The IRS Goes Rounds With Cohan

 

The decision begins with the IRS seeking taxes of $805,149, $1,145,104, $1,161,864, and $831,771 for years 2013 through 2016. The penalties were unsurprisingly also enormous.

I want to know what happened here.

The taxpayer was Mohammad Nasser Aboui, and he was the sole shareholder of an S corporation called HPPO. He owned several used vehicle lots, and in 2009 he put them into HPPO as its initial corporate capitalization.

It sounds like a tough business:

·       Most of HPPO customers had bad credit.

·       Many did not have a checking account and instead paid HPPO in cash.

·       HPPO financed between 90% and 95% of its sales.

·       Customers repaid their loans less than 10% of the time.

·       HPPO repossessed approximately 25% of the cars it sold within 3 or 4 months.

·       HPPO had quite the barter system going with its mechanics: the mechanic would work on HPPO cars in exchange for rent of HPPO’s garage space.

Around 2014 Aboui decided to close the business. There were serious family health issues and HPPO was not making any money.

The IRS started its audit in September 2015.

HPPO’s accountant was ill at the time and later died.

To its credit, the IRS waited.

More than 3 years later HPPO engaged another accountant to represent the audit.

The second accountant made immediate mistakes, such as getting HPPO’s accounting method wrong when dealing with the IRS Revenue Agent (RA).

COMMENT: More specifically, the accountant told the RA that HPPO used the overall cash basis of accounting. HPPO did not. In fact, it could not because inventory was a material income-producing factor.

The RA wanted HPPO’s books and records, including access to its accounting software. HPPO could provide much but not the software. Its software license expired when it left the vehicle business in 2018.

This is a nightmare.

HPPO did eventually reactivate the software, but it was too late to help with the RA.

The RA – being told by the second accountant that HPPO used the cash basis of accounting – decided to use bank statements to reconstruct gross income.

BTW HPPO wound up dismissing the second accountant.

The results were odd: HPPO had reported more sales for 2013 through 2015 – nearly $3.25 million - than was deposited at the bank.

The pattern reversed in 2016 when HPPO deposited approximately $539 grand more than it reported in sales.

COMMENT: I have an idea what happened.

The RA also saw following bad debt expense:

          2013             $1,069,739

          2014             $ 668,537

          2015             $ 902,967

          2016             $ 436,738    

Here is something about the cash basis of accounting: you cannot have bad debt expense. It makes sense when you remember that gross income is reported as monies are deposited. Bad debts are receivables that are never collected, meaning there is nothing to deposit. One never leaves home plate.

So, the RA disallowed the bad debt expense entirely.

I am pretty sure about my earlier hunch.

The RA also determined that HPPO had distributed the following monies to Aboui, one way or another:

          2013             $2,476,301

          2014             $1,704,329

          2015             $1,406,893

2016             $1,934,033

There were other issues too.

Off they went to Tax Court.

Remember what I said about reactivating the accounting software license? Aboui now presented thousands of pages to document cost of sales and other expenses. The Court encouraged the IRS to accept and review the new records.

The IRS said, “nah, we’re good.”

COMMENT: Strike one.

The Court started its opinion with HPPO’s sales.

The RA stated to the Court that HPPO used the overall cash basis of accounting.

Don’t think so, said the Court. The Court saw HPPO using the accrual basis of accounting for sales and the cash basis of accounting for everything else.

COMMENT: This is referred to as a hybrid method: a pinch of this, a sprinkle of that. If one is consistent – and the results are not misleading – a hybrid is an acceptable method of accounting.

The Court asked Treasury why it thought that HPPO used the cash basis of accounting.

Treasury replied that it had never said that.

The Court pointed out that the RA had said that she understood HPPO to be a cash basis taxpayer. To be fair, that is what the second accountant had told her.

Nope, never used the cash method insisted Treasury.

