IRS Challenges Rent In A Small Town

Let’s look at a case involving rent.

What sets this up is a C corporation in Montana.

A C corporation means that it pays its own tax. Contrast this with an S corporation, which (with rare exception) passes-through its income to its shareholders, who then combine that income with their own income (W-2, interest and dividends) and pay tax personally.

As a generalization, a tax advisor working with entrepreneurial clients is much more likely to work with S corporations (or LLCs, an increasingly popular choice). The reason is simple: a C corporation has two levels of tax: once to the company itself and then to the owners when distributed as dividends. Now that may not be an issue to a Fortune 1000, some of which are larger than certain countries and themselves are near-permanent entities - expected to outlive any current corporate officer or investor. It however is an issue to a closely-held company that will be lucky to transition one generation and unlikely to transition two.

Plentywood Drug is a Montana corporation that operates the only pharmacy in Plentywood, Montana and serves four counties spanning 7,200 square miles.

The company has four owners, representing two families.

It leases a building owned by its four owners.

COMMENT: So far, there is zero unusual about this.

The company paid the following rent:

           2011                       $ 83,584

           2012                       $192,000

           2013                       $192,000

The IRS did not like this one bit.

Why not?

Let’s go tax nerd for a moment. The IRS said that the company was paying too much in rent. Rent is deductible. Excess rent is considered a dividend and is not deductible. The corporation would lose a deduction for its excess rent. The owners however received $192,000, so they are going to be taxed on that amount. How will they be taxed if the IRS ratches-down the rent? The excess will be considered dividends and taxed to them accordingly.

Remember: a C corporation does not get a deduction for dividends. The IRS gets more tax from the company while the individual taxes of the four owners stays the same. It’s a win for the IRS.

An S corporation does not have this issue, as all income of the S is taxed to its owners. This is another reason that tax advisors representing entrepreneurial wealth prefer working with S corporations.

How does the IRS win this?

Well, it has to show that $192,000 is too much rent.

Problem: the town of Plentywood has 1,700 people.

Another problem: Montana is a nondisclosure state, meaning real estate data – such as sales prices – is legally confidential and simply not available.

The IRS brought in its valuation specialist. Third problem: Montanans do not tend to share financial information easily with strangers.

The IRS expert remarked that that he did not identify himself as an IRS agent while he was in Plentywood.

Probably for the best.

Then the IRS expert made a fateful decision: he would base his appraisal solely on Plentywood data.

Well, that should take about half a day.

He looked at the post office, two apartment buildings and a 625-square-foot commercial space.

He did the best he could to compensate by making adjustments: for commercial versus residential, for the safety of the Post Office as a tenant, for Aaron Rodgers possibly leaving the Packers.

The two families brought in their specialist, who supplemented his database by including Williston, North Dakota – the “big town” about an hour away and with a population about eight times the size.

The IRS argued that Williston was simply not comparable.

Here is the Court:

We therefore do not accept the Williston properties as being reasonable comparisons.”

Oh oh.

The two families argued that the IRS specialist was mixing tamarinds and eggplants.

Here is the Court:

His expert used two residential properties in his analysis. Government-subsidized multifamily residential housing is like a retail drugstore in that both are rented. But not in much else.”

You can tell the Court was frustrated.

How about the post office? Both sides used the post office.

Yet even though both sides agree that the post office is comparable, they disagree about the number of square feet it has.”

The Court – having to do something – decided that fair rent was $171,187.

The IRS then wanted penalties. The IRS always wants penalties.

What for?

The Commissioner alleges that the first cause on this list – negligence or disregard of rules or regulations … - applies to Plentywood Drug ….”

The Court squinted and said: What? You brought a trial, the rent turned out to be within $20 grand of what the families deducted in the first place, we have heard far too much about appraising properties over frontier America and you have the nerve to say that there was negligence or disregard?

The Court adjusted the rent and nixed the penalties.

Our case this time was Plentywood Drug Inc v Commissioner, T.C. Memo 2021-45.

No Shareholder, No S Corporation Election

 Our case this time takes us to Louisville.

There is a nonprofit called the Waterfront Development Corporation (WDC). It has existed since 1986, and its mission is to development, redevelop and revitalize certain industrial areas around the Ohio river downtown. I would probably shy away from getting involved - anticipating unceasing headaches from the city, Jefferson county and the Commonwealth of Kentucky - but I am glad that there are people who will lift that load.

