Posts Tagged ‘Judge Swift’

Bad records help stick struggling S corporation owner with extra salary

Thursday, December 27th, 2012 by Joe Kristan

S corporation K-1 income isn’t subject to self-employment or payroll taxes.  This tempts S corporation owners to take minimal salary and take earnings out as S corporation distributions instead.   Former vice-presidential nominee and model husband John Edwards famously used an S corporation to minimize his payroll taxes.

20121227-1The IRS has had success in imposing additional payroll taxes when owners of profitable S corporations take little or no salary.  Yesterday the Tax Court also imposed payroll taxes on the owner of a struggling S corporation.

The owner of a small Twin Cities courier business reported wages of $24,452 to $28,452 in 2004-2006.  He took only $2,400 in salary in 2007.  The IRS found that $55,000 was transferred from the S corporation to the owner’s bank accounts in 2007 and imposed payroll taxes on that amount of salary.

How do we know the business struggled?  The Tax Court explains:

During petitioners’ operation of H&H up to some point in 2009, H&H either lost money every year or earned little income. In 2009 petitioners finally closed the business down, after losing their home on  account of losses incurred in the business and their inability to make payments on a home equity loan obtained in 2004 to finance their purchase of the business.

This wasn’t like the CPA who earned around $200,000 from his busienss and reported salary of only $24,000.  Yet the IRS didn’t let the taxpayer’s financial ruin stand in the way of an assessment of additonal payroll taxes.  The Tax Court upheld part of the assesment:

     We believe and accept petitioner’s testimony that he in fact paid significant H&H expenses with cash using funds received from H&H. For example, petitioner credibly testified that after finishing deliveries, truck drivers often would assist with repairs on the trucks and that he would pay the drivers cash for their assistance. No evidence indicates any unusual personal use by petitioners of the funds in question received from H&H.

     In spite of the limited evidence before us, we believe it improper and excessive to charge petitioner with receipt from H&H in 2007 of $52,600 in additional wages. However, we also believe petitioner’s reported H&H wages of $2,400 are unreasonably low.

Unfortunately, as you might have guessed from this, the taxpayer’s records were a mess.  The Tax Court used a very rough estimate:

To estimate what portion of the funds petitioner received from H&H in 2007 is to be treated as wages, we believe it appropriate to average petitioner’s wages for 2002 through 2006 and to use the average wage amount as the total for petitioner’s 2007 H&H wages subject to employment taxes — namely, $30,445.

I think the result would have been better if the taxpayer had kept better records.  If the taxpayer had kept personal and company spending separate and could account for all expenses, the Tax Court might have left him alone.

Still, I think the IRS and the Tax Court did the taxpayer a disservice.  Lee Iacocca famously took a $1 salary when he was in charge of struggling Chrysler.  If Warren Buffett can hold his salary to $100,000 in a fabulously profitable company, it’s plain mean to stick a struggling owner with additional salary just to collect more payroll taxes.

Fortunately this is a “summary opinion,” which isn’t supposed to serve as precedent.  A better-represented and better-organized taxpayer might well do better.

Cite:  Herbert, T.C. Summary Opinion 2012-124



Split-dollar roll-out clobbers executives

Tuesday, August 28th, 2012 by Joe Kristan

Earlier in my career “split dollar” life insurance was all the rage.  A company and its executive would enter into an insurance policy on the executive.  The executive would be the beneficiary of the policy and the corporation would pay the premiums; the policy ownership was “split” because the company was entitled to recover the premiums on the executive’s death before the executive’s beneficiaries benefited.  The executive would pick up an amount in compensation, but it was based on outdated IRS tables, making it a good deal for the employee.  They spread quickly because they were also a good deal for the insurance brokers.

The policies have become less popular since the IRS tables have been updated, but they were always fraught with other risks, as two executives learned in Tax Court yesterday.

