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One of the benefits of Subchapter S corporations is the ability to have losses flow through from the business’ tax return to the individual shareholder’s tax return. These flow-through losses are limited by the shareholder’s tax basis in the S corporation stock. The court recently addressed this limitation in Tinsley v. Commissioner, T.C. Summary Opinion 2017-9. This case is timely given that this issue is the focus of the IRS’s new audit campaigns.
The taxpayer in Tinsley was the sole shareholder of an S corporation. The corporation had borrowed approximately $100,000 from a bank. The S corporation then dissolved under state law and reported a loss on its 1120S tax return. The bank then renewed the loan, but it listed the old corporation as the borrower. It also had the taxpayer guarantee the loan. The taxpayer continued to operate the business under the old name. The taxpayer reported the loss on his personal tax returns. The IRS disallowed the flow-through loss.
The taxpayer did not have any tax basis in the S corporation stock due to capital contributions to the business. He argued that he had tax basis in the S corporation stock given his personal guarantee of the $100,000 bank loan:
he contends that upon the liquidation, he assumed the balance due on the note as guarantor, and because he was the sole remaining obligor, this assumption was a contribution to capital, allowing him to deduct the amount of Command Computers’ losses. Further, Mr. Tinsley asserts that following Command Computers’ liquidation, the Bank expected him, as guarantor, to repay the loan and that the Bank’s expectation was sufficient to generate a basis for Mr. Tinsley in Command Computers.
The court did not agree. The court noted that merely guaranteeing an S corporation’s debt is not sufficient to generate a basis under section 1366(d). The court noted that a shareholder may obtain an increase in basis in an S corporation only if there is an economic outlay on the part of the shareholder that leaves him or her “poorer in a material sense.” The taxpayer has to have an economic outlay. This can come about if the lender looks primarily to the taxpayer to repay the loan.
According to the court, there was no evidence that the lender in this case looked only to the taxpayer to repay the loan. The court seems to say that the lender looks to the non-existent corporation that is listed as the borrower. The court also said there was no evidence of an economic outlay by the taxpayer as the court record did not include evidence that the taxpayer was the party paying the loan.
These 1366(d) basis rules are in addition to the Sec. 465 at-risk and Sec. 469 passive activity loss rules. It should also be noted that this same fact pattern would satisfy the Sec. 465 at-risk rules as they do not require an economic outlay or the taxpayer to be the primary source of repayment.
To avoid this type of Sec. 1366(d) tax basis issue, taxpayers should document their economic outlays and/or that the borrower looks primarily to them to satisfy the loan.
Sometimes it is best to wait for the IRS’s collection statute to expire. This is a wait-and-see approach where the taxpayer waits to see if the IRS attempts to collect the tax debt. To succeed, it is important for the taxpayer to not extend the IRS’s collection statute. This issue came to a head in United States v. Kidwell, Civ. No. 2:16-433 WBS EFB (E.D. Cal. 2017).
The Kidwell case involved unpaid employment taxes. The taxes were reported on a Form 941 for the period ending September 30, 2004, which was filed on April 4, 2005, and a Form 941 for the period ending December 31, 2004, which was filed on January 31, 2005. The IRS assessed the taxes on March 28, 2005 and May 23, 2005. On March 1, 2016, the government sued the taxpayer to reduce the tax debt to a judgment. This would allow the government to continue to try to collect the unpaid taxes beyond the normal 10-year collection statute.
The IRS’s collection statute is generally 10 years from the day the tax is assessed. So it would seem that the 10 year period had lapsed by the time the government brought suit to collect the taxes. There are several actions that can extend the statute. The rules that extend the statue when the taxpayer submits an offer in compromise were considered in this case.
The offer in compromise is a formal administrative process for submitting a proposal to settle unpaid taxes. The statute of limitations rule for offers says that the IRS’s 10-year collection statute is suspended while an offer-in-compromise is pending and for thirty days after any rejection or appeal of the rejection.
In the Kidwell case, the IRS provided records showing that an offer in compromise was submitted, but it could not produce the offer or any other evidence about the offer having been submitted. The government conceded that the IRS destroyed the administrative records.
