Tappan Company Pays Its Sole Shareholder, Carlita Hill, a Salary

Essay

Tappan Company pays its sole shareholder, Carlita Hill, a salary of $200,000. At the end of each year, the company pays Carlita a "bonus" equal to the difference between the corporation's taxable income for the year (before the bonus) and $75,000. For year 1, Tappan reported pre-bonus taxable income of $800,000 and paid Carlita a bonus of $725,000. On audit, the IRS determined that individuals working in Carlita's position earned $300,000 per year on average. The company had no formal compensation policy and never paid a dividend. How much of Carlita's compensation (salary plus bonus) might the IRS recharacterize as a dividend? Assuming the IRS recharacterizes $500,000 of Carlita's bonus as a dividend, what additional income tax liability does Tappan Company face? (Ignore payroll taxes)