One of those individuals was Clinton Deckard, who wanted to assist WDC financially, and to that effect he formed Waterfront Fashion Week Inc. (WFWI) in 2012. WFWI was going to organize and promote Waterfront Fashion Week – essentially a fundraiser for WDC.

Seems laudable.

Mr Deckard had been advised to form a nonprofit, on the presumption that a nonprofit would encourage people and businesses to contribute. He saw an attorney who organized WFWI as a nonprofit corporation under Kentucky statute.

Unfortunately, Waterfront Fashion Week failed to raise funds; in fact, it lost money. Mr Deckard wound up putting in more than $275,000 of his own money into WFWI to shore up the leaks. There was nothing to contribute to WDC.  What remained was a financial crater-in-the-ground of approximately $300 grand. Whereas WFWI had been organized as a nonprofit for state law purposes, it had not obtained tax-exempt status from the IRS. If it had, Mr Deckard could have gotten a tax-deductible donation for his generosity.

COMMENT: While we use the terms “nonprofit” and “tax-exempt” interchangeably at times, in this instance the technical difference is critical. WFWI was a nonprofit because it was a nonprofit corporation under state law. If it wanted to be tax-exempt, it had to keep going and obtain exempt status from the IRS.  One has to be organized under as a nonprofit for the IRS to consider tax-exempt status, but there also many more requirements.

No doubt Mr Deckard would have just written a check for $275 grand to WDC had he foreseen how this was going to turn out. WDC was tax-exempt, so he could have gotten a tax-deductible donation. As it was, he had ….

…. an idea. He tried something. WFWI had never applied for tax-exempt status with the IRS.

WFWI filed instead for S corporation status. Granted, it filed late, but there are procedures that a knowledgeable tax advisor can use. Mr Deckard signed the election as president of WFWI. An S election requires S corporation tax returns, which it filed. Mind you, the returns were late – the tax advisor would have to face off against near-certain IRS penalties - but it was better than nothing.

Why do this?

An S corporation generally does not pay tax. Rather it passes its income (or deductions) on to its shareholders who then include the income or deductions with their other income and deductions and then pay tax personally on the amalgamation

It was a clever move.

Except ….

Remember that the attorney organized WFWI as a nonprofit corporation under Kentucky statute.

So?

Under Kentucky law, a nonprofit corporation does not have shareholders.

And what does the tax Code require before electing S corporation status?

Mr Deckard has to be a shareholder in the S corporation.

He tried, he really did. He presented a number of arguments that he was the beneficial owner of WFWI, and that beneficial status was sufficient to allow  an S corporation election.

But a shareholder by definition would get to share in the profits or losses of the S corporation. Under Kentucky statute, Mr Deckard could NEVER participate in those profits or losses. Since he could never participate, he could never be a shareholder as intended by the tax Code. There was no shareholder, no S corporation election, no S corporation – none of that.

He struck out.

The sad thing is that it is doubtful whether WFWI needed to have organized as a nonprofit in the first place.

Why do I say that?

If you or I make a donation, we need a tax-exempt organization on the other side. The only way we can get some tax pop is as a donation.

A business has another option.

The payment could just be a trade or business expense.

Say that you have a restaurant downtown (obviously pre-COVID days). You send a check to a charitable event that will fill-up downtown for a good portion of the weekend. Is it a donation? Could be. It could also be just a promotion expense – there are going to be crowds downtown, you are downtown, people have to eat, and you happen to be conveniently located to the crowds. Is that payment more-than-50% promotion or more-than-50-% donation?

I think of generosity when I think of a donation. I think of return-on-investment when I think of promotion or business expenses.

What difference does it make? The more-than-50% promotion or business deduction does not require a tax-exempt on the other side. It is a business expense on its own power; it does not need an assist.

I cannot help but suspect that WFWI was primarily recruiting money from Louisville businesses. I also suspect that many if not most would have had a keen interest in downtown development and revitalization. Are we closer to our promotion example or our donation example?

Perhaps Mr Deckard never needed a nonprofit corporation.

Corporation Still Owed Penalties Even After Its Officers Died

I had a conversation this week with another practitioner.