One would think that taxpayers who are trying to run out the statute of limitations would know whether they submitted an offer in compromise. That was not the case here. The taxpayer did not recall submitting an offer in compromise:
all of the deposition testimony that defendant points to states that defendant and his agents could not recall whether defendant submitted an offer-in-compromise. Defendant testified that he did not handle the taxes for the business, he “would only be guessing” whether an offer-in-compromise was filed, and it was “a possibility” that his accountant filed an offer for him. (Kidwell Dep. 64:17-65:21.) Defendant’s accountant, Ms. Kendall, stated that she “didn’t even remember [they] did an offer for [defendant].” (See Luoma Decl., Ex. B 52:5-8 (Docket No. 13-3).) Defendant’s business secretary, when asked whether she was aware that defendant made an offer-in-compromise, admitted that she was not the person who was corresponding with the IRS and was “not aware of an Offer in Compromise that [Ms. Kendall] would have made.” (Id., Ex. C 48:6-49:10.)
The Taxpayer argued that these facts created a triable issue and that it should get its day in court to prove these items. The court did not agree. The court concluded that this evidence did not create a triable issue of material fact as to the tolling or expiration of the statute of limitations. As such, it ruled in favor of the government.
It should also be noted that the Taxpayer argued that the tax liability was his wife’s, which means any offer would have been submitted for her and not for him. We have seen the IRS do this. It is a common practice. The IRS also does this with bankruptcy holds. The court was not presented with expert testimony explaining this and, as such, it did not find this argument persuasive.
In Scheurer v. Commissioner, T.C. Memo. 2017-36, the court denied a bad debt deduction for a loan that an unrelated third party would not have made given that the borrower had bad credit. This is one of the factors the courts consider in deciding whether a bad debt deduction is allowable. The case adds to the substantial body of law that helps clarify what facts are needed to support a bad debt deduction.
The IRS will often assert trust fund recovery penalties against anyone who signs checks written on the business checking account. The court addressed this in Shaffran v. Commissioner, T.C. Memo. 2017-35, concluding that some check signing activity alone is not sufficient to impose a trust fund recovery penalty. The case provides some insight as to how the IRS assesses these penalties.
The facts and procedural history are as follows:
- The case involved unpaid employment taxes for a restaurant.
- The restaurant had gone out of business before the IRS began its review of the unpaid employment taxes.
- The IRS revenue officer assigned the case spoke to the former landlord and was told that Mr. Shaffran was the bookkeeper for the restaurant.
- This was the sole information the IRS revenue officer used to determine that Mr. Shaffran was a responsible person and liable for the trust fund recovery penalty.
- The IRS mailed Mr. Shaffran a letter letting him know that the IRS was assessing the trust fund recovery penalty against him, but the letter was intercepted by the restaurant owner and not received by Mr. Shaffran.
- Mr. Shaffran was not the bookkeeper. The facts suggest that he was basically a friend of the individuals who owned the restaurant who assisted with the restaurant occasionally.
- This help included writing four checks from the business checking account when the owners were on vacation.
- The IRS issued an administrative summons to the bank to obtain the restaurant’s checking account records and confused the owner’s signature on the checks with Mr. Shaffran’s signature.
The issue for the court was whether these facts justify holding Mr. Shaffran liable for the trust fund recovery penalty. This turned on whether he had the ability to pay other creditors in lieu of the IRS. The court concluded that he did not:
The preponderance of the evidence establishes that petitioner lacked sufficient control over Restaurant Group’s affairs to avoid the nonpayment of its employment taxes during the tax periods in question. Petitioner was not an officer, director, employee or owner of Restaurant Group at any time. He was never an authorized signatory on Restaurant Group’s bank accounts. It is also clear from petitioner’s credible testimony and the administrative record that he: (1) did not have the authority to hire and fire Restaurant Group’s employees; (2) had no duty to, and did not, review or reconcile Restaurant Group’s bank statements; and (3) had no control over disbursements and decisions pertaining to Restaurant Group’s bank accounts, including the payroll account. Furthermore, there is no evidence that petitioner had any involvement in the preparation or filing of Restaurant Group’s employment tax returns or the payment of its employment taxes.
