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.

Unforced Error on Short Stop

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

Let’s talk about it.

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

Short Stop was a C corporation.

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

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

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

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

At the company level you have:

                   Cash                     100,000

                   Equity                 (100,000)                                 

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

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

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

Make sense.

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

At the company level you now have:

                   Land                     100,000

                   Equity                 (100,000)

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

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

Is there tax to the company on the way out?

You betcha, and here it is:

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

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

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

Is there tax to you on the way out?

Yep, and here it is:

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

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

Let’s summarize.

How much money did the land sell for?

$5 million.

How much of it went to the IRS?

$1,950,298

What is that as a percentage?

39%

Is that high or low?

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

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

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

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

Why?

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

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

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

However, Bob had a plan.

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

Happens all the time. So what?

Bob would have Short Stop pay interest on the loan.

Again: so what?

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

What Bob was doing was clever.

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

There were problems, though.

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

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

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

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

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

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

My thoughts?

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

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

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.

Tax Return That Surprised An Accountant

Let’s do something a little different this time.

I want you to see numbers the way a tax CPA does.

Let’s say that you are semi-retired and you bring me your following tax information:

                    W-2                                         24,000

                    Interest income                            600

                    Qualified dividend income      40,000

                    Long-term capital gains          10,000

                    IRA                                         24,000

Looks to me like you have income of $98,600.

How about deductions?

                    Real estate taxes                    10,000

                    Mortgage interest                      5,000

                    Donations                                26,000

I am seeing $41,000, not including your exemptions.

You did some quick calculations and figure that your federal taxes will be about $6,500. You want to do some tax planning anyway, so you set up an appointment. What can you do to reduce your tax? 

What do I see here?

I’ll give you a hint.

Long-term capital gains have a neat tax trick: the capital gains tax rate is 0% as long as your ordinary income tax rate is 15% or lower. This does not mean that you cannot have a tax, mind you. To the extent that you have taxable income in excess of those capital gains, you will have tax.

Let’s walk though this word salad.

Income $98,600 – deductions $41,000 – exemptions $8,100 = $49,500 taxable income.

You have capital gains of $10,000.

Question: will you have to pay tax on the difference – the $39,500?

Answer: qualified dividends also have a neat tax trick: for this purpose, they are taxed similarly to long-term capital gains.

NOTE: Think of qualified dividends as dividends from a U.S. company or a foreign company that trades on an U.S. exchange and you are on the right path.

You have capital gains and qualified dividends totaling $50,000.

Your taxable income is $49,500.

All of your taxable income is qualified dividends and capital gains, and you never left the 15% tax bracket.

What is your tax?

Zero.

How is that for tax planning, huh?

From a tax perspective, you hit a home run.

Let me change two of the numbers so we can better understand this qualified dividend/capital gain/taxable income/15% tax bracket thing.

                    W-2                                         36,000

                    Qualified dividends                 28,000

As you probably can guess, I left your taxable income untouched at $49,500, but I changed its composition.

You now have capital gains and qualified dividends of $38,000. Your taxable income is $49,500, meaning that you have “other” income in there. You are going to have to pay tax on that “other” income, as it does not have that qualified dividend/capital gain trick.

The tax will be $1,153.

You still did great. It is just that no tax beats some tax any day of the week.

It is something to consider when you think about retirement planning. We are used to thinking about 401(k)s, deductible IRAs, Roth IRAs, social security and so on, but let’s not leave out qualified dividends and capital gains. Granted, capital gains are unpredictable and not a good fit for reliable income, but dividend-paying stocks might work for you. When was the last time Proctor & Gamble missed a dividend payment, for example?

OK, I admit: if you leave the 15% tax bracket the above technique fizzles. That however would take approximately $76,000 taxable income for marrieds filing jointly. Congrats if that is you.

BTW I saw scenario one during tax season (I tweaked the numbers somewhat for discussion, of course). The accountant was perplexed and asked me to look at the return with him. The zero tax threw him.

Now he knows the dividend/capital gain thing, and so do you.

Nails, REITs And Coffins

I am reading an article that includes the following sentence:

If these deals become widespread, they’d be another nail in the coffin of the corporate income tax.”

That sounds ominous.

