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Tax Memo Page 1

TO: Mr. Kim FROM: DATE: October 10th 2010 RE: Tax Memo #2-Executive Compensation

Issue One and Applicable Case Law, Code & Regulations

As one of our esteemed client, we are glad to assist you and we would like to give you some information concerning the current situation at your company. It has come to our attentions that you requested to obtain information about the CEOs salary that may be termed as approriate if the IRS audits it.

The case of Elliott v Commissioners 716 F.2d 1241, 1983 US is the best one to decide on whether the IRS auditing will reveal that Mr. Kims compensation is unreasonable.1 The court brought out some five factors, to look at in determining whether compensation is reasonable. The first one is that compensation must compare with the other similar firms. The role of the employee in the firm should have no conflict of interest. The condition and the nature of the company need consideration and finally internal consistency needs attention.2 These are the factors to use to analyze whether Kims compensation is or is not reasonable. The reason is that the company makes a gross profit of one million dollars of which nine hundred thousand goes to the pocket of Mr. Kim. The Automatic Divided Rule, Lev 441/447 of 1974, notes that compensation may be considered reasonable if there exists a compensatory purpose.3

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(bvresources.com, 1983) (Mark, A. et al, 1987) 3 (Jones, S. & Shelley, R., 2009)

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From the case, it is clear that as KimTechs CEO, you have met all the criteria and the requirements set in the Elliot case to consider your compensation reasonable. The company is performing well as a requirement since there is a growth of 7 percent. The board of directors who comprises of the CEO, CFO and the vice president agrees. The CEO also has some other duties that he must attend to which makes him multi task at the company. You need to be compensated for that and all these factors make your compensation reasonable.

Issue Two and Applicable Case Law, Code & Regulations

The issue under concern here is that even with the auditing IRS approaching your salary as reasonable using the Elliot case, other approaches may differ with this one. Such approaches are the use of the independent investor or return on equity approach. You also requested to know whether using this approach; the salary will still be deemed reasonable.

The case of Sunset Scavenger Company v. Commissioner 84 F.2d, 453/455 1936 can be used in the analysis of Mr. Kims salary using the independent investor approach on equity.4 Unlike in the previous approach where it was proved that Kims salary is reasonable owing to the five factors enumerated in the Elliott case; this approach considers this salary unreasonable.5 According to the approach, the salary that the CEO gets is very high because it covers over 80% of the total profit the company makes. This is because; if the CEO gets all this money, there will be a serious effect on the returns on equity of the arms length investor. 26 U.S.C. 162(a) (1) requires that the highest amount of compensation set on executives should not have a serious

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(Sunset Scavenger Company v. Commissioner 84, 1936) (Section 501, 2010)

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effect on the investors return on equity.6 The article requires the deductions of all the expenses, which includes among others include ordinary and necessary expenses and deductions.

Irrespective of whether the executives of the company pays themselves large amount of money, you should consider it reasonable as long as the investors expectations are met.7 In this case, it is clear that the company has realized growth of 7 %. If this is in accordance to the investors expectation, then you should argue that the compensation is reasonable under the independent investor approach on equity.

Issue Three and Applicable Case Law, Code & Regulations

The other issue is that you want to know whether contingency can be used in determination of whether your compensation is in reasonable.

The case of Elliott v Commissioners 716 F.2d 1241, 1983 US is the best case to use to analyze this situation.8 At some point in this case, the court failed to honor the use of the contingent formulae. Instead, it opted to go for the amount that was paid to the executives. Using this ruling, it we can argue that contingency compensation is under no means supposed to be in use in determination of whether compensation is unreasonable. The reason is that viability of compensation should be observed from the results of the five factors that are discussed in the Elliot case, the independent investor approach on equity and the capital assets pricing model. If these three methods are in use and they prove that the compensation paid is legal and reasonable, then it will not matter whether the compensation is in terms of bonuses or otherwise.

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(IRC Section 4958, 2010) (Brennan, 1994) 8 (bvresources.com, 1983)

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Compensation can still be unreasonable even when there are no high bonuses if the factors to be considered are not in line with the compensation.9

The use of contingent approach is therefore not applicable in the determination of whether your salary is reasonable. The reason is that it is clear that the CEO needs compensation, which is higher than what the other employees get. In addition, under this approach, it is questionable for the owner employee and non-owner employee to have a similar salary and this makes it assess the reasonable nature of the salary under this approach.

(IRS Press, 2006)

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References Brennan, J. (1994). Avoiding IRS Challenges To High Shareholder Pay. Contractors Compensation Quarterly . bvresources.com. (1983). Elliotts Inc. v. Commissioner. Retrieved October 9, 2010, from www.bvresources.com/BVWireCentral/Material/BVWire524/Elliots.pdf+ELLIOTTS+CASE&hl=en&gl=ke&pid=bl&srcid=ADGEESgBbJ3e8oifa zpEIV7y7dOZwZ-YxLwZ6wO6svMZKPubg3_-Jh-b8boKReI1BeBWnWcTglvTOvNdyKCfC9YOPchp2Y IRC Section 4958. (2010). Retrieved October 10, 2010, from http://www.sharinglaw.net/npo/section_4958.htm IRS Press. (2006). Your Federal Income Tax. IRS Publication. Menard Inc v. Commissioner of Internal Revenue, No. 08-2125 (United States Court of Appeals March 10, 2009 ). Section 501. (2010). Retrieved October 10, 2010, from http://www.labyrinthinc.com/sharedcontent/sec501.asp?Page=5&subs=6 Siegel, B. (2004, California CPA ). Tax benefits of IRC Sec. 165. California CPA . Square D Company v. Commissioner of Internal Revenue, No. 11 (121 T.C. September 26, 2003). Sunset Scavenger Company v. Commissioner 84, No. 7999 (Circuit Court of Appeals, Ninth Circuit June 8, 1936).