The executives worked at N & J Management.  They entered into new split-dollar policies with the company in 2002, but they decided to close out the split-dollar deal in 2003 when the IRS changed its rules, according to the court opinion.  By that time the company had paid $842,345 in premiums.  It was agreed to turn the policies over to the employees.  Rather than paying back the entire premium, the employees had their accountants compute the present value of the premium recovery based on their current life expectancy; that came out to $131,969.

The IRS didn’t care for this present value thing, and they assessed additional tax based on the difference between the $842,345 in premiums paid by the company and the $131,969 the employees paid the company for the policies.  The Tax Court sided with the IRS (my emphasis):

     In December 2003 upon rollout of the SDLIAs, the income petitioners realized under section 61 or alternatively the taxable value of property transferred to them under section 83 was the $710,376 difference between the $842,345 that N & J Management paid in premiums on their behalf and that was owed by them and the $131,969 they reimbursed N & J Management. Clearly, petitioners realized an accession to wealth of $710,376 for the additional premiums N & J Management paid. This occurred in the context of and related to petitioners’ employment with N & J Management, and the $710,376 constitutes compensation income to them.

     Following the termination of the SDLIA arrangements, petitioners had no risk of forfeiture of the economic benefit of the $710,376 not reimbursed to N & J Management. Petitioners had complete ownership of the policies and were free to transfer the cash value of the polices free of encumbrances. Petitioners had no service requirements or other employment-related conditions that they needed to fulfill with regard thereto.

The present value computation was clever, and it does have some logic behind it; the value to the employer of the reimbursement right was dependent on the employee life expectancy.  But the court said that wasn’t the right way to value the benefit:

Petitioners could not access the cash surrender value and could not sell or dispose of or otherwise transfer their ownership interests in the policies or access the cash surrender value until N & J Management was either reimbursed the $842,345 or gave up its reimbursement rights. N & J Management gave up its reimbursement rights to the $710,376 balance and released petitioners from any further indebtedness on the amount not reimbursed. In essence, the economic benefit of the $710,376 was transferred to petitioners in December 2003 when the SDLIA arrangements were terminated, when N & J Management gave up its additional reimbursement rights, and when  N & J Management was removed from the picture relating to the life insurance policies.

It’s much like the forgiveness of a debt.  If your mortgage holder forgives the mortgage on your house, your net worth goes up by the whole amount of the forgiven mortgage, not the present value of the principal over its remaining term.  Decision for IRS.

Cite:  Neff, T.C. Memo. 2012-244


IRS: you aren’t allowed to escape our trap!

Tuesday, June 19th, 2012 by Joe Kristan

Flickr image courtesy Woodswalker under Creative Commons license

A bunch of McDonalds franchisees in Utah were run in a multy-entity structure: the restaurants were operated in one corporation, while a management company provided payroll, training and benefits services to the restaurants to the operating company.  In 2002 they began working with a consultant who advised them to make an S election for the management company and start an ESOP in it.  The management company also began a non-qualified deferred comp plan for the highly-compensated employees of the managmeent company.

The ink had barely dried on the new structure when the IRS issued new regulations that pretty much wrecked it all.  New rules on S corporation ESOPs, combined with the deferred comp plan, changed everything, as the Tax Court explains (my emphasis):

 On July 21, 2003, the Commissioner issued temporary regulations under which, for the first time, the definition of synthetic equity under section 409(p)(6)(C) included employee balances under nonqualified deferred compensation plans such as the NQDCP which petitioners had established within the management company…

Where the deemed-stock ownership tests of section 409(p) are violated, there are significant consequences to the disqualified persons, to the S corporation, and to the ESOP. Prohibited allocations in favor of disqualified persons are treated as currently taxable to the disqualified persons, sec. 409(p)(2)(A), and excise taxes equal to 50% of the total prohibited allocations are imposed on the S corporation, sec. 4979A. Further, the ESOP will not satisfy the requirements of section 4975(e)(7) and will cease to qualify as an ESOP.

