IRS Individual Tax Payment Plans

I anticipate a question about an IRS payment plan this tax season. It almost always comes up, so I review payment options every year. It occurred to me that this topic would make a good post, and I could just send a link to CTG if and when the question arises.

Let’s review the options for individual taxes. We are not discussing business taxes in this post, with one exception. If the business income winds up on your personal return – say through a proprietorship or an S corporation – then the following discussion will apply. Why? Because the business taxes are combined with your individual taxes.

YOU DO NOT HAVE THE MONEY BUT WILL SOON

You do not have the money to pay with your return, but you do have cash coming and will be able to pay within 120 days. This is a “short-term” payment plan. There is no application fee, but you will be charged interest.

BTW you will always be charged interest, so I will not say so again.

YOU OWE $10,000 OR LESS

You cannot pay with the return nor within 120 days, but you can pay within 3 years. This is the “guaranteed” payment plan. As with all plans, you have to be caught up with all your tax filings and continue to do so in the future.

If you are self-employed you can bet the IRS will require that you make estimated tax payments. I have seen this requirement sink or almost sink many a payment plan, as there isn’t enough cash to go around.

The IRS says they will not allow more than one of these plans every 5 years. I have had better luck, but (1) I got a good-natured IRS employee and (2) the combined tax never exceeded $10 grand. Point is: believe them when they say 5 years.

YOU OWE MORE THAN $10,000 BUT LESS THAN $25,000

This is a “streamlined” payment plan. Your payment period can be up to six years.  

As long as your balance is under $25 grand, the IRS will allow you to send a monthly check rather than automatically draft your bank account.

YOU OWE MORE THAN $25,000 BUT LESS THAN $50,000

This is still a “streamlined” plan, and the rules are the same as the $10-25 grand plans, but the IRS will insist on drafting your bank account.

DOWNSIDE TO THE GUARANTEED AND STREAMLINED PLANS

Have variable income and these plans do not work very well. The IRS wants a monthly payment. These plans are problematic if your income is erratic – unless you sit on a stash of cash no matter whether you are working or not. Then again, if you have such stash, I question why you are messing with a payment plan.

UPSIDE TO THE GUARANTEED AND STREAMLINED PLANS

A key benefit to both the guaranteed and the streamlined is not having to file detailed financial information. I am referring to the Form 433 series, and they are a pain. You have to attach copies of bank statements and provide documentation if you want more than IRS-provided amounts for certain cost-of-living categories. Rest assured that – whatever you think your “essential” bills are – the IRS will disagree with you.

Another benefit to the guaranteed and streamlined is avoiding a federal tax lien. I have had clients for whom the threat of a lien was more significant than the endless collection letters they received previously. Once the lien is in place it is quite difficult to remove until the tax debt is substantially paid.

YOU OWE MORE THAN $50,000

If you go over $50 grand you will have to provide Form 433 financial information, work your way through the cost-of-living categories, fight (probably) futilely with the IRS to spot you more than the tables and then agree on an amount that will pay off the debt over your remaining statute-of-limitations (collections) period.

If you are at all close to the $50,000 tripwire, SERIOUSLY consider paying down the debt below $50,000. The process, while not good times with old friends, will be easier.

YOU CANNOT PAY IT ALL OVER THE REMAINING COLLECTIONS PERIOD

It is possible that – despite the best you can do – there is no way to pay-off the IRS over the remaining statute-of-limitations (collections) period. You have now gone into “partial pay” territory. This will require Form 433 paperwork and working with a Collections officer. If one is badly injured in a car wreck and has indefinitely decreased earning power, the process may be relatively smooth. Have a tough business stretch but retain substantial earning power and the process will likely not be as smooth. 

HOW TO APPLY

There are three general ways to obtain a payment plan:

(1)   Mail

(2)   Call

(3)   Website

There is a charge for anything other than the 120-day plan. The cheapest way to go is to use the IRS website, but the charge – while more if not using the website – is not outrageous.

