Friday, September 23, 2016
Worst. Tax. Advice. Ever.
Dad owned a tool and die company. Son-in-law worked there. The company was facing severe foreign competition, and - sure enough - in time the company closed. For a couple of years the son-in-law was considerably underpaid, and dad wanted to make it up to him.
The company's accountant had dad infuse capital into the business. The accountant even recommended that the money be kept in a separate bank account. Son-in-law was allowed to tap into that account near-weekly to supplement his W-2. The accountant reasoned that - since the money came from dad - the transaction represented a gift from dad to son-in-law.
Let's go through the tax give-and-take on this.
In general, corporations do not make gifts. Now, do not misunderstand me: corporations can make donations but almost never a gift. Gifts are different from donations. Donations are deductible (within limits) by the payor and can be tax-free to the payee, if the payee has obtained that coveted 501(c)(3) status. Donations stay within the income tax system.
Gifts leave the income tax system, although they may be subject to a separate gift tax. Corporations, by the way, do not pay gift taxes, so the idea of a gift by a corporation does not make tax sense.
The classic gift case is Duberstein, where the Supreme Court decided that a gift must be made under a "detached and disinterested generosity" or "out of affection, respect, admiration, charity or like impulses." The key factor the Court was looking for is intent.
And it has been generally held that corporations do not have that "detached and disinterested" intent that Duberstein wants. Albeit comprised of individuals, corporations are separate legal entities, created and existing under state law for a profit-seeking purpose. Within that context, it becomes quite difficult to argue that corporations can be "detached and disinterested."
It similarly is the reason - for example - that almost every job-related benefit will be taxable to an employee - unless the benefit can fit under narrow exceptions for nontaxable fringes or awards. If I give an employee a $50 Christmas debit card, I must include it in his/her W-2. The IRS sees an employer, an employee and very little chance that a $50 debit card would be for any reason other than that employment relationship.
What did the accountant advise?
Make a cash payment to the son-in-law from corporate funds.
But the monies came from dad, you say.
It does not matter. The money lost its "dad-stamp" when it went into the business.
What about the separate bank account?
You mean that separate account titled in the company's name?
It certainly did not help that the son-in-law was undercompensated. The tax Code already wants to say that all payments to employees are a reward for past service or an incentive for future effort. Throw in an undercompensated employee and there is no hope.
The case is Hajek and the taxpayer lost. The son-in-law had compensation, although I suppose the corporation would have an offsetting tax deduction. However, remember that compensation requires FICA and income tax withholding - and no withholdings on the separate funds were remitted to the IRS - and you can see this story quickly going south. Payroll penalties are some of the worst in the tax Code.
What should the advisor have done?
Simple: have dad write the check to son-in-law. Leave the company out of it.