Corporate Tax Planning: XYZ Corporation and Mr. Pink

Introduction to the Tax Scenario

Mr. Pink owns all the shares of XYZ Corporation, a subchapter C corporation, and leases property to XYZ Corporation. XYZ Corporation has earnings and profits (E&P) of $1,000,000 for the taxable year 2014 before paying Mr. Pink a salary. The corporation holds cash of $1,200,000 and disposable appreciated property with a fair market value (FMV) of $500,000 and an adjusted basis of $200,000. The central tax planning challenge is how to structure payments and distributions between the corporation and its sole shareholder to minimize the double tax burden inherent in the C corporation form, while remaining compliant with the Internal Revenue Code and relevant case law.

Constructive Distributions and Income Splitting

The best way to split income between XYZ Corporation and Mr. Pink is to minimize double taxation by carefully structuring the form in which Mr. Pink receives value from the corporation. A constructive distribution allows members of the board of directors to take payments in ways other than just cash — through property transactions of one form or another. For instance, when a company rents its offices from a shareholder and pays in excess of the office's fair market value, the excess rent payment is treated as a constructive dividend (U.S. Legal, n.d.). Accordingly, XYZ Corporation could pay Mr. Pink with the disposable appreciated property, but such a transfer would still be subject to double taxation.

However, one planning approach would be for the corporation to transfer the property to Mr. Pink at its adjusted basis of $200,000, after which he could sell it on the open market for its FMV of $500,000. Rather than being taxed on the gain as ordinary income, Mr. Pink would pay capital gains tax on the $300,000 appreciation — generally a more favorable rate. The prototypical transaction giving rise to constructive dividends sometimes involves blatant attempts by taxpayers to extract value from their corporation while avoiding double tax. These transactions involve a direct payment or the receipt of an economic benefit by the shareholder, and resolution of the issue requires an evaluation of all the facts and circumstances, applying broad standards such as "reasonable compensation," "shareholder benefit vs. corporate benefit," and "intent."

Qualified Dividends and Tax Rate Planning

To minimize the overall tax burden, it generally makes more sense for individual shareholders to receive value in the form of qualified dividends rather than ordinary income. This approach significantly reduces the effective tax rate — from approximately 40% on ordinary income down to 20% or lower on qualified dividends, depending on the total income of the individual. In the context of tax planning for XYZ Corporation, structuring a portion of Mr. Pink's compensation as a dividend rather than salary can meaningfully reduce combined federal tax liability, provided the dividend qualifies under applicable IRS rules.

Salary Determination and Additional Payments to Mr. Pink

Mr. Pink's salary from XYZ Corporation should be kept as low as reasonably justifiable. By accepting a smaller salary and receiving additional value as a dividend in his capacity as an investor, Mr. Pink can reduce his ordinary income tax burden. This strategy takes advantage of the lower qualified dividend tax rate while also reducing the corporation's payroll tax obligations.

Beyond salary, Mr. Pink could accept the appreciated property as a form of payment. Although this transfer would be subject to double taxation — once at the corporate level under IRC § 311(b) and again at the shareholder level — the applicable rates may be lower than those imposed on ordinary income, making it a relatively more efficient form of distribution.

However, certain other forms of payment are not legally permissible. In Hood v. Commissioner, 115 T.C. 172 (2000), the court held that the sole owner of a corporation could not deduct legal expenses incurred to defend himself against tax evasion charges, because those expenses represented a form of dividend payment rather than deductible business costs (Leagle.com, n.d.). Courts have consistently applied similar reasoning in analogous situations.

The case of Nicholls, North, Buse Co. v. Commissioner, 56 T.C. 1225 (1971), further illustrates the limits of deductible business expenses. In that case, a log entry for a third of the days in question noted that a boat was brought up the Miller River in Milwaukee "for the purpose of entertaining our bankers and attorneys," yet there was no indication in the log that business was actually transacted on those occasions. IRC § 274(d) requires disallowance of a deduction with respect to an entertainment facility unless there is either an adequate record made at the time of the activity, or sufficient corroborating evidence of: (a) the amount of the expense; (b) the time and place of use of the facility; (c) the business purpose of the expense; and (d) the business relationship of the persons entertained or using the facility. As established in John L. Ashby, 50 T.C. 409 (1968), each element must be established separately for each occasion of use (Leagle, n.d.). See also Menard, Inc. v. Commissioner, 560 F.3d 620 (7th Cir. 2009), for additional judicial guidance on the limits of reasonable compensation and permissible corporate deductions.