Friday, September 2, 2016

The Hosbrook Road Terrible Tax Tale

Let's talk about S corporations.

There are two types of corporations: C corporations and S corporations. Think Amazon or Apple and we are talking about "C" corporations: they file their own returns and pay their own taxes. Think of family-owned Schmidt Studebaker Carriage & Livery and we are talking about "S" corporations: only so many shareholders, do not normally pay tax, the numbers flow-through to the owners who pay the tax on their personal returns.

S corporations are almost the default tax structure for entrepreneurial and family-owned businesses, although in recent years LLCs have been giving them a run for their money. They are popular because the owner pays tax only once (normally), as contrasted to a C corporation with its two levels of tax.

But there are rules to observe.

For example, you have to keep track of your basis in your stock - that is, the amount of after-tax money you have invested in the stock. Your basis goes up as you put the business income on your personal return, but it also goes down as you take distributions (the S equivalent of dividends) from the company. You are allowed to take distributions tax-free as long as your basis does not go negative. Why? Because you paid tax on the business income, meaning you can take it out without a second tax.

Accountants keep permanent schedules to track this stuff.  Or rather, they should. I have been involved in more than one reconstruction project over the years. You have to present these schedules upon IRS audit.

I did not previously have a worse-case story to tell. Now I do. The best part is that the story takes place in Cincinnati.

Gregory Power is a commercial real estate broker with offices first on Montgomery Road and then on Hosbrook Road. He started his company (Power Realty Advisors, Inc.) in 1993. Somewhen in there he used Quicken for his accounting, and he would forward selected reports to his accountant for preparation of the returns.
COMMENT: Quicken is basically a check-register program. It tracks deposits and withdrawals, but it is not a general ledger - that is, the norm for a set of business books. It will not track your inventory or depreciable assets or uncollected invoices, for example.
There was chop in the preparation. For example, the numbers were separated between those Mr. Power reported as a proprietor (Schedule C) and those reported on the S return. Why? Who knows, but it created an accounting problem that would come back to haunt.

He lost money over several years, including the following selected years:

            1995              (191,044)
            1996              ( 70,325)
            2002              ( 99,813)

Nice thing about the S corporation as that he got to put these losses on his personal return. To the extent his return went negative, he had a net operating loss (NOL) which he could carry-over to another year. Mind you, he got to put those losses on his personal return to the extent he did not run out of basis - yet another reason to maintain permanent schedules.

He took distributions. In fact, he took distributions rather than taking a salary, which is a tax no-no. The IRS did not come after him on this issue because it had another angle of attack.

He had the corporation pay some of his personal and living expenses, which is another no-no. Accountants will reclassify these to distributions and tell you to stop.

Some of his S corporation returns did not show distributions. This is not possible, of course, as he was taking distributions rather than salary. That tells me that the accountant did not have numbers. It also tells me the accountant could not maintain the schedules - at least not accurately - that we talked about.

Sure enough, his big payday years came. There was tax to pay ... except for those NOLs that he was carrying-forward from his bad years. He told the IRS that he had over $500,000 of NOLs, which he could now put to good use.

Problem: He did not have those schedules.

Solution: He or his accountant went back and reconstructed those schedules.

Problem: The IRS said they were bogus.

Solution: You go to Tax Court.
COMMENT: It would have been cheaper to keep schedules all along.
Mr. Power ran into a very severe issue with the Court: it does not have to accept your tax returns as proof of the numbers.  The Court can request the underlying books and records: the journals, ledger and what-not that constitutes the accounting for a business.

The Court did so request.

He trotted out those Quicken reports and handwritten summaries.

The Court noted that Mr. Power was somehow splitting numbers between his proprietorship and the corporation, although it did not understand how he was doing so. This made it difficult for the Court to review a carryforward schedule when the Court could not first figure-out where the numbers for a given year were coming from.

Strike one.

The Court wanted to know what to do with those tax returns that did not show distributions, which it knew was wrong as he was taking distributions rather than a salary.

Strike two.

And there was the matter of personal expenses being paid through the company. It appears that in some years the corporation deducted these expenses, and in other years it did not. The Court wasn't even sure what the amounts were. It did not help when Mr. Power commingled business and personal funds when buying his house in Indian Hill.

Strike three.

His business accounting was so bad that the Court bounced the NOL carryforward. The whole thing.

He owed tax. He owed penalties.

And no one knows if he really had an NOL that he could use to sop-up his profitable years because he had neglected his accounting to an extreme degree. He could not prove his own numbers. 

But Mr. Power has attained tax fame.

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