But other than immediate tax, a 50% penalty tax, and ESOP termination, the structure would work just fine.  So the franchisees went back to the drawing board.  They bought the management company stock back from the ESOP. paid out the deferred comp balances of about $3 million, and terminated the ESOP under their own terms.  The taxpayers pretty much undid their plan and went back to their old setup.  But the IRS had another surprise:

On audit respondent determined that petitioners’ July 12, 2004, purchase and acquisition from the ESOP of the stock in the management company occurred for the principal purpose of avoiding or evading taxes by obtaining a loss deduction to which petitioners would not otherwise have been entitled, and respondent disallowed under section 269 the approximate loss deduction of $2,969,000 petitioners claimed.

They weren’t even joking.  Now Sec. 269 is a very obscure and rarely used tool in the IRS terror kit.  In the rare cases when it is used, it usually involves C corporations trying to buy net operating losses or tax credits.  I have never heard of it used on an S corporation, and the Tax Court seemed surprised too:

Respondent acknowledges that because S corporations are passthrough entities for Federal income tax purposes and do not keep their own deductions and losses (i.e., S corporation deductions and losses automatically pass through to the shareholders), it is extremely rare that the Commissioner would seek to make a section 269 adjustment in the context of a taxpayer’s acquisition of an S corporation.

The Tax Court sensibly saw things the taxpayers way.  The judge pointed out that the taxpayers would have been stuck with a bad tax structure caused by IRS rules adopted after they had already set it up (citations omitted):

The above transactions and steps clearly were related and planned as part of an effort to avoid problems created for petitioners by the Commissioner’s temporary regulations, to restructure the management company, and to terminate the ESOP; but they represent valid and real transactions with economic effect that require our recognition as legitimate business transactions.

It’s disturbing to see the IRS try to use Sec. 269 here.  Every ownership structure is tax-motivated in one way or another.  To challenge  a taxpayer’s entity structure is an improperly tax-motivated transaction, absent some weird result like a windfall tax loss or credit, is grossly improper.  This kind of position would result in penalties if taken by a taxpayer.  Taxpayers should be able to collect a similar penalty from the IRS when the agency litigates abusively like this.

Cite: Love, T.C. Memo 2012-166


You want to deduct that loss? Be ready to prove you are non-passive

Thursday, January 19th, 2012 by Joe Kristan

A Tax Court case yesterday illustrates the problems taxpayers with day jobs face when they want to deduct losses for side activities. A Minnesota entrepreneur named Alfred Iverson, who founded a successful manufacturer of surgical and medical equipment, also had a 14,000 Colorado ranch where he raised Angus and Herford cattle. The ranch generated tax losses in 2005 and 2006, and the couple deducted the losses.
The IRS challenged the losses, saying they are “passive” under the tax law. The taxpayers failed to convince the Tax Court that they spent enough time in farm activity to deduct the losses. From the Tax Court opinion:

Petitioners claim that in each of 2005 and 2006, whether at the ranch in Colorado or from petitioners’ home in Minnesota, Mr. Iversen spent a total of at least 400 hours working on matters relating to Stirrup Ranch, Mrs. Iversen spent at least another 100 to 150 hours working on matters relating to the horses at the ranch, and that they together meet the 500-hour test of section 1.469-5T(a)(1), Temporary Income Tax Regs.

Our analysis of the time and activity petitioners spent in 2005 and 2006 working on matters relating to Stirrup Ranch is made difficult by the lack of meaningful contemporaneous or other records and documentation regarding specifically what petitioners did on a day-to-day basis and how much time they spent on matters relating to Stirrup Ranch. In this case, the lack of records and documentation are not cured by estimates made years after the fact in writing or by testimony.

