Paying Personal Expenses Through A Business

I am looking at a tax case.

It reminds me of something.

There is a too-common belief that paying an expense through a business can somehow transmute an otherwise personal expenditure into a tax deduction.

Here are common ways I have heard the question:

(1)  My spouse is going to replace her car. Should we buy it through the business?

(2)  I run my business from my home. That makes my home a “headquarters,” right? Can’t I deduct all the expenses related to my business headquarters?

(3)  I am going to borrow money to [go on vacation/pay college tuition/buy a boat I’ve been wanting]. Should I have the business borrow the money to make it deductible?

Do not misunderstand, many times there is a more tax-efficient way to accomplish something. There may still be some tax though, and the goal is to minimize the tax. Making it disappear may not be an option, at least for a responsible practitioner.

Let’s look at the above questions.

(1) Realistically, if there is no business use of the vehicle, you are not allowed to deduct any of the ownership or operating expenses of a vehicle. Despite that, does it happen routinely? Of course. Practitioners do what they can, but it is like fighting the tide.

(2)  I consider this quackery, but it is a true story. No, working from home does not make your house fully deductible. You might get a home office deduction out of it, but that is a fraction of some – and not all – expenses. No, your house is not Proctor and Gamble. Get over it.

(3) This one might have traction, but in general the answer is no. Even if the interest is deductible, how is the company getting you the money? Is it going to lend it to you? If so, you will have to pay interest to the company, although you may be able to arbitrage the rate. Will the company bonus you the money? If so, I see FICA and income taxes in your future. Explain to me the win condition here.

Let’s look at Justin Maderia (JM).

JM lived in Florida and owned 50% of Lindy Inc (Lindy).

Lindy must be a C corporation, which is the type that pays its own taxes. I say this because the Court refers to earnings and profits (E&P), which is a C corporation concept. The purpose of E&P is to track a corporation’s ability to pay dividends. When it pays dividends, a corporation is sharing its accumulated profits with its shareholders. The corporation has already paid taxes on these profits (remember: a C corporation pays taxes). When it pays dividends, you are personally taxed on that previously taxed profit. This is the reason for “qualified dividends” in the tax Code: to cut you a break on that second round of taxation.

The IRS was looking at JM’s 2018 personal return. It was also looking at Lindy’s 2018 business return.

COMMENT: It is not unusual to include a closely held company with the audit of an individual tax return.

The IRS wanted to increase JM’s 2018 income by $192 grand of “stuff” that Lindy paid on his behalf.

COMMENT:  Sounds to me like Lindy was paying for EVERYTHING.

Let’s talk procedure here.

The IRS identified personal transactions in Lindy. Lindy was the type of corporation that could pay dividends, and the IRS argument was – to the extent Lindy paid for personal stuff – that such payments represented constructive dividends to JM.

Fair. Consider that the serve.

JM gets to return.

He would argue that the payments were not personal because … well, who knows why.

JM did nothing.

Huh?

JM did nothing because he had a previous audit, and the IRS never pursued the issue of Lindy payments. JM believed he was immunized.

Mind you, there is a kernel of truth here, but JM has googled the concept beyond all recognition.

IF the IRS looks at an issue AND makes no change to your tax return for that issue, you can challenge a later proposed assessment based on that same issue. You might not win, mind you, but you have grounds for the challenge.

Is this what happened to JM?

Let’s look at it.

The IRS examined his prior year return.

Score one for JM.

The IRS never looked at Lindy.

We are done.

There is no immunity. JM cannot challenge a proposed 2018 assessment on an issue the IRS did not examine in a prior year.

JM had to return on different grounds. He did not. He - procedurally speaking - automatically lost.

JM had $192 grand of additional income.

The IRS next wanted the accuracy-related penalty.

Well, of course they did. If they were any more predictable, we could just put it on a calendar.

The Court said “no” to the penalty.

Why?

Because the IRS had looked at JM’s previous return. The IRS either did not bring up or dismissed the Lindy issue, so JM kept reporting the same way. While this would not protect him from a challenge of additional income, it did provide a “reasonable basis” defense against penalties.

Our case this time was Maderia v Commissioner, T.C. Summary 2024-5.