You use Form 9465 for mail.

The website is https://www.irs.gov/payments/online-payment-agreement-application for online.

Set aside time if you intend to call the IRS. You may want to download a movie.

What Is Unclaimed Property?

I was reading an IRS Revenue Ruling that made me laugh, albeit in a cynical way.

Here is the issue:

If an IRA is being sent to a state unclaimed property fund, can the IRS force the trustee to withhold and remit taxes?

There are several things going on here, beginning with: what is an unclaimed property fund?

An easy example is a deceased person’s bank account. Take Florida. If someone dies in Florida without a will and without requiring probate, you as an inheritor are going to have difficulties getting to their bank account – unless you name is also on the account. You likely have to hire an attorney to obtain a court letter to provide the bank stating that you are a valid inheritor of said bank account.

How many folks do think just leave the bank account unclaimed because it isn’t worth the cost of an attorney?

It is not just bank accounts. Unclaimed funds can include uncashed dividend or payroll checks, utility security deposits, safety deposit boxes, retirement accounts and a hundred variations thereon. The concept is that you are holding somebody else’s money, and that somebody disappears. It is referred to as dormancy, and the definition is what you would expect: there has been no activity in the account or contact with the owner for a while; account statements are returned because of an invalid address; phone numbers are no longer active.

The “while” depends on the state and the type of asset. In Ohio, an uncashed payroll check is considered dormant after one year whereas a customer overpayment requires three years.

Who reports this?

The business, of course. The business is supposed to try to locate the account owner, but sometimes there simply is no one to contact. When the dormancy period is up, the business then transfers the monies with its best available information to the state. The state holds the property until the owner comes forward to claim it.

The legal reasoning behind unclaimed property goes back to common law and real property. If one abandons real property, there is a legitimate public concern that it soon might become blighted. That concern prompts the transfer (the nerd term is “escheat”) of the abandoned property to the Crown – or, these days, to the State.

Unclaimed property is not technically taxation, but its laws operate similarly to tax statutes.

Many states have used unclaimed property as a means to fund their coffers. Delaware is one of the most egregious offenders, with unclaimed property being its third-largest source of state revenues. Delaware can do this because it is home to so many banks.

Here is a link if you are interested in your own unclaimed property search:

https://www.unclaimed.org/

Back to the IRS Revenue Ruling. Here is a short paragraph from the lead-in:

Under the facts presented, is the payment of Trustee Y of Individual C's interest in IRA O to the State J unclaimed property fund, as required by State J law, subject to federal income tax withholding under Section 3405 of the Internal Revenue Code?”

A bracing read, isn’t it? I couldn’t put it down.

Anyway, how do you think the IRS answered this question?

Pretty much the way you would expect. The IRS is getting its cut at some point, and this is as good a point as any. Send the IRS its money, Trustee Y.

A Bank Of America Horror Story

A major corporation hounds you almost to the point of death. You sue. You receive a settlement. Is it taxable?

Like so much of tax law, it depends. For example, did the attorney include the magic words that complete the incantation?  

Mr. and Mrs. French received a deficiency notice for their 2012 tax year. The IRS wanted $7,231 in taxes and $1,446 in penalties.

At issue was whether a settlement payment was taxable.

Let’s lay out the story:

·      In 2008 the French’s bought a house.

·      Shortly thereafter Bank of America bought their mortgage.

·      In August, 2009 Bank of America transferred their loan to a subsidiary, BAC Home Loan Servicing.

·      In December, 2009 Mr. and Mrs. French signed a loan modification agreement. The modification was to become effective February 1, 2010.

A loan modification means that that payments were temporarily suspended, an interest rate was changed, the loan term was lengthened and so on. There was a lot of modifications going on around that time.

·      Mrs. French suffered from a very bad back. She was admitted to the hospital in October, 2009 for surgery.

·      From late 2009 into early 2010 Bank of America began calling the French’s on a routine basis, sometimes up to 5 times a day. They were hounding the French’s that their mortgage was about to go into foreclosure.