It’s up to the taxpayers to prove that they spent enough time on an activity for it to be non-passive. The taxpayers didn’t produce enough time sheets or other records to convince the judge.
The passive loss rules could take on much more importance if the “Affordable Healthcare Act,” or “Obamacare,” remains on the books. The law imposes a 3.8% additional tax on “passive” income starting in 2014. Obamacare defines “passive” using the passive loss rules. At a D.C. bar luncheon yestreday, practitioners noted that this could be a big problem for S corporations ($link)

Unless S corporations begin planning for the tax, shareholders “will be short” when it comes time to pay their taxes, especially those who have passive positions in those passthroughs, he said.
Coupled with a potential increase of the income tax back to 39.6 percent for the highest bracket, the Medicare contribution tax could pose significant problems for S corporations, which must maintain a single class of stock requirement, [Brian] O’Connor said. As a result, the S corporations must “distribute the same amount to everyone,” he said, adding, “So that essentially means that more money is going to be coming out of the company.”
If the income tax rates do rise to pre-Bush era levels, the effect will be “dramatic,” O’Connor said.

The moral? Entrepreneurs with loss activities are wise to keep track of their time daily. Absent AHCA repeal, all entrepreneurs will need to become time trackers.
Cite: Iversen, T.C. Memo 2012-19



Tax Court doesn’t let shareholders have their cake and eat it too

Thursday, December 29th, 2011 by Joe Kristan

C corporation shareholders have a problem when it comes time to sell the business. Buyers usually want to buy assets so they can get fresh basis and higher depreciation deduction. Buyers don’t want to by the corporate stock, which comes with any sins of the prior owners.
Sellers, though, get clobbered with two taxes when they sell the assets: the corporation has to pay tax, usually at 35%, on the gain on the asset sale; the shareholders pay a second tax on their gain on liquidating their shares. The same problem applies to S corporations to the extent they have “built-in gains.”
When Wisconsin’s Woodside Ranch Resort, Inc. decided to sell out to a buyer named Zumwalt, they met with representatives of “MidCoast Credit Corp.” and “MidCoast Acquisition Corp.” who claimed they could solve this double-tax problem. The Tax Court explains (my emphasis in bold):

Representatives of MidCoast repeatedly explained to the Woodside Ranch officers that if the Woodside Ranch stock was sold to MidCoast or to a MidCoast-related entity, MidCoast or its related entity would obtain bad debt losses from other companies and use those losses to offset or eliminate the tax liabilities of Woodside Ranch.
The transaction proposed by the representatives of MidCoast was also referred to by the MidCoast representatives as a “no-cost liquidation”. (Emphasis added.) In other words, instead of directly liquidating Woodside Ranch and distributing to the Woodside Ranch shareholders the cash proceeds from the Zumwalt asset sale (less the combined Federal and State tax liability that would have been paid), the MidCoast proposal was designed so that the cash, in effect, still could be “liquidated” or transferred to the Woodside Ranch individual shareholders, but indirectly and via a few additional steps, as follows: A purported or nominal sale of the Woodside Ranch stock to MidCoast; a transfer by MidCoast to the Woodside Ranch individual shareholders of the cash that would have been distributed to the shareholders on a direct liquidation of Woodside Ranch (i.e., the net proceeds available from Woodside Ranch for a liquidating distribution plus a “premium” — one-third of the taxes owed); and MidCoast would avoid paying the tax liabilities the Woodside Ranch shareholders would have had to pay on a direct liquidation. All this allegedly was to be made possible by MidCoast’s use of bad debt losses from other companies to offset the reportable Woodside Ranch gain on the Zumwalt asset sale.

They failed to convince the Tax Court:

Before us in these cases is a purported stock sale between petitioners and MidCoast that lacks both business purpose and economic substance and that we conclude is to be disregarded for Federal income tax purposes. In substance, there was no sale of the stock of Woodside Ranch; rather, Woodside Ranch was liquidated, and the $1,835,209 cash that Woodside Ranch had on hand (after the partial redemption that occurred on July 18, 2002) was distributed to the Woodside Ranch shareholders less a fee of approximately $500,000 that MidCoast retained for facilitating the sham.
The “no-cost liquidation” terminology used by the MidCoast representatives is telling. In substance, it really was a liquidation, not a stock sale. The effort, assisted by MidCoast’s sleight of hand, to reduce the tax cost of the Woodside Ranch liquidation by cloaking the liquidation in the trappings of a stock sale is to be ignored.