He has an elderly client who is having memory issues. This client in turn is represented by another person – an agent. The agent refuses to sign or provide consent to the filing of the elderly client’s tax return.

My first thought was that there must be odd stuff on the client’s return, but I am assured that is not the case. The agent is – how to say this delicately – not a likeable person.

The practitioner asked me what I would do.

The issue is that a tax return is confidential information. We – as CPAs – are not allowed to release a return, even to the IRS, without permission from the client. The IRS requests that this permission be in writing, which is why you sign a form and return it to your preparer before he/she electronically files your return.

Theory is easy. Life is messy.

Let’s segue by looking at a penalty case.

The taxpayer was protesting $58 thousand in penalties.

Turns out the taxpayer was an S corporation. This type of corporation (normally) does not pay tax. Rather it divides up its income among its shareholders (on Form K-1, to be specific), who in turn include those numbers on their individual tax returns.

For years 2011 through 2013 the company did not file returns with the IRS.

Yep, that is going to hurt.

But it did issue K-1s to its shareholders, so (supposedly) all taxes were timely and correctly paid to the Treasury.

Seems odd. Why would the company issue K-1s but not file the return itself with the IRS?

Turns out that there were a number of related family companies – 19 of them, in fact. The patriarch of the family (Victor) hired a CPA (Tapling) to function as CFO for all his companies.

Victor was diagnosed with and treated for cancer. He died December 30, 2013.

We are talking about penalties for years 2011 through 2013, so I suspect that Victor’s illness is involved.

In 2010 Tapling himself was diagnosed with cancer. He eventually died from complications in 2016.

Tapling prepared and distributed the K-1s for years 2011 through 2013 but did not however send the returns to the IRS. Why? Perhaps he was waiting for the passing of authority within the family. Perhaps he did not consider it within his corporate authority to actually sign the returns. Maybe the transition involved family members who wanted Tapling gone, and he did not want to provide easy reasons for his dismissal.    

The IRS came in hot.

It led with the Boyle decision (of which we have spoken before), arguing that the corporation was more than Victor or Tapling. It had a Board of Directors, for example, and the Board could have – should have – stepped in to be sure that returns were being filed.

The company argued that Boyle involved an agent. This situation involved corporate officers and not agents. Its officers were gravely ill and did not timely discharge their responsibilities, much to the company’s detriment.

I see both sides.

To me, the IRS and the company should compromise. Perhaps the IRS could abate 50% of the penalty, and the company would hold its nose and write a check. Both sides could acknowledge that the other side had valid points. Life is messy.

Not a chance:

Consequently the court grants defendant’s motion for summary judgement and denies plaintiff’s motion for summary judgement.”

The IRS won it all.

Our case this time for the home gamers is Hunter Maintenance & Leasing Corp., Inc.v United States.

Foreign Investment In U.S. Rental Real Estate

We have spoken about Congress’ and the IRS’ increasing reliance on penalties.

Here is one from the new Taxpayer First Act of 2019:

The minimum penalty for filing a return more than 60 days later will now be no less than the lesser of:

·        $330 or

·        100% of the amount required to be shown on the tax return.

The previous marker was $205, adjusted for inflation.

Thanks for saving the republic from near-certain extinction there, Congress.

There is another one that has caught my attention, as it impacts my practice.

By happenstance I represent a fair number of foreign nationals who own rental real estate in the U.S.

Why would a foreign national want to own rental real estate in Georgetown, KY, Lebanon, OH or Arlington, TN?

I don’t get it, truthfully, but then I am not a landlord by disposition. I certainly am not a long-distance landlord.

There is a common structure to these arrangements. The foreign national sets up an U.S.-based LLC, and the LLC buys and operates the rentals. Practitioners do not often use corporations for this purpose.

There is a very nasty tax trap here.

There is special reporting for a foreign corporation doing business in the United States. As a flip to that coin, there is also special reporting for a U.S. corporation that is 25%-or-more owned by nonresidents. We are referring to Form 5472, and it is used to highlight “reportable transactions,” with no dollar minimum.

“Reportable transactions” sounds scary. I suppose we are looking for laundering of illicit money or something similar, right?

Here is an example of a “reportable transaction”:

·        borrowing money

Here is another:

·        paying interest on borrowed money

Yep, we are going full CSI on that bad boy.

