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 lifes 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 Companys 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. Prepare a memorandum to Terry Herbst, your tax manager, regarding all appropriate issues with respect to the accumulated earnings tax. In your memorandum, please address their salaries, dividends and other issues you believe relevant. Please indicate any steps or actions that the couple should consider in getting ready for what appears to be a second phase of this audit?