A man who operated tax prep businesses in California and Nevada probably felt that he knew how to arrange things to stay out of tax trouble. The Tax Court decided otherwise last week in the case of Joseph Anthony D’Errico v. Commissioner.
TPM was a C corporation set up by the taxpayer to provide management services to S corporations that he owned in the tax prep business. It’s possible that he used the C corporation for the “bracket racket,” diverting enough income from the S corporations to fully use the 15% corporate bracket, but the case doesn’t say so. The taxpayer sold his S corporation businesses in 2005, which would leave the taxpayer with a management C corporation with nothing to manage. A few weeks before the January 1, 2005 sale of his businesses, the corporation got another asset:
In December 2004 TPM purchased a Cessna airplane (airplane) for $137,500. Mr. D’Errico had a pilot’s license and several years of flight training at the time TPM purchased the airplane. Mr. D’Errico testified that TPM purchased the airplane in order for him to travel quickly between TPM’s purported office at the Barton Drive home in Stateline, Nevada, and his two active tax preparation corporations
So what does a mangement company with nothing to manage do with its airplane?
On December 29, 2004, TPM entered into an “Aircraft Leaseback Agreement” (leaseback agreement) which allowed the flight training company Flying Start Aero to make the airplane “available to the public for rental” for no more than 75 hours per month. The leaseback agreement stated that TPM was entering into the agreement “with the intention of generating some revenue for the purpose of offsetting a portion of the aircraft operating costs”. Even though the airplane was leased to Flying Start Aero, TPM was still responsible for airplane expenses such as insurance and maintenance. The lease was canceled by Flying Start Aero in early 2006 upon TPM’s failure to pay such expenses.
The airplane was not used in TPM’s tax management related business during 2005 or 2006. Petitioner claimed in his testimony that he used the airplane on business related trips in both January and April 2007. However, Mr. D’Errico did not introduce a log of his airplane use during 2007 into evidence. The only 2007 airplane records summarized expenses one Matthew Laughlin incurred in a trip to Los Angeles. Mr. Laughlin had been Mr. D’Errico’s certified flight instructor since Mr. D’Errico began to fly in 2001. Mr. D’Errico testified that Mr. Laughlin “came out from Denver to talk to me about multiple uses for the airplane. He thought it would be a good idea for us to start our own flight school, in which he would have a flight school and I would rent the airplane to his flight school.”
Perhaps it was an excellent idea, though nothing apparently came out of it. Deducting the airplane expenses in the corporation also seemed like a good idea:
On its TYE April 30, 2006, tax return TPM reported income from the airplane rental of $21,869, airplane expenses of $17,042, and airplane depreciation of $11,408. On its TYE April 30, 2007, tax return TPM reported no airplane rental income,7 airplane expenses of $19,351, and total depreciation of $7,324.
The corporation also deducted expenses for a Chevy Tahoe that the taxpayer testified was “exclusively for business use,” according to the opinion. The corporation also deducted phone expenses, “supplies,” and meals. The corporation paid “rent” to the taxpayer for an office in his home. Also:
TPM deducted utility expenses for the Barton Drive home of $2,695 and $2,491 for its TYE April 30, 2006 and 2007, respectively. These expenses included cable television, Internet, gas, electric, and certain repairs.
Well, the corporation didn’t have a business to manage. Maybe having cable and Internet gave it something to do.
The Tax Court didn’t like the deductions. It had this to say about the airplane:
TPM argues that the airplane was necessary for its tax management business because Mr. D’Errico had to travel between Nevada and southern California to fulfill TPM’s business obligations to [his tax preparation S corporations sold in 2005]. However, at the time TPM purchased the airplane, Mr. D’Errico knew that he was going to be selling… TPM has produced no evidence that the airplane was used in TPM’s tax management business after 2004.
The Tax Court didn’t just disallow the deductions (my emphasis):
As discussed above, TPM failed to establish that it conducted business-related activities at the Barton Drive home, with the result that the rent payments made to Anthony D’Errico are not deductible by TPM. Further, Mr. D’Errico failed to introduce evidence to support his claim that he used only a portion of the Barton Drive home as his personal living area. Neither the lease between TPM and Anthony D’Errico nor the sublease between Mr. D’Errico and TPM identifies certain areas of the Barton Drive home reserved for TPM’s business use. We find that Mr. D’Errico derived a personal benefit from his use of the entire Barton Drive home and received constructive dividend income as a result of the rent payments made by TPM.
Petitioners have also failed to prove TPM’s entitlement to deductions for the airplane expenses. Further, petitioners have failed to introduce evidence to show that Mr. D’Errico did not benefit from TPM’s purchase of the airplane or TPM’s paying for rental of another airplane for Mr. D’Errico to fly. Mr. D’Errico admitted that he “enjoy[ed] flying and everything” and that he used the rented airplane to continue his flight training. Mr. D’Errico also discussed using TPM’s airplane to start a flight training school with his certified flight instructor, Mr. Laughlin. Finally, petitioners failed to substantiate any amount of business travel or lack of Mr. D’Errico’s personal use of the airplane during the years at issue. We find that Mr. D’Errico derived a personal benefit from the airplane expenses paid by TPM and received constructive dividend income as a result.
When an expense of a C corporation is changed to a “constructive dividend” in an audit, the taxpayer loses twice: the corporation loses a deduction, but the taxpayer gets extra dividend income.
The Moral? Sometimes when taxpayers sell their business, they think it might be a good idea to keep the business around “in case they need it.” That’s fine, if pointless, but when you don’t have a business any more, you no longer have a reason to claim business expense deductions. If the corporation pays arguably personal expenses, you run the risk of losing the corporation deduction while boosting your personal tax bill. That’s true no matter how much you know about taxes.
Cite: D’Errico, T.C. Memo 2012-149.