This case is an instance where the penalties should not have been imposed based on an unconfirmed statement that the person was a bookkeeper and corroborated by a mistaken belief that the person signed checks for the business. These are facts that a proper investigation would have disclosed. The IRS revenue officer assigned to the case did not do this investigation and their front line manager did not ensure that the revenue officer worked the case properly.
On appeal, the IRS settlement officer proposed to place the case in currently not collectible status and to abate the penalties for several of the tax periods. The settlement officer should have recorded these facts and proposal in an appeals memo or case closing record. Either this was not done (or the memo or closing record was vague) or the appeals team manager did not review the file properly before closing the case. The case may even have been sent to IRS review in collections or in appeals, which would mean that the reviewer or reviewers did not have enough information in the file to see the issue or they missed it. All-in-all, this means there were four to six IRS employees tasked with ensuring that the correct result was reached and, given the court decision, every one of them failed Mr. Shaffran.
The case serves as a reminder that the IRS is not perfect. IRS employees make a lot of decisions and they often do so with limited and flawed information. It is up to taxpayers to be vigilant and be willing to push back even when their case is reviewed by several different IRS employees at different levels within the IRS. With the trust fund recovery penalty, in particular, taxpayers should not accept that they are liable for the penalty just because they signed a few checks.
The Sixth Circuit Court of Appeals upheld the IC-DISC Roth IRA tax strategy in In Summa Holdings, Inc. v. Commissioner, No. 16-1712 (2017). This tax strategy allows business owners to sidestep the annual Roth IRA contribution limits, thereby allowing the taxpayers to amass sizable amounts in their Roth IRAs to grow tax-free. The case is noteworthy as it addresses the limits of the IRS’s ability to use the substance over form doctrine to recast otherwise legitimate tax strategies.
The Facts & Procedural History
The facts and procedural history of the case are as follows:
- The case involved a family-owned manufacturing business.
- Two of the owner’s children established Roth IRAs in 2001 and contributed $3,500 to each IRA.
- Each Roth IRA then purchased shares in a newly created legal entity (“DISC Entity”) in 2001 for $1,500.
- The family formed another legal entity that purchased the DISC Entity (“Holding Entity”).
- So the Roth IRAs each owned 50% of the Holding Entity and the Holding Entity owned 100% of the DISC Entity.
- The family business paid more than $5 million in commissions to the DISC Entity.
- The DISC Entity distributed this $5 million commissions as dividends to the Holding Entity.
- The Holding Entity paid a 33% income tax on the $5 million dividends and distributed the amounts to the Roth IRAs.
- The IRS issued notices of deficiency to the family business for 2008, arguing that the amounts paid to the DISC Entity were not commissions but rather dividends. This precluded the use of the IC-DISC rules. This also resulted in the family business not being entitled to the deductions it took for the commissions it paid.
- The IRS’s notice of deficiency was based on the substance over form doctrine.
- The U.S. Tax Court agreed with the IRS’s determination.
On appeal, the court was tasked with deciding whether the substance over form doctrine should be used when the actual transactions complied with the law and were consistent with the Congressional intent underlying the relevant tax statutes.
The IC-DISC Rules
The IC-DISC rules are intended to be an incentive for taxpayers to export U.S. products. It accomplishes this by allowing the business to deduct commissions paid to an entity set up to receive the commissions and the entity that receives the commissions may be able to pay tax on the income at the lower dividend tax rate. The resulting tax reduction can prove to be a significant monetary incentive for U.S. manufacturers. The tax reduction can be even greater when, as in this case, the IC-DISC is combined with a Roth IRA–assuming the arrangement is upheld by the courts.
The Importance of Tax Reduction Statutes
This brings us back to the case at hand. The IRS argued that it should be allowed to disregard the formalities of the Roth IRA-IC-DISC transaction, which satisfied the formalities of the law requirement as the transaction complied with the law, to look to the substance of the transactions. To the IRS, the substance of the transaction was to avoid the annual Roth IRA contribution limits.