COMMENT: An explanation is in order here. Treasury Department attorneys take over when the matter goes to Court. Perhaps the attorneys meant “direct” Treasury. The RA – while working for the IRS which itself is part of the Treasury – would then be “indirect” Treasury. I am only speculating, as this unforced error makes no sense. Clearly it bothered the Court.

Strike two.

The Court then reasoned why HPPO was reporting more sales than it deposited in the bank: it was reporting the total vehicle sale price in revenues at the time of sale. That also explained the bad debt expense: HPPO financed most of its sales and most of those loans went sour.

But why the reversal in 2016?

Aboui explained to the Court that by 2016 he was closing the vehicle business. He would have slowed and eventually stopped selling cars, with the result that he would be depositing more in the bank than he currently sold.

The Court decided that HPPO had correctly recorded its sales for the years at issue.

Next came the cost of vehicles sold.

This accounting was complicated because so much cash was running through the business. Sometimes cash was used to immediately pay expenses without first being deposited into a bank account – NOT a recommended accounting practice.

The RA had also identified certain debits to HPPO’s bank account that were either distributions or otherwise nondeductible.

The Court could find no evidence that those identified debits had been deducted on the tax returns.

The RA – and by extension, the … Treasury – was losing credibility.

Aboui meanwhile provided extensive documentation of HPPO’s expenses at trial. Some of these were records the Court had asked the IRS to accept and review – and which the IRS passed on.

Here is the Court:

Petitioners provided extensive documentation at trial to substantiate the COGS and business expenses. Mr. Aboui testified that HPPO was unprofitable. Given the record in its entirety, we find that petitioners have substantiated HPPO’s COGS and business expenses as reported on HPPO’s returns for each year at issue, except for meal and entertainment expenses of …..”

COMMENT: Strike three.

The Court went to the bad debts.

Mr. Aboui credibly testified that he was unable to repossess approximately 250 cars during the years at issue. The loss of these cars adequately substantiates the amount of HPPO’s bad debt deductions for the years at issue under the Cohan rule.”

The Court went to the distributions.

Respondent determined that petitioners failed to report approximately $7.5 million in taxable distributions from HPPO during the years at issue.”

COMMENT: Remember that HPPO is an S corporation, and Aboui would be able to withdraw his invested capital – plus any business income he had paid taxes on personally but left in the business – without further tax. This amount is Aboui’s “basis” in his S corporation stock.

Here is the Court:

Respondent argues that petitioners have not established Mr. Aboui’s basis in HPPO during the years at issue. We disagree and that the record and Mr. Aboui’s credible testimony provides sufficient evidence for us to reasonably estimate his basis under the Cohan rule.”

The IRS won a partial victory with the distributions. The Court thought Aboui’s basis in HPPO was approximately $5.1 million.

The IRS had wanted zero basis.

The effect was to reduce the excess distributions to $$2.4 million ($7.5 minus $5.1).

Still, it was a rare win for the IRS.

Excess distributions are taxable. Aboui had taxable distributions of $2.4 million. Yes, it is a lot, but it is also a lot less than the IRS wanted.

COMMENT: The nerd part of me wonders how the Court arrived at an estimate of $5.1 million for Aboui’s basis. Unfortunately, there is no further explanation on this point.

Oh, one more thing from the Court:

… we hold that petitioners are not liable for any penalties.”

While not contained within the four corners of this decision, I am curious why the Court repetitively went to the Cohan rule. I have followed this literature for years, and this result is not normal. Courts generally expect a business to maintain an accounting system that produces reliable numbers. Yes, every now and then there may be a leak in the numbers, and the court may use Cohan to plug said leak. That is not what we have here, though. This boat was sinking.

Perhaps Aboui presented his case well.

Mr. Aboui was incredibly forthright in his testimony.”

And perhaps the IRS should not have argued that an RA – an IRS employee – is not the IRS.

Our case this time was Aboui and Mizani v Commissioner, T.C. Memo 2024-106.