Taxing A Corvette

I came across an old case recently. It made me smile, as it reminded me of earlier – and skinnier – times.

Let’s set this up.

There are, broadly speaking, two accounting methods when deciding whether you have reportable income for a period: the cash method and the accrual method. There are a variety of sub, sorta- and who-actually-understands-this methods, but cash and accrual are enough for right now.

The cash method is easy: if you can deposit it at the bank you have income.  Maybe you decide not to deposit at the bank until next week, but it is still income today. Why? Because you can deposit it. The definition is “can” not “did.”

Accrual is trickier. Generally it means that you sent an invoice to someone. The act of invoicing means you have income, as someone owes you. What if you delay invoicing for a week or two? Well, then you have a variation on the above cash-basis reasoning: you could have but didn’t. Again, it is the “could,” not the “did,” that drives the test.

What if you are on the cash method and somebody pays you with property instead of cash? You have income. It makes sense when you remember that cash is a form of property. We have just gotten so used to it that we don’t think of cash that way. For tax purposes, though, someone paying you in asiago cheese and gluten-free crackers still represents income. Granted, we have to translate cheese-and-crackers into dollars, but income it is.

Let’s say that you played football. Not just any football, however. You were Vince Lombardi’s running back. It is December 31, and you and Lombardi and the Green Bay Packers are playing the New York Giants in the National Football League Championship.

COMMENT: NFL historians will immediately recognize that this was before the Super Bowl era. There was no game called the Super Bowl until the two leagues – the National Football League and the American Football League – merged in 1966. The first two Super Bowls were won tidily by Lombardi and the Packers. In Super Bowl 3 Joe Namath famously led the New York Jets over the Baltimore Colts.

So it is the championship game. You are the running back. It is December 31 and you are playing outside in Green Bay. I presume you are freezing. You run wild and score 19 points, establishing a league record. You are selected after the game by Sport Magazine as the most valuable player, which comes with the prize of a new Corvette. 

Sweet.

By the way, your Corvette is waiting for you in New York. It is now the evening of December 31, 1961.

Tax issue: Do you have income (the value of that Corvette) in 1961?

The IRS said you did.

But you throw the IRS a loop: the car is not income. No, siree. It was a gift. Alternatively, it is nontaxable to you as a prize or award.

I give you kudos, but the concept of a gift requires the presence of detached and disinterested generosity. While a creative argument, it could not be reasonably argued that a for-profit magazine was awarding an expensive car to the most valuable player of a televised sporting event out of a detached and disinterested generosity. It was much more likely that both Sport Magazine and General Motors were expecting publicity, advertising and social buzz from the award.

You still have your second argument, though.

Problem is, the prize or award exception requires you to receive it for an educational, artistic, scientific or civic achievement.

You argue your point: being a star football player “calls for a degree of artistry” requiring techniques based on “scientific” principles.

Seriously.

The Court decides:

We believe that petitioner should be caught behind the line of scrimmage on this particular offensive maneuver.”

You have income. And the Court gave us a great quote.

But when do you have income: 1961 or 1962?

The Court reasons through the obvious. You are in Green Bay. The car is in New York. You cannot get to that car - much less title it - unless you had Star Trek technology. However, it is 1961 and Star Trek is not on television yet. You have income in 1962, the following day.

Your tax case is seminal in developing the tax doctrine of constructive receipt. Normally constructive receipt accelerates when you have income, but it did not in your case.You could not have made it to the bank even if you wanted to.

So why did the IRS push the issue of 1961 versus 1962? They didn’t. Remember that you were arguing that the Corvette wasn’t taxable. The IRS had to fight back on that issue. The 1961 thing was a sidebar, albeit that is what the case is remembered for all these years later.

By the way, do you know which football player we have been talking about?

The IRS Should Apologize To This Taxpayer

In income tax land if …

•  You own a corporation, and

•  The corporation has property, and

•  The corporation gives you the property, and

•  You do not pay anything for it, …

… then the IRS will consider you as receiving distribution from the corporation. The classic distribution is a dividend, taxable to you and not deductible by the corporation. 

Perhaps the corporation distributes property and you pay some – but not all – of what the property is worth. A classic example is a corporation distributing a car to the owner’s child for a nominal amount. There is a distribution taxable as a dividend, and the dividend amount would be the value of the car over any amount paid. It would not be the full value of the car in this case.