The appeals court did not agree. The appeals court focused on the fact that the Roth IRA and IC-DISC rules are tax reduction statutes. Congress made it clear that these statutes were intended to be used by taxpayers to reduce their tax liabilities:
Congress designed DISCs to enable exporters to defer corporate income tax. The Code authorizes companies to create DISCs as shell corporations that can receive commissions and pay dividends that have no economic substance at all. See 26 C.F.R. § 1.994-1(a); Addison Int’l, Inc. v. Comm’r, 887 F.2d 660, 666 (6th Cir. 1989); Jet Research, Inc. v. Comm’r, 60 T.C.M. (CCH) 613 (1990). By congressional design, DISCs are all form and no substance, making it inappropriate to tag Summa Holdings with a substance-over-form complaint with respect to its use of DISCs. The same is true for the Roth IRAs. They, too, are designed for tax-reduction purposes.
When the Substance Over Form Doctrine Applies
According to the appeals court, the substance over form doctrine should only apply to transactions that are a labeling game sham (i.e., calling a dog a cow and seeking an incentive that applies to cows) and transactions that defy economic reality. The substance over form doctrine is not to apply when two potential options for structuring a transaction lead to the same end and the taxpayers choose the lower-tax path, when these types of tax reduction statues are in question.
In Estate of Hake v. United States, No. 1:15-CV-1382 (M.D. Pa 2017), the court considered whether relying on an attorney for when a tax return had to be filed, rather than relying on the attorney to file the tax return, was reasonable cause. The case should make it easier to get failure-to-file penalties removed for taxpayers in Delaware, New Jersey, and Pennsylvania and will no doubt be cited by taxpayers in other states as well.
In Hake, the taxpayer hired an attorney. The attorney told the taxpayer that they had obtained an extension of time to file their tax return. The taxpayer then filed their return within the time period specified by the attorney. The attorney was mistaken as to the extended filing deadline, however. The law is clear that the extension was only to pay, not to file. The IRS assessed a failure to file penalty. The attorney admitted his error. The court considered whether taxpayer’s reliance on the attorney’s error was reasonable cause.
There is no bright line rule that defines the term “reasonable cause.” There is no succinct summary that can even defines the contours of what facts may qualify for reasonable cause. Instead, there is only a body of case law that largely says what is not reasonable cause. So one can only rely on court cases that say what is not reasonable cause to establish reasonable cause given different facts.
Most attempts to define reasonable cause are framed in terms of the Supreme Court’s United States v. Boyle, 469 U.S. 241, (1985) decision. Boyle stands for the proposition that a taxpayer cannot establish reasonable cause by simply delegate their filing obligation to an attorney who fails to file on time. As noted in Hake, the Boyle case does not go any further than this.
Categories of Late Tax Return Filing Cases
The court in Hake identified the following three types of late tax return filing cases:
In the first category consists of cases that involve taxpayers who delegate the task of filing a return to an agent, only to have the agent file the return late or not at all. Id. (citing Boyle, 469 U.S. at 249-50). In Boyle, the Supreme Court held that in such cases, reliance upon one’s attorney to file a timely tax return was not reasonable cause to excuse the late filing. Id. The second category of late-filed cases identified in Boyle, as that decision is construed by the court of appeals in Thouron, is where a taxpayer, in reliance on the advice of an accountant or attorney, files a return after the actual due date, but within the time that the taxpayer’s lawyer or accountant advised the taxpayer was available. Id. Finally, in the third category are those cases where “an accountant or attorney advises a taxpayer on a matter of tax law[.]” Id. (quoting Boyle, 469 U.S. at 251) (emphasis in Boyle).
With respect to the second and third type of cases, the court noted that:
…the holding of Boyle does not reach the very circumstances of this case, where the executors did not delegate their filing duty to their lawyer, but where they did rely upon their lawyer to advise them when their taxes needed to be paid and their return filed….
in Boyle the Supreme Court expressly declined to address the question of whether a taxpayer demonstrates “reasonable cause” when, in reliance upon the advice of counsel, the taxpayer files a return “after the actual due date but within the time the adviser erroneously told him was available.”
The court also noted the split in authroity for this issue:
In reaching this result, we recognize that some other courts have interpreted Boyle in the manner urged by the United States, and on facts that are substantially similar to those presented in this case. See, e.g., Knappe v. United States, 713 F.3d 1164 (9th Cir. 2013); West v. Koskinen, 141 F.Supp.3d 498 (E.D. Va. 2015).
