Don’t Tell My Clients About This Case

I always tell my clients to keep good records.  Often, I tell them again and again annoyingly.  It is my experience, and I daresay the experience of most other tax practitioners, that a taxpayer’s failure to keep good books and records will almost always result in a bad experience, if the taxpayer has to tangle with the IRS.  Well, I said almost always.

Mr. Singer owned an S corporation of which the primary business was servicing, repairing, and modifying recreational vehicles.  The corporation also sold Kraftmaid cabinets used in the construction of homes.

Mr. Singer relocated his business from Florida to Colorado in 1999. After a slow start, Mr. Singer’s operations grew quickly.  He needed money to fund the business’s growth.  He established a home equity line of credit; he refinanced his home; he borrowed money from his mother and her boyfriend.  In total, from his own funds or from funds that he borrowed personally, he injected $646,443 into his corporation.

The corporation recorded the advances as loans from shareholder on its general ledger and Form 1120S, U.S. Income Tax Return for an S Corporation.  However, there were no promissory notes between Mr. Singer and the corporation, there was no interest charged, and there were no maturity dates.

It is no surprise what happened to the business in 2008.  Most money spent on recreational vehicles is discretionary and revenues dried up during the Great Recession.  Mr. Singer had to scramble. He moved his business back to Florida.  He borrowed more money from his mother and her boyfriend.  He paid personal bills out of the corporation’s bank account.  The corporation treated those bill payments as repayments of the shareholder loans.  He was taking no other compensation payments from the business.

In a recent case before the Tax Court, the IRS wanted to classify the payments from Mr. Singer to the corporation as contributions to capital and the corporate payments of Mr. Singer’s bills as wages to Mr. Singer.  As a result of those classifications, the IRS wanted to collect employment taxes from the corporation.

The court cited thirteen factors to consider in classifying funds flowing between a closely held corporation and its owner.   Then, the court pretty much ignored the factors.  To my surprise, the court said that, up until the Great Recession ravaged his business, the advances by Mr. Singer were loans.  After that, the advances were contributions to the corporation’s capital.  The court further ruled that all the payments of the personal expenses by the corporation were repayments of the loans.

I would tell you that, without proper documentation of a loan, almost always the IRS will win the argument that arose in this case.  That’s almost always.

VKM

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