Here is the
Court:
While a taxpayer is fee to organize [her] affairs as [she]
chooses, nevertheless once having done so, [she] must accept the tax
consequences of her choice, whether contemplated or not, and may not enjoy the
benefit of some other route [she] might have chosen to follow but did not.”
This is the
tax equivalent of “you made your bed, now lie in it.” The IRS reserves the right
to challenge how you structure a transaction, but – once decided – you yourself
are bound by your decision.
Let’s talk
about Stuller v Commissioner. They were appealing a District Court decision.
The Stullers
lived in Illinois, and they owned several Steak ‘n Shake franchises. Apparently
they did relatively well, as they raised Tennessee walking horses. In 1985 they
decided to move their horses to warmer climes, so they bought a farm in
Tennessee. They entered into an agreement with a horse trainer addressing prize
monies, breeding, ownership of foals and so on.
In 1992 they
put the horse activity into an S corporation.
They soon
needed a larger farm, so they purchased a house and 332 acres (again in Tennessee)
for $800,000. They did not put the farm into the S corporation but rather kept it
personally and charged the farm rent.
So far this
is routine tax planning.
Between 1994
and 2005, the S corporation lost money, except for 1997 when it reported a
$1,500 profit. All in all, the Stullers invested around $1.5 million to keep the
horse activity afloat.
Let’s brush
up on S corporations. The “classic” corporations – like McDonald’s and Pfizer –
are “C” corporations. These entities pay tax on their profits, and when they
pay what is left over (that is, pay dividends) their shareholders are taxed
again. The government loves C
corporations. It is the tax gift that keeps giving and giving.
However C
corporations have lost favor among entrepreneurs for the same reason the
government loves them. Generally speaking, entrepreneurs are wagering their own
money – at least at the start. They are generally of different temperament from
the professional managers that run the Fortune 500. Entrepreneurs have increasingly
favored S corporations over the C, as the S allows one level of income tax
rather than two. In fact, while S corporations file a tax return, they themselves
do not pay federal income tax (except in unusual circumstances). The S corporation income is instead reported
by the shareholders, who combine it with their own W-2s and other personal
income and then pay tax on their individual tax returns.
Back to the
Stullers.
They put in
$1.5 million over the years and took a tax deduction for the same $1.5 million.
Somewhere in
there this caught the IRS’ attention.
The IRS wanted
to know if the farm was a real business or just somebody’s version of
collecting coins or baseball cards. The IRS doesn’t care if you have a hobby,
but it gets testy when you try to deduct your hobby. The IRS wants your hobby
to be paid for with after-tax money.
So the IRS
went after the Stullers, arguing that their horse activity was a hobby. An expensive
hobby, granted, but still a hobby.
There is a
decision grid of sorts that the courts use to determine whether an activity is a
business or a hobby. We won’t get into the nitty gritty of it here, other than
to point out a few examples:
·
Has
the activity ever shown a profit?
·
Is
the profit anywhere near the amount of losses from the activity?
·
Have
you sought professional advice, especially when the activity starting losing
buckets of money?
·
Do
you have big bucks somewhere else that benefits from a tax deduction from this
activity?
It appears
the Stullers were rocking high income, so they probably could use the
deduction. Any profit from the activity was negligible, especially considering
the cumulative losses. The Court was not amused when they argued that land
appreciation might bail-out the activity.
The Court
decided the Stullers had a hobby, meaning NO deduction for those losses. This
also meant there was a big check going to the IRS.
Do you
remember the Tennessee farm?
The Stullers
rented the farm to the S corporation. The S corporation would have deducted the
rent. The Stullers would have reported rental income. It was a wash.
Until the
hobby loss.
The Stullers
switched gears and argued that they should not be required to report the rental
income. It was not fair. They did not get a deduction for it, so to tax it would
be to tax phantom income. The IRS cannot tax phantom income, right?
And with
that we have looped back to the Court’s quote from National Alfalfa Dehydrating & Milling Co. at the beginning of
this blog.
Uh, yes, the
Stullers had to report the rental income.
Why? An S
corporation is different from its shareholders. Its income might ultimately be taxed
on an individual return, but it is considered a separate tax entity. It can
select accounting periods, for example, and choose and change accounting
methods. A shareholder cannot override those decisions on his/her personal
return. Granted, 99 times out of 100 a shareholder’s return will change if the
S corporation itself changes. This however was that one time.
Perhaps had
they used a single-member LLC, which the tax Code disregards and considers the
same as its member, there might have been a different answer.
But that is
not what the Stullers did. They now have to live with the consequences of that decision.
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