FACTS:
Rachel was your college roommate. After graduating, she started her own business, a bakery and deli that has become the most popular and successful bakery in town. She hears that you are now a CPA handling business tax clients, and comes to your office. ¡°I¡¯d really like for you to handle my tax matters from now on¡±, she says. You agree to take her on as a new client, pending approval by your managing partner, and request the files from her previous CPA.
She explains that she incorporated her business 3 years ago, on January 1, 2007, at the advice of her lawyer, and operates as a C corporation, of which she owns 100% of the stock. She shows you her balance sheet, and you notice a Note Receivable from Shareholder of $200,000. She explains that this is one reason for hiring you. The note was set up 3 years ago upon the advice of her previous CPA. ¡°I never planned to actually pay off the note. It was just set up for tax purposes. When I incorporated, my CPA advised me to make a bookkeeping entry for the personal promissory note to avoid adverse taxable gain upon incorporation, so I did. I assumed we could just get rid of it. However, I have recently received an IRS notice that says they wish to audit my prior corporate returns. The document request form asks about the note, and I am nervous.¡±
After further research, you discover that the assets and liabilities that existed on 1/1/2007 were as follows:
ASSETS BASIS FMV
Cash $20,000 $20,000
Inventory 50,000 50,000
Fixed Assets 180,000 730,000
250,000 800,000
LIABILITIES
Accounts Payable $50,000
Mortgage Payable 400,000
450,000
Here are a few more facts that you learn:
1. The tax returns show revenues of $4,000,000(2007) and $5,000,000(2008). Operating expenses, excluding salary to Rachel were $3,200,000(2007) and $4,100,000(2008). Rachel paid herself a salary of $700,000(2007) and $800,000(2008). Taxable income of the C corporation was approximately $100,000 for both years. The revenues, expenses and salary to Rachel for 2009 are approximately the same as 2008.
2. No dividends have been paid from the corporation to Rachel.
3. No interest or principal payments were received on the Note Receivable-Shareholder. There is no formal promissory note document, or any legal documentation of the note.
4. The IRS recently sent a notice requesting documents for an examination of the 2007 Form 1120. One item on the document request form is ¡°Promissory note document for Note Receivable-Shareholder.¡±
Rachel asks for you to start the relationship by representing her in the IRS audit, and filing her 2009 tax return. She would like you to send her a letter with your opinion about whether the Note Receivable-Shareholder transaction was handled properly, what exposure she may have in the upcoming IRS audit and how she should handle this note now.
Assignment: Prepare a Memorandum to the Client File addressed to Rachel outlining the facts, issues, analysis and your conclusion of the Note Receivable-Shareholder transaction. Make a recommendation on the treatment of the Note Receivable-Shareholder from this date forward.
To: Rachel
From: [Your Name]
Date: [Current Date]
Subject: Note Receivable-Shareholder Transaction Analysis
Dear Rachel,
I have thoroughly reviewed the facts and information regarding the Note Receivable-Shareholder transaction and its potential impact on your business. Below, I will outline the facts, discuss the issues, provide analysis, and conclude with a recommendation on how to handle the Note Receivable-Shareholder from this point forward.
Facts:
1. On January 1, 2007, you incorporated your business as a C corporation, of which you own 100% of the stock.
2. At the advice of your previous CPA, you set up a Note Receivable from Shareholder for $200,000 on the same day of incorporation.
3. The purpose of setting up the note was to avoid adverse taxable gain upon incorporation, and it was not intended to be paid off.
4. The IRS has recently issued a notice requesting documents for an examination of the 2007 Form 1120, including the Promissory note document for Note Receivable-Shareholder.
Issues:
1. The treatment of the Note Receivable-Shareholder transaction in relation to your business's incorporation and subsequent financials.
2. The potential exposure you may have in the upcoming IRS audit due to the existence and handling of the note.
Analysis:
The Note Receivable from Shareholder transaction raises certain concerns and needs further evaluation. Although it was created for tax purposes, it is essential to determine if the transaction was handled properly. The following points should be considered during the analysis:
1. Substantiation of the Note: As there is no formal promissory note document or legal documentation of the Note Receivable-Shareholder, it may require additional support to establish its legitimacy in the eyes of the IRS.
2. Purpose and Nature of the Note: It is crucial to evaluate the true purpose and nature of the note to determine if it complies with the relevant tax laws and regulations. If the note was created solely to avoid taxable gain without any genuine business purpose, it may raise red flags during the IRS audit.
3. Adequate Consideration: The value of the note should be evaluated to ensure that it represents adequate consideration for the transfer of funds to the corporation.
Conclusion:
Based on my analysis of the provided facts, it is apparent that further investigation is necessary to determine the appropriate treatment of the Note Receivable-Shareholder transaction. Additionally, the lack of supporting documentation and the potential scrutiny by the IRS during the upcoming audit indicates the need for careful consideration and proactive measures.
Recommendation:
1. Consultation with an Attorney: It is advisable to seek legal counsel to evaluate the validity and implications of the Note Receivable-Shareholder transaction. An attorney specialized in tax law can provide guidance on how to handle the situation and ensure compliance with applicable regulations.
2. Preparation of Supporting Documentation: It is essential to prepare any available documentation that may substantiate the existence and purpose of the Note Receivable. This could include contemporaneous correspondence, internal memos, or any other evidence that can support the transaction.
3. Open Communication with the IRS: It is crucial to maintain open communication with the IRS regarding the examination of the 2007 Form 1120 and the associated note. Promptly responding to their requests while seeking professional assistance can help minimize potential risks.
4. Adjusting the Note Receivable: Considering the potential scrutiny and lack of genuine business purpose, it may be advisable to restructure or dissolve the Note Receivable-Shareholder transaction. This should be done under the guidance of legal and tax professionals to ensure compliance with applicable regulations.
Please note that this memorandum is intended for informational purposes only and should not be considered as legal or tax advice. It is strongly recommended to consult with a qualified professional who can provide tailored advice based on your specific circumstances.
Should you have any further questions or concerns, please do not hesitate to reach out to me. I will be glad to assist you in any way I can.
Sincerely,
[Your Name]