Research Problem 1.

Kenny Merinoff and his son, John, own all outstanding stock of Flamingo Corporation. Both John and Kenny are officers in the corporation and, together with their uncle, Ira, comprise the entire board of directors. Flamingo uses the cash method of accounting and has a calendar year-end. In late 2009, the board of directors adopted the following legally enforceable resolution (agreed to in writing by each of the officers): Salary payments made to an officer of the corporation that shall be disallowed in whole or in part as a deductible expense for Federal income tax purposes shall be reimbursed by such officer to the corporation to the full extent of the disallowance. It shall be the duty of the board of directors to enforce payment of each such amount. In 2014, Flamingo paid Kenny $800,000 in compensation. John received $650,000. On an audit in late 2015, the IRS found the compensation of both officers to be excessive. It disallowed deductions for $400,000 of the payment to Kenny and $350,000 of the payment to John. The IRS recharacterized the disallowed payments as constructive dividends. Complying with the resolution by the board of directors, both Kenny and John repaid the disallowed compensation to Flamingo Corporation in 2016. John and Kenny have asked you to determine how their repayments should be treated for tax purposes. John is still working as a highly compensated executive for Flamingo, while Kenny is retired and living off his savings.

Prepare a memo for your firms client files describing the results of your research.