FACTS:

Question

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.