Kansas Corporation is a 68% shareholder in Colorado, Inc. Last year, Colorado paid Kansas $100,000 as compensation for unspecified services provided by Kansas employees to Colorado, and deducted the payment on its federal income tax return. The revenue agent who audited both corporations' returns concluded that the payment is a constructive dividend. Both corporations have a 21% marginal tax rate. What is the effect of this audit conclusion on each corporation's income tax liability?

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The payment being reclassified as a constructive dividend means it is not deductible for Colorado, increasing its taxable income by $100,000, resulting in a $21,000 tax increase (21% of $100,000). For Kansas, the $100,000 is now considered dividend income, which is eligible for the dividends received deduction, reducing its taxable income by $65,000 (65% of $100,000), leading to a $13,650 tax decrease (21% of $65,000).

Kansas Corporation Is a 68% Shareholder in Colorado, Inc