IRS Notice of Proposed Adjustment Research Paper

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Accounting

A Notice of Proposed Adjustment is sent by the Internal Revenue Service (IRS) regarding an adjustment that it made to a tax return. The subject of the return can then challenge the claim made by the IRS, should they feel that the IRS' adjustment is unwarranted or erroneous (IRS.gov, 2016). On this notice, there are three issues that have been identified.

The first issue is the unreasonable compensation. The fact is that the owner took $5 million in salary, and then a further $5 million from the company based on gross revenue. There is nothing in the taxpayer's claim that argues the purpose of that second $5 million payment. The IRS is claiming the second $5 million payment is a constructive dividend. A constructive dividend is usually in the form a loan from the company to the shareholder, but in this case was just a payout. The key for the IRS is that this is not counted as salary (an expense) but rather as a constructive dividend, which would increase the taxable revenue for the company, since dividends are paid out on an after-tax basis (Investopedia, 2016). At issue here is what the IRS considers to be reasonable salary for the client. This appears to be entirely discretionary on the part of the IRS. The payout here, however structured, is viewed as excessive by the IRS.

This will be difficult under current law to defend against. It is possible that the company could argue that it did not earn enough money for this distribution to be classed as a dividend. However, we know that the company had $300 million in revenue. The company's net income is not known, but the revenue is enough to sustain the salary. There is room to argue that a company of that size would normally pay that sort of salary/bonus to its CEO. Some evidence might be required to demonstrate that this level of payment is the industry norm. If such evidence is not forthcoming, then the IRS ruling on the matter of the constructive dividend will likely stand.

The second issue is the stock redemptions.

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The facts are as follows. The case states that the NPA was related to the building supply business, but this one actually relates to the construction company. The construction company redeemed during the audit period 50% of the outstanding stock owned by the client, and 50% of the outstanding stock owned by the client's son. The IRS is considering this to a be a stock redemption. The case does not clarify what type of stock, but is written in a way that makes it seem as though the stock is common.

A stock redemption is reserved for preferred stock, not common stock. If common stock is purchased, that would be considered a buyback. One of the main distinctions between a redemption and a buyback is that with a buyback, the shares still exist, and they can be resold at a later date. If preferred shares are being reduced, this is not necessarily the case (Investopedia, 2016).

If the corporation only has one class of stock, then the distribution will be considered as a 301 distribution, according to section 302 of the IRC. This section states clearly as follows:

"The redemption of all of one class of stock (except section 306 stock) either at one time or in a series of redemptions generally will be considered as a distribution under section 301 if all classes of stock outstanding at the time of the redemption are held in the same proportion."

This makes it clear that these distributions will be considered as 301 distributions. These distributions were not for preferred stock, but the law does not distinguish between preferred and common stock in the way that most of the literature on the subject does. The law notes that where there is one class of stock, distributions are usually going to be classed on 301.

The third issue is that of rental loss. This stems from a building that was rented by the construction company to the owner and his son. No other details are provided. However, the research on the constructive dividend showed that when an exchange below fair market value is.....

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