It turns out that the author is writing about real estate investment trusts, more commonly known as REITs (pronounced “reets”).

I do not work with REITs. The last time I came near one was around 2000, and that was in a limited context. My background is entrepreneurial wealth and is unlikely to include REIT practice – unless said wealth is selling its real estate to said REIT.    

REITs have become popular as an investment alternative in an era of low interest rates, as they are required to pay dividends. Well, to be more accurate, they are required IF they want to remain REITS.

REITS are corporations, but they have access to a unique Code section – Section 857. Qualify and the corporation has an additional deduction not available to you or me – it can deduct dividends paid its shareholders from taxable income.

This is a big deal.

Regular corporations cannot do this. Say you and I own a corporation and it makes a million dollars. We want the money. How do we get it out of the corporation? We have the corporation pay us a million-dollar dividend, of course.

Let’s walk through the tax tao of this.

The corporation cannot deduct the dividend. This means it has to pay tax first. Let’s say the state tax is $60,000, which the corporation can deduct. It will then pay $320,000 in federal tax, leaving $620,000 it can pay us.

In a rational world, we would not have to pay tax again on the $620,000, as it has already been taxed.

That is not our world. The IRS looks around and say “the two are you are not the corporation, so we will tax you again.” The fact that you and I really are the corporation – and that the corporation would not exist except for you and me – is just a Jedi mind trick.

You and I are taxed again on the $620,000. Depending upon, we are likely to bump from the 15% dividend rate to the 20% rate, then on top of it we will also be subject to the 3.8% “net investment income” surtax. The state is going to want its share, which should be another 6% or so.

Odds are we have parted with another 29.8% (20% plus 3.8% plus 6%), which would be approximately $185,000. We now have $435,000 between us. Not a bad chunk of change, but the winner in this picture is the government.

Think how sweet it would be if we could deduct the million dollars. The corporation would not have any taxable income (because we paid it out in full as dividends). Yes, you and I would be taxable at 29.8%, but that is a whole lot better than a moment ago. We just saved ourselves over $260,000.

Congress did not like this. This is referred to as “erosion” of the corporate income tax base and is the issue our author was lamenting. Yes, you and I keeping our money is being decried as “erosion.” Words are funny like that.

Back to our topic.

Real estate has to represent at least 75% of REIT assets. In a similar vein, rental income must comprise at least 75% of REIT income. Get too cute or aggressive and you will lose REIT status – and with it that sweet dividends-paid deduction. For years and years these entities were stuffed with shopping malls, apartments and office complexes. They were boring.

Someone had to push the envelope. Maybe it was a tax planner pitching the next great idea. Maybe it was a corporate raider looking to make his or her next billion dollars. All one has to do is redefine “real estate” to include things that are not – you know – real estate.

For example, can you lease the rooftop of an office building and consider it real estate? What about pipelines, phone lines, billboards, data centers, boat slips?

In recent years the IRS said all were real estate.

Something that started as a real estate equivalent to mutual funds was getting out of hand. Pretty soon a Kardashian reality TV show was going to qualify as real estate and get stuffed into a REIT.

In the “Protecting Americans from Tax Hikes Act of 2015,” Congress put a chill on future REIT deals.

To a tax nerd, getting assets out of a corporation into another entity (say a REIT) is referred to as a “divisive.” These transactions take place under Section 355, and - if properly structured - result in no immediate taxation.

Let’s tweak Section 355 and change that no-immediate-taxation thing:

* Unless both (or neither) the distributing and the distributed are themselves REITs, the divisive will be taxable.

* If neither are REITS, then neither can elect REIT status for 10 years.

This tweak is intended to be a time-out, giving the IRS time. It is, frankly, an issue the IRS brought upon itself The IRS has issued multiple private letter rulings that seem to confound “immoveable” with “real estate.” The technical problem is that there are multiple Sections in the tax Code - Sections 168, 263A, 1031, and 1250 for example – that affect real estate. Each may be addressing different issues, and grafting definitions from one Section onto another can result in unintended consequences.

Again we have the great circle of taxation. Somebody stretches a Code section to the point of snapping. Eventually Congress pays attention and changes the law. There will be another Code section to start the process again. There always is.

