Flaky tax shelters are supposed to generate pretend losses. You know a shelter has gone very bad when it generates pretend income instead. Yet that’s how it worked out for an “S corporation ESOP management company” plan considered by the Tax Court yesterday.
The plan involved a partnership, a C corporation, an S corporation, and an Employee Stock Ownership Plan. The ESOP owned 100% of the S corporation. S corporation income is taxed to its owners. As a tax-exempt entity receiving special treatment from the tax law, ESOP-owned S corporations can achieve Tax Fairy-like results. The ESOP’s can earn non-taxed business income passing through from the S corporation (though this gets very tricky and dangerous when there are few ESOP beneficiaries).
The plan was hatched by A. Blair Stover, who has shown up in these pixels before. Mr. Stover started his tax career with a national firm in Nebraska, moving on from there to Kansas City and then to California, leaving questionable tax shelters in his wake. He was barred from promoting shelters like the one in this case in an injunction affirmed by the Eighth Circuit in 2011.
This plan involved the payment of “management fees” and other purported expenses by a partnership owned by the taxpayer and his spouse that ended up in his ESOP-owned S corporation. The partnership appears to have had no other purpose than to gin up deductions by paying pretend management fees and other expenses. The taxpayers deducted the “expenses” on their 1040, with the idea that they would avoid tax because they flowed through the S corporation to the ESOP.
When the IRS went after Mr. Stover’s shelters, his clients received unpleasant IRS attention. In yesterday’s Tax Court case, the taxpayers signed a settlement agreeing to include in income on their 1040 the purported management fees paid to the ESOP.
So far, so good. But the agreement didn’t address the other side of the deal – the deduction for the payment of the purported fees by the partnership. The taxpayers claimed that if they had to pick up the pretend fees in income, they should get to deduct them too. Fair’s fair.
But if you want fairness, the tax law might not be the place to seek it. The court held that while they agreed to pick up the extra income, their settlement said nothing about a deduction, and they were stuck with the results (my emphasis, citations omitted):
Generally, recognition of income does not inexorably prove a corresponding deductible expense. For example, payments to a promoter in furtherance of a tax avoidance scheme constitute income to the promoter, but they are not deductible under section 162 by the payor. Furthermore, that petitioners might otherwise be obliged to recognize phantom income does not relieve them of their obligation to identify some legal authority for the deduction, nor does it permit the Court to manufacture such authority from whole cloth.
Petitioners’ phantom income argument amounts, in essence, to a plea for fairness. This Court strives to avoid unjust results, but “we are not a court of equity and cannot ignore the law to achieve an equitable end.” Moreover, the parties’ recent stipulation assuages our fairness concerns. In our order of July 1, 2014, we directed the parties to stipulate if possible, or to otherwise brief, the source of and factual and/or legal basis for the income inclusions required by the SOSI. The parties stipulated that the required income inclusions represent “the amount of taxable income petitioners avoided reporting” for tax years 2001 through 2003 because of their use of the management S corporation/ESOP structure. Taxable income is a term that is defined in the Code. Section 63 generally defines taxable income as gross income less allowable deductions. The parties’ chosen language thus implies that the $84,837 of income petitioners must include for 2003 pursuant to the SOSI represents not “phantom income” but bona fide, net taxable income that petitioners received and should have reported. So interpreted, the stipulation is difficult, if not impossible, to reconcile with petitioners’ theory for deducting the administration fee.
The result: a reverse tax shelter, generating only phantom income.
I’m not sure this too-bad-to-be-true result would hold up on appeal, but it does serve a warning. The Tax Fairy is a fickle sprite, and she can magically generate income for those seeking magical deductions. And if you agree to include phantom income when the IRS comes after you, make sure they allow the offsetting phantom deduction in writing.
Cite: Wakefield, T.C. Memo 2015-4.
Leslie Book, Bank of America on Hot Seat For Issuing Allegedly Incorrect 1099C to Disabled Veteran (Procedurally Taxing)
Robert D Flach explains WHAT’S NEW FOR THE 2014 FORM 1040?
Kay Bell, Daily Tax Tip #2: A tax quiz!
Robert Wood, The 1031 Exchange That Ate New York City. A lesson on the scalability of swaps.
TaxProf, The IRS Scandal, Day 609. The Worst Commissioner Ever comes out the other side of the revolving door.
Scott Sumner on low-income use of untraceable cash at Econlog:
College professors who advocate the elimination of currency are often unaware of how important currency is for those with low incomes, many of who lack bank accounts. For instance, consider someone getting government benefits that are conditional on income (food stamps, EITC, disability, welfare, Medicaid, etc.) This group often faces relatively high implicit marginal tax rates. However currency allows them to supplement their meager benefits with additional earned income, perhaps doing home repair for neighbors, or working as a nanny. Lots of those jobs are paid in cash. If we eliminate physical cash then all transactions will be easily traceable by the government… That’s bad for two reasons; low-income people would see reduced incomes (increasing inequality), and the rest of us will be denied the services that they might have produced in the underground economy. Economists who advocate the elimination of currency need to consider those side effects.
This highlights one of the dangers of the earned income tax credit: its phase-outs serve as a hidden high tax rate on low incomes, resulting in a poverty trap on those earning their way out of poverty.
Russ Fox, The Tax Court Looks for $1,410 in Dividends. Sometimes you can fight a small injustice and win.
We are the 1%. Admit It: You’re Rich (Megan McArdle):
The cutoff for the global 1 percent starts quite a bit lower than the parochial American version preferred by pundits. I’m on it. So is David Sirota. And if your personal income is higher than $32,500, so are you.
It’s all a matter of perspective.