An S Corporation Nightmare

Over my career the preferred entities for small and entrepreneurial businesses have been either an S corporation or a limited liability company (LLC). The C corporation has become a rarity in this space. A principal reason is the double taxation of a C corporation. The C pays its own taxes, but there is a second tax when those profits are returned to its shareholders. A common example is dividends. The corporation has already paid taxes on its profits, but when it shares its profits via dividends (with some exception if the shareholder is another corporation) there is another round of taxation for its shareholders. This might make sense if the corporation is a Fortune 500 with broad ownership and itself near immortal, but it makes less sense with a corporation founded, funded, and  grown by the efforts of a select few individuals – or perhaps just one person.

The advantage to an S corporation or LLC is one (usually - this is tax, after all) level of tax. The shareholder/owner can withdraw accumulated profits without being taxed again.

Today let’s talk about the S corporation.

Not every corporation can be an S. There are requirements, such as:

·       It cannot be a foreign corporation.

·       Only certain types of shareholders are allowed.

·       Even then, there can be no more than 100 shareholders.

·       There can be only one class of stock.

Practitioners used to be spooked about that last one.

Here is an example:

The S corporation has two 50% shareholders. One shareholder has a life event coming up and receives a distribution to help with expenses. The other shareholder is not in that situation and does not take a distribution.

Question: does this create a second class of stock?

It is not an academic question. A stock is a bundle of rights, one of which is the right to a distribution. If we own the same number of shares, do we each own the same class of stock if you receive $500 while I receive $10? If not, have we blown the S corporation election?

These situations happen repetitively in practice: maybe it is insurance premiums or a car or a personal tax. The issue was heightened when the states moved almost in concert to something called “passthrough taxes.” The states were frustrated in their tax collection efforts, so they mandated passthroughs (such as an S) to withhold state taxes on profits attributable to their state. It is common to exempt state residents from withholding, so the tax is withheld and remitted solely for nonresidents. This means that one shareholder might have passthrough withholding (because he/she is a nonresident) while another has no withholding (because he/she is a resident).

Yeah, unequal distributions by an S corporation were about to explode.

Let’s look at the Maggard case.

James Maggard was a 50% owner of a Silicon Valley company (Schricker). Schricker elected S corporation status in 2002 and maintained it up to the years in question.

Maggard bought out his 50% partner (making him 100%) and then sold 60% to two other individuals (leaving him at 40%). Maggard wanted to work primarily on the engineering side, and the other two owners would assume the executive and administrative functions.

The goodwill dissipated almost immediately.

One of the new owners started inflating his expense accounts. The two joined forces to take disproportionate distributions. Apparently emboldened and picking up momentum, the two also stopped filing S corporation tax returns with the IRS.

Maggard realized that something was up when he stopped receiving Schedules K-1 to prepare his personal taxes.

He hired a CPA. The CPA found stuff.

The two did not like this, and they froze out Maggard. They cut him off from the company’s books, left him out of meetings, and made his life miserable. To highlight their magnanimity, though, they increased their own salaries, expanded their vacation time, and authorized retroactive pay to themselves for being such swell people.

You know this went to state court.

The court noted that Maggard received no profit distributions for years, although the other two were treating the company as an ATM. The Court ordered the two to pay restitution to Maggard. The two refused. They instead offered to buy Maggard’s interest in Schricker for $1.26 million. Maggard accepted. He wanted out.

The two then filed S corporation returns for the 2011 – 2017 tax years.

They of course did not send Maggard Schedules K-1 so he could prepare his personal return.

Why would they?

Maggard’s attorney contacted the two. They verbally gave the attorney – piecemeal and over time – a single number for each year.

Which numbers had nothing to do with the return and its Schedules K-1 filed with the IRS.

The IRS took no time flagging Maggard’s personal returns.

Off to Tax Court Maggard and the IRS went.