The Ninth Circuit includes California, Arizona, Nevada, Oregon, Washington, Montana, and Idaho.
Accrual method taxpayers generally must recognize advance payments in taxable income in the year of receipt, because receipt satisfies the all events test. The trading stamp rules are an exception to this all-events test. These rules apply to businesses that have customer loyalty programs.
The rules can result in significant tax deferral as they allow the taxpayer to receive income now and defer recognition of a portion of the income to a future date when the customer takes advantage of the loyalty program. For example, if the taxpayer sold merchandise for $100 and issued 10 points to the customer as part of its loyalty program, the trading stamp rules would say that a portion of the $100 is for the 10 points and, based on mathematical calculations, it is not likely that all 10 of the points will be redeemed in the current year. So the trading stamp company rules allow the taxpayer to defer part of the $100 of income they received to account for this reality.
There is little guidance that addresses trading stamp companies, which is surprising given the large amounts that are at stake. This brings us to the topic of this post. The IRS recently issued Attorney Memo 2017-002 to clarify its position that hybrid coupons are discount coupons that do not qualify for this tax deferral.
The Trading Stamp Company Rules
The trading stamp company rules are found in Sec. 453 of the Code. They generally say that a trading stamp company can subtract from income both (1) the cost of merchandise, cash, and other property used for redemptions in the taxable year and (2) the net addition to the provision for future redemptions during the taxable year. It is this second element that can result in the tax deferral and savings, as it allows the accrual to be subtracted from income in the current tax year and deferred to a later year. This can be particularly beneficial if the coupons, points, etc. for the customer loyalty program are not redeemed for several years.
This begs the question as to what type of loyalty programs qualify. There has been little guidance on this issue. The IRS’s recent AM 2017-002 address this topic by considering the difference between premium, discount, and so-called hybrid coupons offered by loyalty programs.
Premium coupons are specifically listed as qualifying in Sec. 453. They are not defined in this code section, however. In AM 2017-002, the IRS provides a definition by looking to the explanation provided by the Joint Committee on Taxation:
A premium coupon … generally is issued in connection with the sale of some item and entitles the holder to tender it (or, more usually, a large number of such coupons) in exchange for a product, often selected from a catalog, of the consumer’s choosing. These coupons are used to promote the sale of the product with which the coupon is issued by allowing the consumer to collect coupons in order to acquire a different product.
The coupon is used to acquire a different product than the one being purchased when the coupon is issued. It is used to get a free product.
According to the IRS’s AM 2017-002, a premium coupon is different than a discount coupon. The IRS’s memo defines a discount coupon by looking at former Sec. 466, which has been repealed:
A discount coupon is a sales promotion device used to encourage the purchase of a specific product by allowing a purchaser of that product to receive a discount on its purchase price. … A discount coupon normally entitles its holders to receive nothing more than a reduction in the sales price of one of the issuer’s products. The discount may be stated in terms of a cash amount, a percentage or fraction of the purchase price, a ‘two for the price f one’ deal, or any other similar provision. A discount coupon need not been printed on paper in the form usually associated with coupons; it may be a token or other object so long as it functions as a coupon.
The IRS notes that discount coupons apply to a specific product. The focus is on a discounted product.
The IRS’s AM 2017-002 goes on to define hybrid coupons as being a mix of premium and discount coupons:
[H]ybrid coupons can be viewed as discount coupons allowing a member to acquire enough coupons to receive a discount off the purchase of a product. After a member has acquired a sufficient number of hybrid coupons to receive a discount on the purchase of an item, the member may also continue accumulating coupons until the purchase price is reduced to zero. However, the fact that a discount coupon may be accumulated in sufficinet quantities to result in a free product does not alter the nature of the coupon as a discount coupon. Thus, hybrid coupons are more properly characterized as discount coupons and are not premium coupons under section 1.451-4 because the nature of hybrid coupons, like discount coupons, is that of a price reduction.
The IRS memo concludes that hybrid coupons are more akin to discount coupons and, as such, they do not qualify for the trading stamp company rules.