McGraw-Hill's Taxation of Individuals and Business Entities 3rd Edition by Brian Spilker, Benjamin Ayers, John Robinson, Edmund Outslay, Ronald Worsham, John Barrick, Connie Weaver

Exercise 27

Nittany Company pays its sole shareholder, Joe Papa, a salary of $100,000.At the end of each year, the company pays Joe 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.For 2011, Nittany reported prebonus taxable income of $675,000 and paid Joe a bonus of $600,000.On audit, the IRS determined that individuals working in Joe'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 Joe's bonus might the IRS recharacterize as a dividend?
b.What arguments might Joe make to counter this assertion?
c.Assuming the IRS recharacterizes $200,000 of Joe's bonus as a dividend, what additional income tax liability does Nittany Company face?