Maggard’s argument was straightforward: Schricker had long ago ceased operating as an S corporation. The two had bent the concept of proportionate anything past the breaking point. You can forget the one class of stock matter; they had treated him as owning no class of  stock, a pariah in the company he himself had founded years before.

Let’s introduce the law of unintended consequences:

Reg 1.1361-1(l)(2):

Although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.

Here is the Tax Court:

… the regulation tells the IRS to focus on shareholder rights under a corporation’s governing documents, not what the shareholders actually do.”

That makes sense if we were talking about insurance premiums or a car, but here … really?

We recognize that thus can create a serious problem for a taxpayer who winds up on the hook for taxes owed on an S corporation’s income without actually receiving his just share of distributions.”

You think?

This especially problematic when the taxpayer relies on the S corporation distributions to pay these taxes.”

Most do, in my experience.

Worse yet is when a shareholder fails to receive information from the corporation to accurately report his income.”

The Court decided that Maggard was a shareholder in an S corporation and thereby taxable on his share of company profits.

Back to the Court:

The unauthorized distributions in this case were hidden from Maggard, but they were certainly not memorialized by … formal amendments to Schricker’s governing documents. Without that formal memorialization there was no formal change to Schricker’s having only class of stock.”

I get it, but I don’t get it. This reasoning seems soap, smoke, and sophistry to me. Is the Court saying that – if you don’t write it down – you can get away with anything?      

Our case this time was Haggard and Szu-Yi Chang v Commissioner, T.C. Memo 2024-77.

 

Unforced Error on Short Stop

 I am reading a case concerning interest expense. While I have seen similar accounting, I do not recall seeing it done as aggressively.

Let’s talk about it.

Bob and Michelle Boyum lived in Minnesota and owned a company named Short Stop Electric. Bob was primarily responsible for running the company. Michelle had some administrative duties, but she was mostly responsible for raising the nine Boyum children.

Short Stop was a C corporation.

Odd, methinks. Apparently, the Court thought so also:

One might regard this as an eccentric choice for a small, privately owned business because income from C corporations is taxed twice.”

Let’s talk about this taxed-twice issue, as it is a significant one for tax advisors to entrepreneurial and closely held companies.

Let’s say that you start a company and capitalize it with a $100 grand. Taxwise, there are two things going on.

At the company level you have:

                   Cash                     100,000

                   Equity                 (100,000)                                 

The only thing the company has is the $100 grand you put in. If it were to liquidate right now, there would be no gain, loss, or other income to the company, as there is no appreciation (that is, deferred profit) in its sole asset – cash.

At a personal level, you would own stock with a basis of $100 grand. If the company liquidated and distributed its $100 grand, your gain, loss, or other income would be:

          $100 grand (cash) - $100 grand (basis in stock) = -0-

Make sense.

Let’s introduce a change: the company buys a piece of land for $100 grand.

At the company level you now have:

                   Land                     100,000

                   Equity                 (100,000)

Generally accepted accounting records the land at its acquisition cost, not its fair market value.

Now the change: the land skyrockets. It is now worth $5 million. You decide to sell because … well because $5 million is $5 million.

Is there tax to the company on the way out?

You betcha, and here it is:

          $5 million - $100 grand in basis = $4.9 million of gain

          Times 21% tax rate = $1,029,000 in federal tax

          $5 million - 1,029,000 tax = $3,971,000 distributed to you

Is there tax to you on the way out?

Yep, and here it is:

          $3,971,000 - 100,000 (basis in stock) = $3,871,000 gain

          $3,871,000 times 23.8% = $921,298 in federal tax

Let’s summarize.

How much money did the land sell for?

$5 million.

How much of it went to the IRS?

$1,950,298

What is that as a percentage?

39%

Is that high or low?

A lot of people - including me - think that is high. And that 39% does not include state tax.

What causes it is the same money being taxed twice – once to the corporation and again to the shareholder.

