Question

Paula is the sole shareholder of Violet, Inc. For 2020, she receives from Violet a salary of $300,000 and dividends of $100,000. Violet's taxable income for 2019 is $500,000. On audit, the IRS treats $100,000 of Paula's salary as unreasonable. Which of the following statements is correct?

a. Paula's gross income will increase by $100,000 as a result of the IRS adjustment.
b. Violet's taxable income will not be affected by the IRS adjustment.
c. Paula's gross income will decrease by $100,000 as a result of the IRS adjustment.
d. Violet's taxable income will decrease by $100,000 as a result of the IRS adjustment.
e. None of these is correct.

Answer 1

The reclassification of $100,000 from salary to dividend by the IRS leads to an increase in Violet, Inc.'s taxable income by the same amount, while Paula's gross income remains the same. The correct option is a. Paula's gross income will increase by $100,000 as a result of the IRS adjustment.

Step-by-step explanation:

If the IRS treats $100,000 of Paula's salary from Violet, Inc. as unreasonable, then the $100,000 would likely be reclassified as a dividend. This reclassification has implications for both Paula's gross income and Violet's taxable income. Since dividends are not deductible expenses for a corporation, Violet, Inc.'s taxable income would increase by $100,000 which is no longer considered a salary expense. However, Paula's gross income would remain the same overall because although her salary income would decrease by $100,000, her dividend income would increase by the same amount. Consequently, the correct statement is d. Violet's taxable income will decrease by $100,000 as a result of the IRS adjustment.

The correct option is a. Paula's gross income will increase by $100,000 as a result of the IRS adjustment.