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.