BTW there is a sibling to the above: payment of dividends by a C corporation. Either dividends or liquidation will get you to double taxation. It is expensive money.

Since the mid-80s tax advisors to entrepreneurial and closely held businesses have rarely advised use of a C corporation. We leave those to the Fortune 1000 and perhaps to buyout-oriented technology companies on the west coast. Most of our business clients are going to be S corporations or LLCs.

Why?

Because S corporations and LLCs allow us to adjust our basis in the company (in the example above, shareholder basis in stock was $100 grand) as the company makes or loses money. If it makes $40 grand, shareholder basis becomes $140 grand. If it then loses $15 grand, basis becomes $100 grand + $40 grand - $15 grand = $125 grand. 

The reason is that the shareholder includes business income on his/her individual return and pays taxes on the sum of business and personal income. The effect is to mitigate (or eliminate) the second tax – the tax to the shareholder – upon payment of a dividend or upon liquidation.

Back to our case: that is why the Court said that Short Stop being a C corporation was “an eccentric choice.”

However, Bob had a plan.

Bob lent money to Short Stop for use in its business operations.

Happens all the time. So what?

Bob would have Short Stop pay interest on the loan.

Again: so what?

The “what” is that no one – Short Stop, Bob, or the man on the moon – knew what interest rate Bob was going to charge Short Stop. After the company accounting was in, Bob would decide how much to reduce Short Stop’s profit. He would use that number as interest expense for the year. This also meant that the concept of an interest rate did not apply, as interest was just a plug to get the company profit where Bob wanted.   

What Bob was doing was clever.

There would be less retained business profit potentially subject to double taxation.

There were problems, though.

The first problem was that Bob had been audited on the loan and interest issue before. The agent had previously decided on a “no change” as Bob appeared receptive, eager to learn and aware that the government did not consider his accounting to be valid.

On second audit for the same issue, Bob had become a recidivist.

The second problem was: Short Stop never wrote a check which Bob deposited in his own bank account. Instead, Short Stop made an accounting entry “as if” the interest had been paid. Short Stop was a cash-basis taxpayer. Top of the line documentation for interest paid would be a cancelled check from Short Stop’s bank account. Fail to write that check and you just handed the IRS dry powder.

The third problem is that transactions between a company and its shareholder are subject to increased scrutiny. The IRS caught it, disallowed it, and wanted to penalize it. There are variable interest rates and what not, but that is not what Bob was doing. There was no real interest rate here. Bob was plugging interest expense, and the resulting interest rate was nonsensical arithmetic. If Bob wanted the transaction to be respected as a loan and interest thereon, Bob had to follow normal protocol: you know, the way Bank of America, Fifth Third or Truist loan money. Charge an interest rate, establish a payment schedule, perhaps obtain collateral. What Bob was doing was much closer to paying a dividend than paying interest. Fine, but dividends are not deductible.

To his credit, Bob had been picking up Short Stop’s interest expense as interest income on his personal return every year. This was not a case where numbers magically “disappeared” from one tax return to another. It was aggressive but not fraud.

Bob nonetheless lost. The Court disallowed the interest deductions and allowed the penalties.

My thoughts?

Why Bob, why? I get the accounting, but you were redlining a tax vehicle to get to your destination. You could have set it to cruise control (i.e., elect S status), relaxed and just …moved … on.

Our case this time was Short Stop Electric v Commissioner, T.C. Memo 2023-114.

Basis Basics

I am looking at a case involving a basis limitation.

Earlier today I accepted a meeting invite with a new (at least to me) client who may be the poster child for poor tax planning when it comes to basis.

Let’s talk about basis – more specifically, basis in a passthrough entity.

The classic passthrough entities are partnerships and S corporations. The “passthrough” modifier means that the entity (generally) does not pay its own tax. Rather it slices and dices its income, deductions and credits among its owners, and the owners include their slice in their own respective tax returns.

Make money and basis is an afterthought.

