are allocated, IRS has some very strong legislation in place to make a determination of how to treat any distribution or allocation of management fees, dividends, income or other items at its discretion if IRS feels that the existing arrangement has been established to avoid tax.

To quote IRC 482:

"In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses."

The Service may allocate expenses between or among commonly controlled taxpayers, but courts reject expense allocations that are unreasonable, arbitrary or contrary to the evidence.

Factors in Determining Reasonableness —

Under U.S. rules, compensation paid to an employee who is related to a shareholder-employee is subject to close scrutiny. The payments may be considered gifts rather than payments for services rendered. They may also be considered a means of equalizing payments to stockholders.

Determination of reasonableness of compensation is based on salary history of employee, salaries paid by employer to other employees performing comparable work, industry-wide pay scales for comparable positions, special qualifications of employee, and relationship of employee to employer. No one factor is controlling. The Ninth Circuit and the Tax Court have used five criteria to determine the reasonableness of compensation: 

l the employee's role in the company;

l an external comparison of the employee's salary with similarly situated employees;

l the character and condition of the company;

l whether the relationship of the company to the employee creates a conflict of interest with respect to the awarding of compensation and, if so, whether the level of compensation would provide a satisfactory level of return on equity for a hypothetical independent investor; and

l the internal consistency of salaries paid to all employees of the company 

More specific factors that have been considered by the courts include the volume and profitability of business; comparison of an unrelated successor's salary; the necessity of paying same amount to replace an employee and the employee's ability to get same amount of compensation elsewhere; gross sales, net profits, dividends paid and capital investment; the cash condition of the employer; and the value of an officer's services as a director.

Year-End Payments —

A large salary or other payment to an employee at the end of a company's tax and accounting year may be a factor indicating the compensation is unreasonable. Most corporations and partnerships determine their profits and distribute them at this time, so the Service and the courts are careful to scrutinize year-end salary payments to prevent attempts to disguise nondeductible distributions of profits as deductible compensation.

The payment of year-end bonuses, especially when it is shown to be customary in the company and in the industry, does not prevent deductibility per se, but failure to establish the amount of the bonus as an absolute dollar amount or as a percentage of net profits before year end is strong evidence of an intent to divert profits into compensation. Even if it is impossible to determine the absolute dollar amount of an employee's year-end bonus before year end because it is to be linked to the company's net profits, it is always possible at least to establish the percentage amount in advance. Failure to put any limits on the amount of the bonus at all, when it is possible to do so before year end, is evidence of an attempt to distribute profits disguised as compensation. Similarly, arrangements by which an employee receives a year-end bonus and then lends all or part of this amount to the company are generally deemed to involve unreasonable compensation and diversion of profits.

The best way for a corporation to avoid this extra scrutiny is to determine an employee's annual salary before the year in which it is paid and to pay the salary periodically during that year, although this may not be possible when it is customary in the industry to compensate employees by a combination of salary and year-end bonus. 

Special incentive awards require special treatment. When the company pays an employee a salary and a year-end bonus that is fixed in advance as a percentage of profits, but decides to increase the bonus as a special incentive award because of the employee's special efforts, it should be able to demonstrate that this is not done every year, that there is clear evidence of the employee's special efforts and contribution to the company, and that there was no attempt to divert profits into salary. Authorization of the incentive policy in advance in the corporate minutes would strengthen the company's position. 

The Tax Court found that a corporation's decision to pay a bonus to its president and sole shareholder two days before the end of the fiscal year showed a deliberate effort to distribute earnings in the form of compensation.  The court found that the president was directly responsible for the corporation's growth, the president received no compensation from the corporation for the two prior years and the corporation never provided the president with retirement benefits. The court ultimately determined that the amount of reasonable bonus was somewhere between what the corporation originally provided and what the Service thought was reasonable.

Mark T. Serbinski Certified Public Accountants and Serbinski Partners PC, Chartered Accountants specialize in situations involving the taxation of U.S. citizens living abroad and Canadians living or working in the United States.  Please contact us for a complimentary initial review of your particular situation on a confidential basis. 

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