Sara owns 60% of Mayfield Corporation's single class of stock. A group of five family members and three key employees own the remaining 40%. Mayfield is a calendar year taxpayer that uses the accrual method of accounting. Sara is a Mayfield officer and director and uses the cash method of accounting. During the period Year 1 through Year 3, Sara received the following amounts as salary and nontaxable fringe benefits from Mayfield: Year 1, $160,000; Year 2, $240,000; and Year 3, $290,000. She earned these amounts evenly throughout the tax years in question. In Year 4, upon auditing Mayfield's tax returns for Year 1 through Year 3, a revenue agent determined that reasonable compensation for Sara's services for the three years in question is $110,000, $165,000, and $175,000, respectively. The bylaws of Mayfield were amended on December 15, Year 2, to provide that:
Any payments made to an officer of the corporation, including salary, commissions, bonuses, other forms of compensation, interest, rent, or travel and entertainment expenses incurred, and which shall be disallowed in whole or in part as a deductible expense by the Internal Revenue Service, shall be reimbursed by such officer to the corporation to the full extent of such disallowance.
Following the disallowance of $240,000 of the total salary expense, the board of directors met and requested that Sara reimburse Mayfield for the portion of her salary deemed to be excessive. Because of the large amount of money involved, the board of directors approved an installment plan whereby Sara would repay the $240,000 in five annual installments of $48,000 each over the period Year 5 through Year 9. The corporation would not charge Sara interest on the unpaid balance of $240,000. Prepare a memorandum for your tax manager explaining what salary and fringe benefits are taxable to Sara in the period Year 1 through Year 3 and what reimbursements Sara can deduct during the period Year 5 through Year 9.