Buffett's Berkshire Hathaway Is Buying Duracell From Procter & Gamble

You may have read that Warren Buffett (through Berkshire Hathaway) is acquiring the Duracell battery line of business from Procter & Gamble in a deal worth approximately $4.7 billion. The transaction will be stock-for-stock, although P&G is stuffing approximately $1.7 billion of cash into Duracell before Berkshire takes over. Berkshire will exchange all its P&G stock in the deal. Even better, there should be minimal or no income tax, either to P&G or to Berkshire Hathaway.

Do you wonder how?

The tax technique being used is called a “cash rich split off.” Believe it or not, it is fairly well-trod ground, which may seem amazing given the dollars at play.

Let’s talk about it.

To start off, there is virtually no way for a corporation to distribute money to an individual shareholder and yet keep it from being taxable. This deal is between corporations, not individuals, albeit the corporations contain cash. Lots of cash.

How is Buffett going to get the money out? 

·        Buffet has no intention of “getting the money out.” The money will stay inside a corporation. Of course, it helps to be as wealthy as Warren Buffett, as he truly does not need the money.

·        What Buffett will do is use the money to operate and fund ongoing corporate activities. This likely means eventually buying another business.

Therefore we can restrict ourselves to corporate taxation when reviewing the tax consequences to P&G and Berkshire Hathaway.

How would P&G have a tax consequence?

P&G is distributing assets (the Duracell division) to a shareholder (Berkshire owns 1.9% of P&G stock). Duracell is worth a lot of money, much more money than P&G has invested in it. Another way of saying this is that Duracell has “appreciated,” the same way you would buy a stock and watch it go up (“appreciate”) in value.

And there is the trip wire. Since the repeal of General Utilities in 1986, a corporation recognizes gain when it distributes appreciated assets to a shareholder. P&G would have tax on its appreciation when it distributes Duracell. There are extremely few ways left to avoid this result.

But one way remaining is a corporate reorganization.

And the reorganization that P&G is using is a “split-off.” The idea is that a corporation distributes assets to a shareholder, who in turn returns corporate stock owned by that shareholder. After the deed, the shareholder owns no more stock in the corporation, hence the “split.” You go your way and I go mine.

Berkshire owns 1.9% of P&G. P&G is distributing Duracell, and Berkshire will in turn return all its stock in P&G. P&G has one less shareholder, and Berkshire walks away with Duracell under its arm.

When structured this way, P&G has no taxable gain on the transaction, although it transferred an appreciated asset – Duracell. The reason is that the Code sections addressing the corporate reorganization (Sections 368 and 355) trump the Code section (Section 311) that would otherwise force P&G to recognize gain.

P&G gets to buy back its stock (via the split-off) and divest itself of an asset/line of business that does not interest it anymore - without paying any tax.

What about Berkshire Hathaway?

The tax Code generally wants the shareholder to pay tax when it receives a redemption distribution from a corporation (Code section 302).  The shareholder will have gain to the extent that the distribution received exceeds his/her “basis” in the stock.

Berkshire receives Duracell, estimated to have a value of approximately $4.7 billion. Berkshire’s tax basis in P&G stock is approximately $336 million. Now, $336 million is a big number, but $4.7 billion is much bigger.  Can you imagine what the tax would be on that gain?

Which Berkshire has no intention of paying.

As long as the spin-off meets the necessary tax requirements, IRC Section 355 will override Section 302, shielding Berkshire from recognizing any gain.

Berkshire gets a successful business stuffed with cash – without paying any tax.

Buffett likes this type of deals. I believe he has made three of them over the last two or so years. I cannot blame him. I would too. Except I would take the cash. I would pay that tax with a smile.

There are limits to a cash-rich split off, by the way.

There can be only so much cash stuffed into a corporation and still get the tax magic to happen. How much? The cash and securities cannot equal or exceed two-thirds of the value of the company being distributed. In a $4.7 billion deal, that means a threshold of $3.1 billion. P&G and Berkshire are well within that limit.

Why two-thirds?

As happens with so much of tax law, somebody somewhere pushed the envelope too far, and Congress pushed back. That somebody is a well-known mutual fund company from Denver. You may even own some of their funds in your 401(k). They brought us IRC Section 355(g), also known as the two-thirds rule. We will talk about them in another blog.