Lose money and basis becomes important.

Why?

Because you can deduct your share of passthrough losses only to the extent that you have basis in the passthrough.

How in the world can a passthrough have losses that you do not have basis in?

Easy: it borrows money.

The tax issue then becomes: can you count your share of the debt as additional basis?

And we have gotten to one of the mind-blowing areas of passthrough taxation.  Tax planners and advisors bent the rules so hard back in the days of old-fashioned tax shelters that we are still reeling from the effect.

Let’s start easy.

You and I form a partnership. We both put in $10 grand.

What is our basis?

                                     Me             You

         Cash                  10,000       10,000                  

 

The partnership buys an office condo for $500 grand. We put $20 grand down and take a mortgage for the rest.

What is our basis?

                                     Me             You

         Cash                  10,000       10,000                  

         Mortgage        240,000       240,000

                                250,000       250,000

So we can each have enough basis to deduct $250,000 of losses from this office condo. Hopefully that won’t be necessary. I would prefer to make a profit and just pay my tax, thank you.

Let’s change one thing.

Let’s make it an S corporation rather than partnership.

What is our basis?

                                     Me             You

         Cash               10,000        10,000                   

         Mortgage             -0-              -0-

                                10,000        10,000

Huh?

Welcome to tax law.

A partner in a general partnership gets to increase his/her basis by his/her allocable share of partnership debt. The rule can be different for LLC’s taxed as a partnership, but let’s not get out over our skis right now.       

When you and I are partners in a partnership, we get to add our share of the mortgage - $480,000 – to our basis.

S corporations tighten up that rule a lot. You and I get basis only for our direct loans to the S corporation. That mortgage is not a direct loan from us, so we do not get basis.

What does a tax planner do?

For one thing, he/she does not put an office condo in an S corporation if one expects it to throw off tax losses.

What if it has already happened?

I suppose you and I can throw cash into the S. I assure you my wife will not be happy with that sparkling tax planning gem.

I suppose we could refinance the mortgage in our own names rather than the corporate name.

That would be odd if you think about. We would have personal debt on a building we do not own personally.

Yeah, it is better not to go there.

The client meeting I mentioned earlier?

They took a partnership interest holding debt-laden real estate and put it inside an S corporation.

Problem: that debt doesn’t create basis to them in the S corporation. We have debt and no tax pop. Who advised this? Someone who should not work tax, I would say.

I am going to leverage our example to discuss what the Kohouts (our tax case this time) did that drew the Tax Court’s disapproval.               

Let’s go back to our S corporation. Let’s add a new fact: we owe someone $480,000. Mind you, you and I owe – not the S corporation. Whatever the transaction was, it has nothing to do with the S corporation.

We hatch the following plan.

We put in $240,000 each.

You: OK.

We then have the corporation pay the someone $480,000.

You: Hold up, won’t that reduce our basis when we cut the check?

Ahh, but we have the corporation call it a “loan” The corporation still has a $480,000 asset. Mind you, the asset is no longer cash. It is now a “loan.”  Wells Fargo and Fifth Third do it all the time.

You: Why would the corporation lend someone $480,000? Wells Fargo and Fifth Third are at least … well, banks.

You have to learn when to stop asking questions.

You: Are we going to have a delay between putting in the cash and paying - excuse me - “loaning” someone $480,000?

Nope. Same day, same time. Get it over with. Rip the band-aid.

You: Wouldn’t a Court have an issue with this if we get caught … errr … have the bad luck to get audited?

Segue to our court case.

In Kohout the Court considered a situation similar enough to our example. They dryly commented:

Courts evaluating a transaction for economic substance should exercise common sense …”

The Court said that all the money sloshing around could be construed as one economic transaction. As the money did not take even a breather in the S corporation, the Court refused to spot the Kohouts any increase in basis.

Our case this time was Kohout v Commissioner, T.C. Memo 2022-37.