·      Mr. French was concerned about the effect of these endless calls on his wife. He requested that Bank of America call him on another line, that way he could shield his wife from the stress. Bank of America couldn’t care less. If anything, they were continued receiving multiple calls from multiple people across multiple BAC offices.

·      Mrs. French went into the hospital in December, 2009 and again in January, 2010.

·      In January, 2010 Mr. French spoke with a BAC representative. He explained the loan modification. The representative had no idea what Mr. French was talking about. He explained that – whoever Mr. French sent the modification to – it was not BAC. He instructed Mr. French to redo the paperwork, stop payment on the old check and enclose a new check.

·      After much hassle, Mr. French was told that the modification was accepted and that he should start making payments per the new agreement. He made 10 payments of $1,067.10.

·      When she was finally discharged from the hospital on January 21, 2010, a Bank of America representative called to tell Mrs. French that “officers were on their way to evict” them.

·      On January 23, she started experiencing chest pain and shortness of breath. She went back to the hospital. He suffered two pulmonary emboli, passed away twice but was resuscitated. She was discharged February 4, 2010.

·      BAC did not process the first modification as they promised Mr. French. BAC kept their higher monthly payments and interest rate. To make matters worse, they posted their monthly payments to a non-interest- bearing escrow account and treated the payments as if they were processing fees.

·      In October 2010 BAC told Mr. French that they were not honoring the first modification and that the loan was severely delinquent. They sent a second modification, with conditions and terms injurious to the French’s. For example, the second modification did not even address the 10 payments the French’s had previously sent. Mr. French, his back to a wall, signed the second modification in November, 2010.

·      BAC continued, increasing their monthly payment from $1,067.10 to $1,081.49. In September, 2011, BAC sent the French’s a notice that their checks would not be applied and would instead be returned if not for the higher amount.

Finally, the French’s hired an attorney.

The phone calls stopped.

The French’s sued on six claims, alleging fraud, integration of the first and second loan modifications, punitive damages, additional damages, attorney fees and so forth.

What they did not sue for was personal damages to Mrs. French’s health. 

They settled in 2012. The French’s received $41,333, and the attorneys received $20,666.

The French’s did not report the settlement as income on their 2012 tax return.

The IRS wanted to know why.

The French’s presented several arguments:

(1)  $7,500 of the settlement was not taxable under the “disputed debt” doctrine.

If one party does not agree to the terms of a debt, later settlement does not necessarily mean income. It may mean repayment of amounts improperly charged the borrower, for example. An interesting argument, but the Court noted that the settlement agreement never mentioned disputed or contested debt.

(2)  They were being repaid their own money.

(3)  IRC Section 104(a)(2)

 § 104 Compensation for injuries or sickness.

 (a)  In general.

Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include-

(1)  amounts received under workmen's compensation acts as compensation for personal injuries or sickness;

(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;

To me, this was – by far – their best argument.

But it is one that BAC would never, ever put in writing.

The Court was however willing to look back to the six claims the attorneys filed for Mr. and Mrs. French. Unfortunately, the only language it found was the following:

… suffered lost time, inconvenience, distress [and] fear, and have been denied the benefit of the loan modification they were promised, and are being charged too much on their loan.”

These, folks, are not the magic words to open the Section 104(a)(2) door. For one thing, the words referred to both Mr. and Mrs. French.

The French’s owed the tax, but the IRS relented on the penalties.

Too bad the attorneys did not run the paperwork past a competent tax practitioner before it was too late.

Our case this time was French v Commissioner, T.C. Summary Opinion 2018-36.

Should I Have A Separate Bank Account For …?

One of the accountants recently told me that a client had asked whether he/she should set-up a separate bank account for their business.

The short answer is: yes.

It is not always about taxes. An attorney might recommend that your corporation have annual meetings and written minutes – or that you memorialize in the minutes deferring a bonus for better cash flow.  It may seem silly when the company is just you and your brother. Fast forward to an IRS audit or unexpected litigation and you will realize (likely belatedly) why the recommendation was made.

