Tax Effects of Bonuses Paid by Small Businesses

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Julian Block
Columnist
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I’ve received emails from accountants on how to craft responses to questions from clients. I’ve edited and condensed the questions for clarity and brevity.

Q: I own all the shares of a family-run corporation. For many years, I’ve authorized the corporation to give yearly bonuses, equal to 3 percent of its net profit, for outstanding work performed by two key, longtime employees who aren’t related to me. Because this arrangement is informal, it doesn’t obligate the company to pay any bonuses.

The way I see things, my employees shouldn’t be liable for income taxes on these payments because they’re gifts. That would also excuse the corporation from withholding income taxes and Social Security taxes. But now, the IRS is auditing the company’s returns for the past three years and an examiner insists that these payments should be treated as compensation for services, not gifts. Therefore, the company gets slapped with back payroll taxes and interest charges. Should I hire a tax expert to show the IRS that it’s wrong?

A: No. Your arguments would get exactly nowhere with the agency. Nor would it pay to take your case to court. The judge must be guided by what the Internal Revenue Code says. Unfortunately, Section 61 uses a mile-wide definition of “income” that entitles the IRS to share in “all income from whatever source derived,” including payments that are “compensation for services.” Whether or not your arrangement is in writing or you took deductions for those payments, the courts routinely hold that they’re actually for services rendered.

Q: I ran up sizable travel and entertainment expenses for my corporation, for which I’m entitled to get reimbursed. But I neglected to get reimbursed for them before the corporate return was filed. To keep things simple and to get an immediate tax deduction, can’t I just claim them on my own return as employee business expenses?

A: The IRS will automatically disallow them because you’re entitled to reimbursement. They’re the corporation’s expenses, not yours. And it makes no difference even if you’re the only stockholder. You still can’t deduct expenses you pay on the corporation’s behalf. Collect your tax-free reimbursement now and deduct the expenses on your corporation’s next return.

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By wflora
May 18th 2017 16:49

The answer to your last question has a typo. It should be that the cost basis of the "building" has a zero basis, not the cost basis of the "land". This was a very interesting list of Q&A. Thanks for the info.

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to wflora
May 22nd 2017 18:36

Hi wflora, thank you for your comment. As a result, Julian has reworded that question and his answer to clarify what the tax rules should be. We appreciate your comment.

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May 23rd 2017 01:10

Wflora, I appreciate your careful reading of my article.
Always feel free to chime in.
Julian

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