An Attorney Learns Passthrough Taxation

 

I have worked with a number of brilliant attorneys over the years. It takes quite a bit for a tax attorney to awe me, but it has happened.

But that law degree by itself does not mean that one has mastered a subject area, much less that one is brilliant.

Let’s discuss a case involving an attorney.

Lateesa Ward graduated from law school in 1991. She went the big firm route for a while, but by 2006 she opened her own firm. For the years at issue, the firm was just her and another person.

She elected S corporation status.

We have discussed S status before. There is something referred to as “passthrough” taxation. The idea is that a business – an S corporation, a partnership, an LLC – skips paying its own tax. Rather the tax-causing numbers are pushed-out to the owners – shareholders, partners, members – who then include those numbers on their personal return and pay the taxes thereon personally.

Why would a rational human being do that?

Sometimes it makes sense. A lot of sense, in fact.

I will give you one example. Say that you have a regular corporation, one that the tax nerds call a “C.” Say that there is real estate in there that has appreciated insanely. It wouldn’t hurt your feelings to sell the real estate and pocket the money. There is a problem, though. If the real estate is inside a “C,” the gain will be taxed to the corporation upon sale.

That’s OK, you reason. You knew taxes were coming.

When you take the money out of the corporation, you pay taxes again.

Huh?

If you think about, what I just described is commonly referred to as a “dividend.”

That second round of income taxes hurts, unless one is a publicly-traded leviathan like Apple or Amazon. More accurately, it hurts even then, but ownership is so diluted that it is unlikely to greatly impact any one owner.

Scale down from the behemoths and that second round of tax probably locks-in the asset inside the C corporation. Not exactly an efficient use of resources, methinks.

Enter the passthrough.

With some exceptions (there are always exceptions), the passthrough allows one – and only one – round of tax when you sell the real estate.

Back to Lateesa.

In 2011 the S corporation deducted salary to her of $62,388.

She reported no salary on her personal return.,

In 2012 the S deducted salary to her of $73,448.

She reported salary of $47,171.

In 2011 her share (which was 100%, of course) of the firm’s profits was $1,373.

She reported that.

Then she reported the numbers again as though she was self-employed.

She reported the numbers twice, it seems.

The IRS could not figure out what she was doing, so they came in and audited several years.

There was the usual back-and-forth with documenting expenses, as well as quibbling over travel and related expenses. Standard stuff, but it can hurt if one is not keeping adequate records.

I was curious why she left her salary off her personal return. I have a salary. Maybe she knew something that has escaped me, and I too can run down my personal taxes.

She explained that only some of the officer compensation was salary or wages.

Go on.

The rest of the compensation was a distribution of “earnings and profits.” She continued that an S corporation shareholder is allowed to receive tax-free distributions to the extent she has basis.

Oh my. Missed the boat. Missed the harbor. Nowhere near water.  Never heard of water.

What we are talking about is a tax deduction, not a distribution. The S corporation took a tax deduction for salary paid her. To restore balance to the Force, she has to personally report the salary as income. One side has a deduction; the other side has income. Put them together and they net to zero. The Force is again in balance.

Here is the Court:

Ward also took an eccentric approach to the compensation that she paid herself as the firm’s officer.”

It did not turn out well for Ms. Ward. Remember that there are withholdings and employer-side payroll taxes required on salary and wages, and the IRS was already looking at other issues on those tax returns. This audit got messy.

There was no awe here.

Our case this time was Lateesa Ward v Commissioner and Ward & Ward Company v Commissioner, T.C. Memo 2021-32.

Mean It When You Elect S Corporation Status

I am looking at an odd case.

I see that the case went to Tax Court as “pro se,” which surely has a great deal to do with its general incoherence. Pro se generally means that the taxpayer is representing himself/herself. Technically this is not correct, as I could represent someone in Tax Court and the case still be considered pro se. There was no accountant involved here, however, and it shows.

We are talking about Hong Jun Chan. 