I am skimming a case where the taxpayer:

·      Had three jobs

·      Was self-employed providing landscaping and janitorial services (Bass & Co)

·      Owned and operated a nonprofit that collected and distributed clothing and school supplies for disadvantaged individuals (Lend-A-Hand).

The fellow is Duncan Bass, and he sounds like an overachiever.

Since 2013, petitioner, Bass & Co …, and Lend-A-Hand have maintained a single bank account….”

That’s different. I cannot readily remember a nonprofit sharing a bank account in this manner. I anticipated that he blew up his 501(c)(3).

Nope. The Court was looking at his self-employment income.

He claimed over $8 thousand in revenues.

He deducted almost $29 thousand in expenses.

Over $19 thousand was for

·      truck expenses

·      payment to Lend-A-Hand for advertising and rental of a storage unit

He handed the Court invoices from a couple of auto repair shops and a receipt from a vehicle emissions test.

Let’s give him the benefit of the doubt. Maybe he was trying to show mileage near the beginning and end of the year, so as to establish total mileage for the year.

Seems to me he next has to show the business portion of the total mileage.

Maybe he could go through his calendar and deposits and reconstruct where he was on certain days. He would still be at the mercy of the Court, as one is to keep these records contemporaneously.  At least he would field an argument, and the Court might give him the benefit of the doubt.

He gave the Court nothing.

His argument was: I reported income; you know I had to drive to the job to earn the income; spot me something.

True enough, but mileage is one of those deductions where you have to provide some documentation. This happened because people for years abused vehicle expenses. To give the IRS more firepower, Congress tightened-up Code Section 274 to require some level of substantiation in order to claim any vehicle expenses.

And then we get to the $9,360 payment to Lend-A-Hand.

Let’s not dwell on the advertising and storage unit thing.

I have a bigger question:

How do you prove that his business paid the nonprofit anything?

Think about it: there is one checking account. Do you write a check on the account and deposit it back in?

It borders on the unbelievable.

And the Tax Court did not believe him.

I am not saying that the Court would have sustained the deduction had he separated the bank accounts. I am saying that he could at least show a check on one account and a deposit to another.  The IRS could still challenge how much “advertising” a small charity could realistically provide.

As it was, he never got past whether money moved in the first place.

Owing A Million Dollar Penalty

What caught my attention was the size of the penalty.

The story involves Letantia Russell, a dermatologist from California who has been in the professional literature way too much over too many years. The story started with her attorneys reorganizing her medical practice into a three-tiered structure and concealing ownership through use of nominees. Then there was the offshore bank account.

Let’s talk about that offshore account.

Back when I came out of school, one had to report foreign accounts above a certain dollar balance. The form was called the “TD 90-22.1.” I remember accountants who had never heard of it. It just wasn’t a thing.

The requirement hasn’t changed, but the times have.

If you have an overseas bank account, you are supposed to disclose it. The IRS has a question on Schedule B (where you report interest and dividends) whether you have a foreign bank account. If you answer yes, you are required to file that TD 90-22.1. The form does not go to the IRS; it instead goes to the Treasury Department. Mind you, the IRS is part of Treasury, but there are arcane rules about information sharing between government agencies and whatnot. Send to Treasury: good. Send to IRS: bad.

The rules were fairly straightforward: bank account, balance over $10 grand, own or able to sign on the account, required to file. There was no rocket science here.

Don’t play games with account types, either. A checking account is the same as a savings account which is the same as a money market and so on. Leave that hair-splitting stuff to the lawyers.

About a decade or so ago, the government decided to pursue people who were hiding money overseas. Think the traditional Swiss bank account, where the banker would risk jail rather than provide information on the ownership of an account. That Swiss quirk developed before the Second World War and was in response to the unstable Third Republic of France and Weimar government of Germany. Monies were moving fast and furious to Switzerland, and Swiss bankers made it a criminal offense to break a strict confidentiality requirement.

