In Brown v. Commissioner, T.C. Memo. 2017-18, the court addresses whether taxpayers can claim a deduction for taxes paid by a defunct S corporation in the current year when the taxes are owed by the corporation for prior tax years. Many taxpayers do not realize they can claim a deduction for taxes in this situation. The case also highlights the importance of clearly designating how voluntary payments are to be applied by the IRS.
The facts and procedural history are as follows:
- The Browns owned an S corporation.
- The S corporation:
- incurred payroll tax liabilities for 2000 – 2002.
- filed income tax returns for 2000 – 2002.
- was administratively dissolved by the state in 2007.
- did not have any business activities or assets in 2012.
- The IRS assessed trust fund recovery penalties against the Browns for the trust fund portion of the S corporation’s payroll taxes.
- The attorney representing the Browns remitted a check for $215,000 to the IRS with a letter indicating that the funds were to be applied the trust fund penalty.
- The IRS applied the funds to the trust fund penalty.
- The S corporation claimed a deduction for the payroll taxes paid in 2012 on a final tax return remitted for 2012 (The S corproation had not remitted income tax returns from 2003 through 2011).
- The Browns then reported the flow through loss on their indivdiual income tax returns in 2012.
The IRS disallowed the deduction on the Browns’ individual income tax return. It made a number of arguments in support of disallowing the deduction.
Cash Basis Taxpayers Can Deduct Prior Taxes for Then Defunct Business
The IRS argued that the Browns could not deduct the expense as the S corporation was not a trade or business in 2012. While the business had ceased operations in 2002 and was dissolved in 2007, the court noted that the taxpayers, who were cash basis taxpayers, were able to deduct expenses in 2012 that were incurred in prior years in which the business was active. Taxpayers who pay their taxes late should take note of this rule, as this is a tax deduction many taxpayers do not know they can take.
Taxes Must be Paid by the Correct Legal Entity
The IRS also argued that the Browns could not deduct the tax payments as they were not paid by the S corporation. It isn’t described in the facts above, but the Browns had another S corporation and it remitted the funds to the attorney, who in turn remitted the funds to the IRS to pay the taxes. The Browns no doubt paid the taxes this way because the defunct S corporation at issue here did not have its own checking account. The Browns argued that this was intended to be a contribution to the defunct S corporation. The court agreed with the IRS on this issue, nothing that the payment did not originate from the correct S corporation and therefore no flow through deduction was allowed from that S corporation. The court disallowed the deduction on this basis.
Taxes are Deductible, Trust Fund Penalties are Not Deductible
The IRS also argued that the Browns could not deduct the tax payments as payments for penalties are not deductible. The Browns countered by citing the letter from their attorney that accompanied the payment to the IRS, which did not make it clear whether the payment was for the S corporation’s liability or the Browns’ personal liability for the trust fund penalties. The law says that the taxpayer is able to designate how the IRS is to apply voluntary payments like the payment at issue here. If the taxpayer had clearly designated the payment to the S corporation’s employment tax liabilities, the taxpayer may have been able to deduct the taxes (ignoring the payment originating from the wrong legal entity, described above). The court read the letter to say that the funds were to pay the penalties, not the S corporation’s liability. Since penalties are not deductible, the court did not allow the deduction.