Let’s play with definitions and drag down a few unattentive tax practitioners, why don’t we?

An LLC with one owner can be considered to be the same as its owner for tax purposes.

Say that Emilio from Argentina sets up an Ohio LLC.  He is the only owner. The LLC goes on to buy rental properties in Cincinnati and Columbus.

For federal income tax purposes, the LLC is disregarded and Emilio is deemed to own the properties individually.

For purposes of information reporting, however, the IRS wants you to treat Emilio’s single-member LLC as a corporation.

A “corporation” that is more-than-25% owned by a nonresident.

Meaning that you have a Form 5472 filing requirement.

What happens if the tax practitioner doesn’t catch this wordplay?

An automatic penalty of $10,000 for not filing that 5472.

Granted, the practitioner will fight the penalty. What choice is there?

Let’s up the ante.

Buried in the new tax law for 2018 (that is, the Tax Cuts and Jobs Act), Congress increased the minimum penalty from $10,000 to $25,000.

So a foreign national buys a rental house or two in name-a-city, and somehow he/she is on par with an Alibaba or Banco Santander?

The IRS automatically charges the penalty if the form is filed late. The practitioner would have to provide reasonable cause to have the penalty abated.  

Remember next that the IRS does not consider an accountant’s error to be necessarily provide reasonable cause, and you can anticipate how this story may not turn out well.

Keeping A Corporation Alive

Recently I received a call from a client requesting that certain records be sent to an attorney as soon as possible, hopefully before noon.

It was not a big request, just the QuickBooks files for two companies (those who know me will understand the inside joke in that sentence). Activity in recent years has been minimal, and the companies have been kept alive primarily because of a lawsuit. The companies previously experienced one of the most astounding thefts of intellectual property I have encountered. It sounds like the attorneys have now stopped playing flag and are now playing tackle, as legal discovery is turning up some rather unflattering information. We are talking retirement-level money here.

Notice what I said: the companies have been kept alive.

Why?

Because it is the companies that are suing.

Keeping the companies alive means filing tax returns, renewing annual reports with the secretary of state and whatever else one’s particular state of organization may require. It may also require the owners kicking-in money to pay those taxes, registrations and fees.

What if you do not do this? To use a rather memorable phrase: what difference does it make?

Let’s talk about the recent Timbron case.

There are two Timbrons: the parent (Timbron Holdings) and the operating company (Timbron Internation). For ease, we will call them both Timbron.

Timbron was organized in California.

Timbron did not pay state taxes.

By 2013 California has suspended corporate rights for both Timbrons.

In 2016 the IRS showed up and issued Notices of Deficiency for 2010 and 2011.

In October, 2016 Timbron filed a petition with the Tax Court.

In November, 2016 the IRS filed its response.

A couple of months later the IRS realized Timbron was no longer a corporation under California law. This is a problem, as corporations are legal entities, meaning they are created and sustained under force of law.

An attorney at the IRS earned one of the easiest paychecks he/she will ever receive.

The IRS moved to dismiss.

Timbron fought back. Someone must have invested in a legal dictionary, as we are introduced to “certificates of reviver.” Timbron continued on, arguing “vitality” and “mere irregularities.”

I am not an attorney, although I did a substantial portion of my Masters at the University of Missouri Law School. When I come across gloss and floss like “vitality” and so forth, I discern that an attorney is hard-pressed.

Here is the Court:

With respect to corporate taxpayers like petitioners, a proper filing requires taxpayers tendering petitions to the Court to have the capacity to engage in litigation before this Court.”

To no one’s surprise:

… we find that petitioners lacked capacity to timely file proper petitions.”

Timbron lost.

On the most basic of facts: it failed to maintain its corporate status under California law.

The Qualified Small Business Stock Exemption

Let’s say that you are going to start your own company. You talk to me about different ways to organize:

(1) Sole proprietor – you wake up in the morning, get in your car and go out there and shake hands. There is no paperwork to file, unless you want to get a separate tax ID number. You and your proprietorship are alter-egos. If it gets sued, you get sued.

(2) Limited liability company – you stick that proprietorship in a single-member LLC, writing a check to your attorney and secretary of state for the privilege. You gain little to nothing tax-wise, but you may have helped your attorney (and yourself) if you ever get sued.