Thurston Howell III joked about it on Gilligan’s Island.

Travel forward to the aughts and the UBS scandal and the U.S. government was not laughing.

Swiss banks eventually agreed to disclose.

The IRS thundered that those who had … ahem, “underreported” … their foreign income in the past might want to clean-up their affairs.

The government dusted-off that old 90-22.1 and gave it a new name: FinCen 114 Report of Foreign Bank and Financial Accounts.

The IRS was still miffed about that government-agency-sharing thing, so it came up with its own form: Form 8938 Statement of Foreign Financial Assets.

So you had to report that bank account to Treasury on the FinCen and to the IRS on Form 8938.  Trust me, even the accountants were trying to understand that curveball.

Resistance is futile, roared the IRS.

Many practitioners, me included, believed then and now that the IRS went fishing with dynamite. The IRS seemed unwilling to distinguish someone who inherited his/her mom’s bank account in India from a gazillionaire hedge-fund manager who knew exactly what he/she was doing when hiding the money overseas.

And you always have … those people.

Letantia Russell is one of those people.

The penalties can hurt. Fail to fail by mistake and the penalty begins at $10,000. Willfully fail to file and the penalty can be the greater of

·      $100,000 or

·      ½ the balance in the account

Letantia dew a $1.2 million penalty on her 2006 tax return. I normally sympathize with the taxpayer, but I do not here. One has to be a taxpayer before we can have that conversation.

It went to District Court. It then went to Appeals, where her attorneys lobbed every possible objection, including the unfortunate trade of Jimmy Garappolo from the New England Patriots to the San Francisco 49ers.

It was to no avail. She gets to pay a penalty that would make a nice retirement account for many of us.

Data Security And Your Tax Preparer

I annually reflect on what was unique about every tax season, other than this is a difficult profession. I can understand why accounting graduates increasingly dismiss public accounting as a career choice.

I am concerned with the increasing concentration of confidential information in an accounting office.

We have always had your name, address, birthdate and social security number.

Right there is big bucks to an Eastern European identity thief.

Riding the best-intentions train, you now have states – Tennessee comes to mind – that will not allow you to pay their (Hall) tax with a check. No sir, you have to have that bad boy drafted against your bank account. I understand Tennessee’s position – it is cheaper than handling a check – but I do not care about their position. How dare they coerce you to make it convenient for them to Soprano your money. If it is so much trouble, then stop taking the money!

You have no choice with those states.

So we have your bank information.

We now have additional “identity theft” safeguards. For example, some states require driver’s license information before you can file your return. Wow, I now have a copy of your driver’s license. And your spouse’s, if you are married.

Seems the government has shifted data protection responsibility to your friendly neighborhood tax preparer.

I did not want your data. I still don’t want it, but there it is - on my server.

Which can be carried away in an instant.

How hard would it be for someone to take down my office door, walk to the server, pull out all the wires and walk out with the thing?

And their goes your name, address, birth date, social security number, bank account information, driver’s license, those of your spouse and children, and who knows what else.

Identity thieves are spending way too much time hacking into Target and other major corporations.

It would be easier to break into CPA offices across the fruited plain. One person. One server. Repeat. You could probably knock out a dozen or two in a day.

Thank heavens our government is standing guard over all CPA firm servers in all the offices in all the cities across the land. 

Otherwise we would have reason to be concerned.

Just Pay The Tax, Boris

I have no problem with minimizing one’s tax liability.

But then there are people who will go to extremes.

Boris Putanec is one of these. I am skimming over a 34-page Tax Court case about a tax shelter he used.

Let’s travel back in time to the dot-com era.

Putanec was one of the founders of Ariba, a business-to-business software company. The initial idea was simple: let’s replace pencil- and pen-business functions with a computerized solution. There are any number of areas in business accounting - routine, repetitious, high-volume – that were begging for an easier way to get things done.

Enter Ariba.

Which eventually went public. Which meant stock. Which meant big bucks to the founders, including Putanec.

