For (very)
closely-held service companies, it is common to “bonus” enough profit to bring taxable
income down to zero (or very close). There are two reasons for this:
(1) The company is a personal services
company (PSC), meaning that it will face a maximum corporate tax rate on
whatever profit is left in the company. This is a tremendous impetus to not
leave profit in the company.
(2) There is one owner (or very few owners) and
the majority of the money is going to him/her/them anyway.
In many
cases the company is also cash-basis taxpayer, and the accountant normally pays
very close attention to cash in-and-out during the last few days of the tax
year. With electronic bank transfers becoming more commonplace, I have seen carefully-monitored
tax planning destabilized by sizeable electronic customer transfers on the last
day or two. It happens, as the customer may be doing cash-basis planning
themselves, and payment to my client is a tax deduction to them.
There are
limitations on how far this can be pushed, though. It is not acceptable to delay
depositing customer checks, for example, in order to avoid income recognition.
In addition, one has to be careful about writing so many checks that it creates
a bank overdraft. A common way to plan around an overdraft is to have a line of
credit available. The bank would then sweep funds from the line as necessary to
cover any overdraft. One might also run an overdraft if he/she knows that a
deposit will arrive early the following month, as that deposit would occur
during the float period of any outstanding checks. A business owner might “know” that check is
coming because said check is already in the owner’s desk drawer, but we will
not speak further of such absurd examples. It is not as though I have ever seen
such a thing, of course.
Let’s talk
about Vanney Associates, Inc. Robert Vanney is an architect with perilously close
to 40 years experience. The firm has about 25 employees, and Robert is the sole
shareholder. He is – without question – the key man. His wife, Karen, is a CPA
with a retired license, and she takes care of the books and records.
In 2008 Mr. Vanney received $240,000 in monthly payroll. At the end of the year, he determined and paid employee bonuses, taking as a personal bonus whatever was left over. The leftover was $815,000. The withholdings on the leftover were approximately $350,000, leaving approximately $464,000 payable to Mr. Vanney.
Problem: there was only $389 thousand in the bank.
There was
enough money to pay the withholding taxes, but there wasn’t enough to also pay Mr.
Vanney. What to do? The Vanney’s did not need the money, so they decided not to
borrow from the bank. Mr. Vanney instead endorsed the check back to the
company, and that was the end of the matter.
But it wasn’t.
The IRS looked at the business tax return and decided to disallow the $815,000
bonus and almost $12,000 in related employer payroll taxes.
Why? The
government got their taxes, so why should they care?
There is a
legal concept when paying with a check. A check is referred to as a
“conditional payment,” because writing the check is subject to a condition subsequent.
That subsequent condition is the check clearing the bank. We take it for
granted, of course, so we overlook that technically there are two steps. When
the check clears, the two steps unify and become as one. This is why you can
send a check to a charity on December 31 and claim the deduction in the same tax
year. There is no chance that the charity is receiving that check and
depositing it by December 31. Still, if it clears in the normal course of business,
all parties – including the IRS – consider the check as having been written on
December 31.
That is not
what happened here. The check never cleared the bank.
Which is
unfortunate, as the IRS now could argue that the check remained conditional.
Being conditional there was never payment in 2008. This was fatal, as Vanney
Associates was a cash-basis taxpayer.
And the
Court agreed.
Think about
this for a moment. The corporation was disallowed a 2008 deduction for the
$815,000. Whereas the Court did not address this point, that bonus was included
on Mr. Vanney’s 2008 Form W-2. He would have reported that W-2 on his 2008
individual tax return.
There is
something seriously wrong with this picture.
I suppose Vanney
Associates could amend its 2008 payroll tax returns. It could reverse that
bonus, as well as the related withholding taxes. It would get a refund, but it would
be amending multiple federal and state (and possibly local) payroll returns.
Mr. Vanney would
then amend his personal 2008 tax return.
But that is
assuming we are within the statute of limitations to amend all those returns.
When then would
Vanney Associates get its $815,000 bonus deduction?
Your first
response might be the following year: in 2009. I believe you would be wrong.
Why? Because Mr. Vanney did not cash his check in 2009. The check remained a
conditional payment in 2009. Same answer for 2010, 2011, 2012 and 2013. This case
was decided September, 2014. Seems to me the first time Mr. Vanney could “cash”
his check is this year – 2014.
Let me ask
you another question: why didn’t the Court allow the (approximately) $350,000
in withholdings as a tax deduction? That check cashed, right?
I think I
know. If the company did not “pay” the $815,000 in 2008, then there is no “bonus”
for that withholding to attach to. From a tax perspective, the company overpaid
its withholding taxes in 2008. The tax problem is that the overpayment is not a "deduction," as no payroll taxes were actually due. Payroll taxes attach to payroll, and there was no payroll. It was a "prepayment," waiting on Vanney to request a refund.
What is our
takeaway?
Over the
years I have heard more than one practitioner declare a tax outcome as “making
no sense.” An unfortunate consequence is that the practitioner may not pursue a
line of reasoning to conclusion. There are reasons for this, of course. First,
an accountant has probably been exposed somewhere to generally accepted
accounting principles. GAAP is a financial statement concept (think auditors,
not tax accountants) and GAAP generally has some symmetry to it. The practitioner
forgets that the IRS not bound by GAAP. The purpose of the IRS is to collect and
enforce, and it does not consider itself bound by any symmetry should GAAP get in its way. The second is human: we respond to an absurd result by assuming we
must have made a mistake in our reasoning. Many times we are right. In Vanney’s
case, we were not.
What could Vanney
have done?
Simple.
He could
have had a line of credit in place. He could have cashed that check.
BTW I almost
invariably recommend my cash-basis clients have a line of credit, even if they
have no intention of using it. This costs them money, as the bank may charge a
flat fee (say $100 or $250) annually for keeping the line of credit available.
In addition, many a bank will require at least one draw over a month-end
annually in order to keep the line open. This means there will be some interest
expense.
Why do I recommend it? It is cheap insurance against
nightmares like this.
