1. Mark is the sole stockholder in a C corporation that operates a chain of retail stores that specializes in selling home furnishings, such as furniture and curtains. He started the business almost 15 years ago and has done so well that three years ago he began looking into ways that would help him lower the amount of corporate taxes paid each year. Things have not been going so well in him marriage. He and his wife, Cindy, have not been getting along for the last two years. Mark and Cindy have seen a marriage counselor and during some of these sessions, Mark has complained about how their marital woes have negatively affected his business. The bottom line is taking a hit because I cannot keep my mind on my business. Mark recently told his friends.

Mark and Cindy recently concluded that they should divorce. They each retained separate lawyers, and you were hired as the forensic accountant by the attorney who represents Cindy. You have been pouring over the financial records of the business and have noted that for the most recent year, the income tax return of the corporation showed sales of $10,000,000 and cost of sales of $4,500,000. The other expenses totaled $3,750,000 leaving income before income taxes of $1,750,000.

You note that inventory and cost of sales is determined by applying the LIFO method. An analysis of the inventory reveals that the difference between LIFO and FIFO is $325,000. You also discover the following items:

-An IRC section 179 expense of $300,000 was taken on qualified equipment during the year. This amount is $240,000 greater than the modified cost recovery system deductions that would have been taken had Mark not claimed the IRC section 179 expense.

-Cost recover deductions (that is, depreciation expense) of $5,000 for a personal vehicle (used entirely by Cindy) were deducted on the corporate income tax return. Expenditures of $400 for repairs and maintenance, license tag renewal, and tolls pertaining to this vehicle were also deducted.

-Expenditures of $10,000 that appear to have been for a personal vacation were deducted as travel and entertainment.

-A salary of $1 million was paid to Mark, and a salary of $250,000 was paid to Cindy. You questioned Cindy about the salary and found that she was unaware that she was being paid. Furthermore, she said that she was not involved at all in the business. When you compared Marks salary to the salary he had been paid over the years, you found that it had increased 5 percent in each of the last 5 years until last year, when it was increased from $450,000 to $1,000,000.

-Repair expenses appeared to be $75,000 higher in the current year than the average of repair expenses during the last five years. When questioned about this, Mark seemed to hesitate and then said, There were a lot of repairs last year, werent there? The maintenance person in charge of the store where the repairs were believed to have been made insisted that no repairs had been made. Further examination of the vendor invoices revealed that the expenditures were for the acquisition and installation of an in-ground pool and materials to construct a patio. Your follow-up with Cindy confirmed what you had suspected: The patio and pool work had been done at Marks and Cindys residence.

a. What is the amount of income before income taxes for Marks business after normalizing the income (correcting for excess deductions taken)?

b. What questions would you like to ask Mark about the salary of $250,000 paid to Cindy, and what might you do before pursuing this line of questioning? Are there any other procedures that you could perform in this situation?

c. Which items in your adjustments used to arrive at the income before income taxes in part (a), if any, do you think Mark, his attorney, and their forensic accountant will contest? Explain.