The revenue agent who audited the Form 1120 filed by LCW Inc. recharacterized $125,000 of the salary paid to Ms. Lewis (LCW's president and controlling shareholder) as a constructive dividend. LCW's marginal tax rate is 21%, and Ms. Lewis' marginal tax rate is 32%. Which of the following is not a consequence of the recharacterization?
A) LCW's taxable income will increase.
B) Ms. Lewis' taxable income will increase.
C) Ms. Lewis' payroll tax liability will decrease.
D) Ms. Lewis' income tax liability will decrease.

Question

Quizplus · Accepted Answer

The recharacterization of salary as a dividend results in LCW's taxable income increasing because the $125,000 is no longer considered a deductible salary expense. For Ms. Lewis, the recharacterization means this amount is now dividend income, not salary, affecting her income differently. Dividends are not subject to payroll taxes, hence her payroll tax liability decreases. However, her income tax liability does not necessarily decrease; it changes based on the treatment of dividends versus salary in her tax bracket. The incorrect statement is that Ms. Lewis' taxable income will increase, as the recharacterization changes the nature of the income, not necessarily the amount of taxable income.

The Revenue Agent Who Audited the Form 1120 Filed by LCW