Up to this point I am on his side.

This guy wound-up owning more than 6 million shares in a company valued (at one point) around $40 billion.

How I wish I had those problems.

You can anticipate much of the next stretch of the story.

Most of Putanec’s money was tied-up in Ariba stock. That is generally considered unwise, and just about every financial planner in the world will tell you to diversify. When 90-plus-% of your net worth is held in one stock, “diversify” means “sell.”

Now Putanec acquired his stock when the company was barely a company. That meant that he paid nothing or close to nothing to get the stock. In tax talk, that nothing is his “basis.” Were he to sell his stock, he would subtract his basis from any sales proceeds to calculate his gain. He would pay tax on the gain, of course. Well, when you subtract nothing (-0-) from something, you have the same something left over.

In his case, big something.

Meaning big tax.

Rather than just paying the tax and celebrating his good fortune, Putanec was introduced to a tax shelter nicknamed CARDS.

Sigh.

CARDS stands for “custom adjustable rate debt structure.” Yes, it sounds like BS because it is. Tax shelters tend to have one thing in common: take a tax position, pretzel it into an unrecognizable configuration and then bury the whole thing in a series of transactions so convoluted and complex that it would take a team of tax attorneys and CPAs a half-year to figure out.

Let’s go through an example of a CARDS deal.

1. Someone has a gigantic capital gain, perhaps from selling Ariba sock.
1. CARDS deals routinely started at $50 million. That threshold easily weeds out you and me.
2. There will be a foreign bank (FB) involved. 
3. There will be foreign currency involved. 
4. The promoter forms a limited liability company (LLC) somewhere. 
5. The FB loans money (let’s say $100 million) to the LLC. 
1. The LLC deposits around 85% of the money in a bank – probably the same bank (FB) that started this thing. 
2. The LLC keeps the other 15%. 
3. The FB wants collateral, so the LLC gives the FB a promissory note. 
1. That note is special. The bank probably has 85% of its money in an account by this point, but the note is for 100%. Why? It’s part of the BS. 
2. There is also something crazy about this note. It can stretch out as long as 30 years, although the bank reserves the right to call it early (probably annually).
6. We now have an LLC somewhere on the planet with an $85 million CD or savings account, a $15 million checking account, and a $100 million promissory note. Just to remind, this is all happening overseas and in foreign currency.
2. Now we leave the rails. 
1. Someone (say Putanec) assumes joint and several liability for that $100 million loan. 
1. Remember that $85 million is already sitting in a CD or likewise, so this is not as crazy as it seems.
2. The LLC will continue to pay the bank interest on the loan. Said someone is not to be bothered. Goes without saying that the bank (FB) will eventually slide the $85 million to itself and make the loan go away.
3. Said someone also takes control of the $15 million parked in that foreign checking account. 
1. In the tax universe, the conversion of that foreign currency to American dollars is a taxable event. Let’s now add gas to the fire.
4. Remember that gain = proceeds – basis.
5. Proceeds in this case are $15 million.
6. Basis in this case … 
1. Is $100 million. 
2. Huh? Yep, because that someone gets to add that $85 million promissory note to his/her $15 million paid in cash.
7. The LOSS therefore is $15 million – $100 million = $85 million.

Now, this could make sense – if said someone had to - some day - write a check to the bank for $85 million.

Not going to happen. The bank already has that $85 million tucked-away in a CD or savings account it controls. The bank never has to leave its front door to get its hands on that $85 million.

But our someone has a sweet yet nutritiously-balanced $85 million capital loss to offset a capital gain.

If only we could come up with a capital gain…. What to do? What can we …? Visualize severe forehead frown.

Got it!!

Let’s sell that Ariba stock. That will generate the gain to absorb that $85 million loss.

Call me He-Man, Tax Master of the Universe.

Yes folks, that is what the gazillion-dollars-a-year “consultants” were peddling to people to avoid paying taxes on something with a huge, latent capital gain.