(3) Form a corporation - a corporation is the old-fashioned way to limit your liability. Once again there is a check to your attorney and secretary of state. Corporations have been out there long before LLCs walked the land.

You then have to make a decision as to the tax flavor of your corporation: 

a.    The “C” corporation – think Krogers, Proctor & Gamble and Macy’s. The C is a default for the big boys – and many non-bigs. There are some goodies here if you are into tax-free reorganizations, spin-offs and fancy whatnot.

Problem is that the C pays its own tax. You as the shareholder then pay tax a second time when you take money out (think a dividend) from the C.  This is not an issue when there are a million shareholders. It may be an issue when it is just you.

b.    The “S” corporation – geared more to the closely-held crowd. The S (normally) does not pay tax. Its income is instead included on your personal tax return. Own 65% of an S and you will pay tax on 65% of its income, along with your own W-2, interest, dividends and other income.

This makes your personal return somewhat a motley, as it will combine personal, investment and business income into one. Don’t be surprised if you are considered big-bucks by the business-illiterate crowd.

The S has been the go-to corporate choice for family-owned corporations since I have been in practice. A key reason is avoiding that double-tax.

But you can avoid the double tax by taking out all profits through salaries, right?

There is a nerdy issue here, but let’s say you are right.

Who cares then?

You will. When you sell your company.

Think about it. You spend years building a business. You are now age 65. You sell it for crazy money. The corporation pays tax. It distributes whatever cash it has left-over to you.

You pay taxes again.

And you vividly see the tax viciousness of the C corporation.

How many times are you going to flog this horse? Apple is a multinational corporation with a quarter of a trillion dollars in the bank. Your corporate office is your dining room.

The C stinks on the way out.

Except ….

Let’s talk Section 1202, which serves as a relief valve for many C corporation shareholders when they sell.

You are hosed on the first round of tax. That tax is on the corporation and Section 1202 will not touch it.

But it will touch the second round, which is the tax on you personally.

The idea is that a percentage of the gain will be excluded if you meet all the requirements.

What is the percentage?

Nowadays it is 100%. It has bounced around in prior years, however.

That 100% exclusion gets you back to S corporation territory. Sort of.

So what are the requirements?

There are several:

(1) You have to be a noncorporate shareholder. Apple is not invited to this soiree.

(2) You have owned the stock from day one … that is, when stock was issued (with minimal exceptions, such as a gift).

(3) The company can be only so big. Since big is described as $50 million, you can squeeze a good-sized business in there. BTW, this limit applies when you receive the stock, not when you sell it.

(4) The corporation and you consent to have Section 1202 apply.

(5) You have owned the stock for at least 5 years.

(6) Only certain active trades or businesses qualify.

Here are trades or businesses that will not qualify under requirement (5):

(1) A hotel, motel, restaurant or similar company.

(2) A farm.

(3) A bank, financing, leasing or similar company.

(4) Anything where depletion is involved.

(5) A service business, such as health, law, actuarial science or accounting.

A CPA firm cannot qualify as a Section 1202, for example.

Then there is a limit on the excludable gain. The maximum exclusion is the greater of:

(1) $10 million or

(2) 10 times your basis in the stock

Frankly, I do not see a lot of C’s – except maybe legacy C’s – anymore, so it appears that Section 1202 has been insufficient to sway many advisors, at least those outside Silicon Valley.

To be fair, however, this Code section has a manic history. It appears and disappears, its percentages change on a whim, and its neck-snapping interaction with the alternative minimum tax have soured many practitioners.  I am one of them.

I can give you a list of reasons why. Here are two:

(1) You and I start the company.

(2) I buy your stock when you retire.

(3) I sell the company.

I get Section 1202 treatment on my original stock but not on the stock I purchased from you.

Here is a second:

(1) You and I start the company.

(2) You and I sell the company for $30 million.

We can exclude $20 million, meaning we are back to ye-old-double-tax with the remaining $10 million.

Heck with that. Make it an S corporation and we get a break on all our stock.

What could make me change my mind?

Lower the C corporation tax rate from 35%.

Trump has mentioned 15%, although that sounds a bit low.

But it would mean that the corporate rate would be meaningfully lower than the individual rate. Remember that an S pays tax at an individual rate. That fact alone would make me consider a C over an S.

Section 1202 would then get my attention.

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.