The tax code views a C corporation (we are not discussing S corporations in this blog) as an entity distinct from its shareholders. That is how Congress justifies taxing the corporation on its income and then taxing the shareholders again when they receive dividends sourced to that income. Since there are two entities, there cannot be double taxation.  

But there is, of course, and it takes sleight of hand to maintain the illusion. Many if not most tax advisors – including me – have steered most of our closely-held business clients away from C corporations and to passthrough entities: perhaps S corporations, partnerships or limited liability companies. Sometimes the weight of the double taxation is unacceptable. 

The Tax Court decided the Welle case just last month. Sure enough, it involved a C corporation and a dividend. More specifically, it involved what the IRS saw as a new species of dividend. 

Let’s walk this through.

There is a construction company (TWC) in North Dakota. It is wholly-owned by Terry Welle (Welle). TWC primarily does multifamily construction, and its historical profit has been around 6 or 7 percent.

Welle decides he is going to build a lakefront property in Minnesota.

NOTE:  Excuse me here, but how about going south with that lakefront property? Is Minnesota that much warmer than North Dakota?

Back to our story. Welle has a company that builds things. He used TWC’s accounting system to track his costs, and he also used its workers to frame the Minnesota house. The company did a calculation of the costs, including overhead, and Welle reimbursed the company to the penny. 

The IRS comes in and finds fault. The IRS wants to know where the company’s profit is. Welle reimbursed the company at cost, including overhead, meaning that they made no profit from him. The IRS says that there should be and must be a profit. They calculate that profit to be around $48,000. Since he did not reimburse the company its erstwhile profit, the IRS assessed him with a $48,000 dividend. It wants $10,620 in income tax.

Oh, the IRS also wants an accuracy-related penalty of over $2,100.

Wow! The IRS is assessing a penalty on a tax theory it has never trotted out before? That is brazen.

This case goes to Court. The IRS argues that a corporate distribution must be measured at fair market value. Fair market value is the amount that would fully reimburse a company for its direct and indirect costs, as well as render a profit.  One cannot disagree with that summary of microeconomics 101.

The Court tells the IRS to back up. It wants the IRS to point to the distribution event before its gets to any issue of measuring and valuing. The Court reasons that a distribution requires assets to be “diverted to or for the benefit of a shareholder.” It must be a vehicle to “distribute available earnings and profits without the expectation of repayment.”

Show us the distribution, says the Court.

The IRS offers and the Court reviews a number of cases, but it cannot see how corporate assets were expended. Welle received services, but then again he paid for them. At most, he used the company as a conduit in maintaining records and paying subcontractors. The company was no better or worse for transacting with him. The event was a nullity.

In frustration, the Court writes:

Respondent does not explain how a corporation’s decision not to make a profit on services provided to a shareholder who fully reimburses the corporation for the cost of services (including overhead) constitutes a distribution of property that reduced the corporation’s earnings and profits under Section 316(a), nor does the respondent cite any cases supporting such a position.”

The Court decided for Welle and against the IRS.

My thoughts? This is one of the lamest tax theories I have come across, and I have near 30 years in the profession. What was the IRS up to? Are there that many North Dakota contractors building lakefront homes that the IRS decided to go where no serious tax practitioner had gone before? 

Let us segue for a moment. 

Do you remember Nina Olsen? She is the Taxpayer Advocate, and we have spoken of her before. The Advocate is supposed to sit outside the IRS and function as a watchdog. It is great idea, but I must admit the IRS for the last half-decade or so has seemed less than interested in the Advocate. Nonetheless, she is promoting an idea she calls the IRS “apology payment.”  The idea is to pay a taxpayer something when the behavior of the IRS causes excessive delay or expense or an undue burden resulting in significant hardship to the taxpayer.

This idea is being refloated in response to the 501(c)(4) scandal. Ms Olson argues that apology payment would: 

Serve as a symbolic gesture that the government recognizes its mistake and the taxpayer’s burden. These payments might enhance the public perception of the IRS and the tax system as just and fair.”

Great idea, although a $1,000 flat sum may be insufficient in some cases.

I would like to see Welle receive his apology payment for the IRS wasting his time.