 Of which Boris Putanec was one.

 The Court bounced him with the following flourish:

The deal is the stuff of tax wizardry, while the Code treats us all as mere muggles. The loan he assumed wasn’t all genuine debt, and any potential obligation he had to repay the entire loan was unlikely or at best contingent.”

I suppose winning the lottery was not enough.

Just pay the tax, Boris.

Caution With S Corporation Losses

I was talking with a financial advisor from Wells Fargo recently.

No, it was not about personal investments. He advises some heavy-hitting clients, and he was bouncing tax questions off me.

The topic of entrepreneurial money came up, and I mentioned that I still prefer the S corporation, although LLCs have made tremendous inroads over the last decade-plus.

The reason is that S corporations have a longer – and clearer – tax history. One can reasonably anticipate the tax predicaments an S can get itself into. The LLCs – by contrast - are still evolving, especially in the self-employment tax area.

But predictability is a two-edged blade. Catch that S-corporation knife wrong and it can cost you big-time.

One of those falling knives is when the S corporation expects to have losses, especially over successive years.

Let’s take a look at the Hargis case.

Let’s say you buy and renovate distressed nursing homes. You spend cash to buy the place, then pay for renovations and upgrades, and then – more likely than not – it will still be a while before full-occupancy and profitability.

Granted, once there it will be sweet, but you have to get there. You don’t want to die a half mile from the edge of the desert.

Here is the flashing sign for danger:

26 U.S. Code § 1366 - Pass-thru of items to shareholders

(d) Special rules for losses and deductions

(1) Cannot exceed shareholder’s basis in stock and debt The aggregate amount of losses and deductions taken into account by a shareholder under subsection (a) for any taxable year shall not exceed the sum of—

(A) the adjusted basis of the shareholder’s stock in the S corporation (determined with regard to paragraphs (1) and (2)(A) of section 1367(a) for the taxable year), and

(B) the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder (determined without regard to any adjustment under paragraph (2) of section 1367(b) for the taxable year).

An S corporation allows you to put the business income on your personal tax return and pay tax on the combination. This sidesteps some of the notorious issues of a C corporation – more specifically, its double taxation. Proctor & Gamble may not care, but you and I as a 2-person C corporation will probably care a lot.

Planning for income from an S is relatively straightforward: you pay tax with your personal return.

Planning for losses from an S – well, that is a different tune. The tax Code allows you to deduct losses to the extent you have money invested in the S.

It sounds simple, doesn’t it?

Let’s go through it.

Your stock investment is pretty straightforward. Generally, stock is one check, one time and not touched again.

Easy peasy.

But you can also invest by lending the S money.

OBSERVATION: How is this an “investment” you ask. Because if the S fails, you are out the money. You have the risk of never being repaid.

But it has to be done a certain way.

That way is directly from you to the S. I do not want detours, sightseeing trips or garage sales en route. Here there be dragons.

Hargis did it the wrong way.

What initially caught my eye in Hargis was the IRS chasing the following income:

·      $1,382,206 for 2009, and

·      $1,900,898 for 2010

Tax on almost $3.3 million? Yeah, that is going to hurt.

Hargis was rocking S corporations. You also know he was reporting losses, as that is what caught the IRS’ eye. The IRS gave him a Section 1366 look-over and said “FAIL.”

Hargis’ first name was Bobby; his wife’s name was Brenda. Bobby was a nursing home pro. He in fact owned five of them. He stuck each of his nursing homes in its own S corporation.

Standard planning.

The tax advisor also had Bobby separate the (nursing home) real estate and equipment from the nursing-home-as-an-operating business. The real estate and equipment went into an LLC, and the LLC “leased” the same back to the S corporation. There were 5 LLCs, one for each S.

Again, standard planning.

Bobby owned 100% of the five nursing homes.

Brenda was a member in the LLCs. There were other members, so Brenda was not a 100% owner.

The tax problem came when Bobby went out and bought a nursing home. He favored nursing homes down on their luck. He would buy at a good price, then fix-up the place and get it profitable again.