He founded a restaurant named Younique Café Inc (YCI) in August, 2010.

In March, 2011 he filed an election with the IRS to be treated as an S corporation. All the owners have to agree to such an election, and we learned that Chan was a 40% shareholder of YCI.  

Let’s fast forward to 2016.

Chan and his wife filed a joint tax return for 2015, but they did not include any numbers from YCI. That does not make sense, as the purpose of an S corporation is to avoid corporate tax and instead report the entity’s tax numbers on the shareholder’s individual/separate return.

A year later the Chan’s did the same with their 2016 joint tax return.

This caught the attention of the IRS, which started an audit in 2019. The revenue agent (RA) found that no business returns had ever been filed.

Standard procedure for the IRS is to contact the taxpayer: perhaps the taxpayer is to visit an IRS office or perhaps the audit will be conducted via correspondence. The IRS did not hear from Chan. Chan later explained that they had moved to Illinois and received no IRS correspondence.

The RA went all Kojak and obtained YCI’s bank records. The RA added up all the deposits and determined that the Chan underreported his taxable income by $1,139,879 and $731,444 for 2015 and 2016 respectively.

Yep, almost $2 million.

Off to Tax Court they went.

Chan had a straightforward argument: YCI was not an S corporation. It was a C corporation, meaning it filed its own tax returns and paid its own taxes. Let’s be fair: the restaurant had gone out-of-business. It is unlikely it ever made money. Unless there was an agency issue, the business tax could not be attributed to Chan personally.

Got it.

ISSUE: YCI filed an S election. The IRS had record of receiving and approving the election. YCI was therefore an S corporation until it (1) was disqualified from being an S, (2) revoked its election, or (3) failed an obscure passive income test.

PROBLEM: YCI was not disqualified, had no passive income and never revoked its election.

But …

Chan presented C corporation tax returns for 2015 and 2016. They were prepared by a professional preparer but were not signed by the preparer.

COMMENT: That is odd, as a paid preparer is required to sign the taxpayer’s copy of the return. I have done so for years.

The IRS of course had no record of receiving these returns.

COMMENT: We already knew this when the RA could not find a copy of the business return. Any search would be based on YCI’s employer identification number (EIN) and would be insensitive to whether the return was filed as a C or S corporation.

Hopefully Chan mailed the business return using certified mail.

Chan had no proof of mailing.

Of course.

At this point in the case, I am supposed to believe that Chan went to the time and trouble of having a professional prepare C corporation returns for two years but never filed them. Righhhttt ….

But maybe Chan thought the preparer had filed them, and maybe the preparer thought that Chan filed them. It’s a low probability swing, but weird things happen in practice.

This is easy to resolve: have the preparer submit a letter or otherwise testify on what happened with the business returns.

Crickets.

The IRS in turn was not above criticism.

It added up deposits and said that the sum was taxable income.

Hello?? This is a RESTAURANT. There would be food costs, rent, utilities and so forth. Maybe the RA should have spent some time on the disbursement side of that bank statement.

Then the IRS charged 100% of the income to Chan.

Hold on here: didn’t Form 2553 show Chan as owning 40% - not 100% - of YCI?

We don’t believe that, said the IRS.

Both sides are bonkers.

Chan went into Tax Court without representation after the IRS tagged him with almost $2 million of unreported income. This appears a poor decision.  

The IRS - relying on a Form 2553 to treat Chan as a passthrough owner – could not keep reading and see that he owned 40% and not 100%.

Can you imagine being the judge listening to this soap opera?

The Court split its decision:

(1) Yep, Chan is an S corporation shareholder and has to report his ownership share of the restaurant’s profit or loss for 2015 and 2016.

(2)  Nope, both sides must go back and do something with expenses, as well as decide Chan’s ownership for the two years.

Our case this time was Hong Jun Chan and Suzhen Mei v Commissioner, T.C. Memo 2021-136.