The judge held former shareholders liable as “transferees” for the tax that the corporation should have paid on the asset sale.
The Moral? There is no tax fairy. The double tax problem for C corporations, in contrast, is all too real.
Cite: Feldman, T.C. Memo. 2011-297


The cobbler’s barefoot children claim the earned income credit

Friday, June 24th, 2011 by Joe Kristan

You have to hope that the clients of a New York accountant have better tax records than he does, based on a Tax Court case yesterday. The Accountant claimed $473,540 in expenses over three years to offset $514,636 in reported income from accounting and photography. After the accountant filed his tax returns late, the IRS disallowed all of the claimed expenses for lack of documentation or lack of connection to the business.
The Tax Court takes up the story:

Petitioner paid his children what petitioner refers to as “per diem”, allegedly in connection with services they performed in petitioner’s accounting activity. These per diem payments, however, appear to have been set at amounts that would allow the children to benefit from the earned income tax credit, not at amounts that reflect the value of any services the children actually performed for petitioner, and the credible evidence does not establish the nature and extent of any services the children performed for petitioner.

So if the cobbler’s children are barefoot, the government isn’t supposed to buy them shoes? Maybe they didn’t actually work, but they appear to have at least been available for duty:

During the years in issue petitioner lived in his father’s house with between 10 to 18 other family members and individuals.

And they were stuck there:

Other than petitioner, none of the persons living in this house owned a car.

But that caused problems with the deductions for business use of the car:

The car petitioner owned and used in his accounting and photographic activities was also used by petitioner and by other persons living with petitioner for their personal use.

You have to wonder what the accountant was hoping to accomplish in Tax Court, considering the evidence he presented. From the Tax Court opinion:

At trial petitioner did not credibly explain how he accounted for the income received and the expenses incurred in his accounting and photographic activities. Petitioner stated he gave funds received to his wife and she did whatever she wanted with them.

I’m pretty sure my accounting firm doesn’t do that.

As noted above, documentation petitioner offered to substantiate claimed expenses relating to his accounting and photographic activities is illegible, some of it is blank, and much of it is not in petitioner’s name, but rather in the names of petitioner’s wife and children.

We don’t do that, either.

There is no credible evidence that petitioners’ children worked in any meaningful way for petitioner in either his accounting or his photographic activities that would have justified the per diem payments petitioner paid to them.
In support of claimed depreciation, petitioner offers a list of assets for 2006. This list is insufficient to establish that petitioner purchased and placed into service the depreciable assets and that the depreciation amounts petitioner claimed during the years in issue were correct

Why so little evidence? The dog ate it! OK, maybe there was no dog. Would you believe a fire?

Petitioner claims that some of the documentation relating to his accounting and photographic activities was destroyed in a fire or lost as a result of a computer crash. Petitioner submitted numerous general receipts at trial but has provided no credible evidence that the purpose for those expenses related to petitioner’s accounting and photographic activities, and petitioner’s ability to produce numerous receipts calls into question petitioner’s allegation that a fire or a computer crash occurred that destroyed his records.

The trip to Tax Court didn’t go well. The IRS won across the board, including late-filing and accuracy-related penalties.
The Moral? You really need to keep records for your business. Even if you are an accountant.
UPDATE, 6/28/2011: An alert reader notes that the taxpayer was suspended from practice before the IRS indefinitely from October 17, 2008 for failing to file his returns.
Cite: Fein, T.C. Memo 2011-142


Tax Court: homebuyer credit doesn’t work when you buy from relatives

Tuesday, February 8th, 2011 by Joe Kristan

The insane, futile and mercifully defunct refundable first-time homebuyer tax credit had one feature that frustrated subsidy seekers: the IRS said it wasn’t available to those buying homes from relatives, even at full fair-market value.
It’s not entirely clear that the law should work that way. The related party rule of 36(c)(1)(3) reads:

The term