Wash. Rinse. Repeat.

But it took money to carry the homes during their loss period.

Bobby borrowed money:

(1) Sometimes he borrowed from the LLCs

(2) Sometimes he borrowed from his own companies

(3) Sometimes he borrowed from a bank

Let’s discuss (1) and (2) together, as they share the same issue.

The loan to the S has to be direct: from Bobby to the S.

Bobby did not do this.

The loans were from the other companies to his S corporations. Bobby was there, like an NFL owner watching from his/her luxury box on Sunday. Wave. Smile for the cameras.

Nope. Not going to work.

Bobby needed to lend directly and personally. Didn’t we just say no detours, sightseeing trips or garage sales? Bobby, the loan had to come from you. That means your personal check. Your name on the personal check. Not someone else’s name and check, no matter how long you have known them, whether they are married to your cousin or that they are founding team owners in your fantasy football league.  What part of this are you not understanding?  

Fail on (1) and (2).

How about (3)?

There is a technicality here that hosed Bobby.

Bobby was a “co-borrower” at the bank.

A co-borrower means that two (or more) people borrow and both (or more) sign as primarily liable. Let’s say that you and I borrow a million dollars at SunTrust Bank. We both sign. We are co-borrowers. We both owe a million bucks. Granted, the bank only wants one million, but it doesn’t particularly care if it comes from you or me.

I would say I am on the hook, especially since SunTrust can chase me down to get its money. Surely I “borrowed,” right? How else could the bank chase me down?

Let’s get into the why-people-hate-lawyers weeds.

Bobby co-borrowed, but all the money went into one of the companies. The company paid any interest and the principal when due to the bank.

This sounds like the company borrowed, doesn’t it?

Bobby did not pledge personal assets to secure the loan.

Bobby argued that he did not need to. Under applicable state law (Arkansas) he was as liable as if the loan was made to him personally.

I used to like this argument, but it is all thunder and no rain in tax-land.

Here is the Raynor decision:

[n]o form of indirect borrowing, be it guarantee, surety, accommodation, comaking or otherwise, gives rise to indebtedness from the corporation to the shareholders until and unless the shareholders pay part or all of the obligation. Prior to that crucial act, ‘liability’ may exist, but not debt to the shareholders.”

Bobby does not have the type of “debt” required under Section 1366 until he actually pays the bank with some of his own money. At that point, he has a subrogation claim against his company, which claim is the debt Section 1366 wants.

To phrase it differently, until Bobby actually pays with some of his own money, he does not have the debt Section 1366 wants. Being hypothetically liable is not the same as being actually liable. The S was making all the payments and complying with all the debt covenants, so there was no reason to think that the bank would act against Bobby and his “does it really exist?” debt. Bobby could relax and let the S run with it. What he could not do was to consider the debt to be his debt until his co-borrower (that is, his S corporation) went all irresponsible and stiffed the bank.

COMMENT: Folks, it is what it is. I did not write the law.

Bobby failed on (3).

The sad thing is that the tax advisors could have planned for this. The technique is not fool-proof, but it would have looked something like this:

(1) Bobby borrows personally from the bank

(2) Bobby lends personally to his S corporation

a.     I myself would vary the dollars involved just a smidge, but that is me.

(3) Bobby charges the S interest.

(4) Upon receiving interest, Bobby pays the bank its interest.

(5) Bobby has the S repay principal according to a schedule that eerily mimics the bank’s repayment schedule.

(6) Bobby and the S document all of the above with an obnoxious level of paperwork.

(7) Checks move between Bobby’s personal account and the business account to memorialize what we said above. It is a hassle, but a good accountant will walk you through it. Heck, the really good ones even send you written step-by-step instructions.

Consider this standard CTG planning for loss S Corporations with basis issues.

The IRS could go after my set-up as all form and no substance, but I would have an argument – and a defensible one.

Hargis gave himself no argument at all. 

He owed the IRS big bucks.