Question

Lamar Loadstone and Marcia Gonzalez own all of the stock of Recognition Corporation. Recognition Corporation is a C corporation and has been in business for a decade. The business has been slowly becoming successful, but both owners have continued to pay themselves a very basic salary. Although their salaries cover life’s necessities, a review of industry statistics shows that the salary of each owner is about one-half or two-thirds of salaries paid by similar sized businesses.

The reason for the low salaries is that, for a number of years, Lamar and Marcia were under continuous pressure to have sufficient working capital to finance inventories and other business needs. Their bank and their depression level thinking caused them to be very reluctant to either borrow money or bring in other investors.

During the past two years, Recognition Corporation has developed solid lines of credit with two new local banks. These lines of credit have alleviated much of the balance sheet pressure. During the two years, the owners had never taken the time to review their compensation.

Recently, an Internal Revenue Service agent asked the Company about items reported in a previously filed tax return. The agent reviewed all open years and proposed a small settlement for the items in question. But, while in the office, the IRS agent indicated to you as the Company’s CPA that, in her opinion, the company had unreasonable accumulated earnings and that she would be investigating that issue before closing the audit file.

Required:

1. What are the appropriate issues with respect to the accumulated earnings tax, please address their salaries, dividends and other issues you believe relevant.
2. Any steps or actions that the couple should consider in getting ready for what appears to be a second phase of this audit?

Answer 1

Accumulated retained earnings are the earnings of a business that have piled up since its inception, rather than being paid to shareholders in the form of dividends or some other form of distributio.

In the given question, company accumulate earnings through savings cost such as:_

• Dividend
• Salary
• Interest
• Tax

Net income will have a direct impact on retained earnings. However, payment of Salary, interest have direct impact on retained earnings (low expenses make increase earnings) In order to avoid the management decided to consume low salary and to avoid interest on borrowing loan for working capital.

Where a company requires expansion or investment, not willing to issue addition capital to avoid payment of dividend

In addition to this, the management intend to avoid paying taxes on such earnings by not distributing dividend.

ii) IRS considers to be the reasonable needs of the business, then the accumulated earnings tax won't be imposed.

The question is, what does the IRS consider reasonable needs of the business?

Here's what the IRS says the reasonable needs of a business are:

• · Specific, definite, and feasible plans for use of the earnings accumulation in the business.
• · The amount necessary to redeem the corporation's stock included in a deceased shareholder's gross estate, if the amount does not exceed the reasonably anticipated total estate and inheritance taxes and funeral and administration expenses incurred by the shareholder's estate.

Business expansion, constructing a new facility, and investing in newer and more productive equipment are reasonable business needs.