Ask The California Employment Tax And Payroll Tax Attorney – EDD And FTB World Views Can Differ On Compensation – The Kriton Corporation Case

By Robert S. Schriebman

2023

Introduction

The EDD and the FTB can have differing points of view on whether payments to corporate officers are considered compensation or a dividend. The recent Kriton Corporation case (2023-OTA-420) presents a potential conundrum with the way the FTB views deductible compensation and potential ramifications at the EDD level when the FTB challenges the deductibility of officer compensation. The Kriton case was decided by the Office of Tax Appeals (OTA). The OTA denied corporate deductions for officer compensation after the corporation filed payroll tax returns with the EDD and paid substantial employment and withholding taxes. This article will discuss the FTB Kriton case and then look at the decision through the eyes of the EDD.

The Kriton Case

Kriton operated a gas station and convenience store in California. The corporation is wholly owned by Mr. and Mrs. Vakilian as 50/50 shareholders. The corporation sold its assets for $5.1 million. The taxable gain on the sale was huge. Their accountant, in order to reduce corporate tax exposure, paid each spouse $100,000 of deductible compensation in 2012 and $185,000 to each in 2013 ($200,000 in 2012 and $370,000 in 2013). The FTB audited the corporation and denied the compensation deductions. Instead, the FTB took the position that the payments of compensation were, in reality, dividends to the shareholders.

Compensation vs. Dividends

Compensation paid by a corporation to its officers is deductible and lowers the corporation’s income tax exposure. Compensation is taxable to the employee as ordinary income. On the other hand, a dividend is not deductible by the corporation, but is also taxable income to the shareholder.

The OTA Ruling

Internal Revenue Code (IRC) § 162(a)(1) generally allows a deduction for ordinary and necessary business expenses, including “a reasonable allowance for salaries or other compensation for personal services actually rendered.” (See R&TC §24343 [generally conforming to IRC § 162].) The payment of dividends to shareholders, however, is not deductible.

There is a two-prong test to determine whether the payment by the corporation is made for actual services rendered and whether the amount of that compensation is reasonable. After hearing testimony from the corporation’s accountant and Mr. and Mrs. Vakilian, the OTA concluded that the Vakilians did not render meaningful services to the corporation and therefore, the compensation paid in 2012 of $200,000 and the compensation paid in 2013 of $370,000 were paid by the corporation primarily to generate deductions from taxable income. Therefore, compensation paid was not reasonable. The OTA concluded that the compensation was, in reality disguised as dividends and not deductible by Kriton. This ruling meant that Kriton owed the FTB substantial additional income taxes plus penalties and interest.

Keep in mind that Kriton, in 2012 and 2013 filed EDD payroll tax returns and paid a substantial amount of payroll taxes in each year.

EDD Worldview

The EDD’s worldview in the Kriton matter may be a mirror image of the worldview of the FTB. Keep in mind that Kriton, in 2012 and 2013 filed EDD payroll tax returns and paid a substantial amount of payroll taxes in each year. Kriton had the rug pulled out from under them by the OTA. If Kriton wants its money back from the EDD they will have to file refund claims for both years. There is a big problem here for Kriton. The EDD statute of limitations for refund may have expired. CUIC § 1178 is the only statute of limitations for EDD refunds. The statute says, in substance, that the time for submitting a refund claim are three years from the filing of quarterly returns or 60 days from payment of a tax, whichever is later. It’s now 2023 and Kriton is seeking refunds for 2012 and 2013. It does not look good for Kriton at the EDD.

If the EDD were to audit Kriton and see that $200,000 of compensation was paid in 2012 and $370,000 paid in 2013, the EDD would probably be satisfied that Kriton had met the two-pronged test of services rendered and reasonableness of compensation. On the other hand, if Kriton followed the FTB position and paid the Vakilians these amounts as dividends, the EDD would have taken the position that the dividends should have been taxable compensation. It appears that Kriton is being whipsawed between the EDD and the FTB. Either way, Kriton cannot win.

Conclusion

The Krition case, coupled with the conflicting worldviews between the FTB and the EDD vis-a-vis corporate distributions, resembles a page out of Alice in Wonderland. In the world of California taxation Tweedledee and Tweedledum are alive and well.

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Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 50 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments.  Mr. Schriebman is in private practice.  He is not affiliated in any way with the EDD, and he is not employed by the EDD or any other agency of the State of California.

Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.

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