galadriel and john married with no children own all the stock in marietta horse supp 4519590

Galadriel and John, married with no children, own all the stock in Marietta Horse Supplies. The couple’s C corporation has been in business for ten years. The business has been successful, permitting both owners to pay themselves a reasonable salary from its revenues. Although the salaries cover life’s 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 horse supply businesses. The reason for the low salaries is that, for a number of years, the owners felt continual pressure to retain as much of the profits in the business as possible to have sufficient working capital to finance inventories and other business needs. In the past two years, the firm has established lines of credit with two local banks that have alleviated much of this pressure. However, the couple has never had time to review the level of their compensation. Recently, an IRS agent asked the couple about items reported in a previously filed tax return. The agent reviewed all three open years and proposed a settlement for the items in question. While in the office, the IRS agent indicated to you as the couple’s CPA that, in her opinion, the company had unreasonably accumulated earnings and that she would be investigating the issue before closing the audit. What advice can you give the couple about their salaries and potential liability for the accumulated earnings tax?

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