Johnson v. Commissioner, T.C. Summ. Op. 21012-13 (February 2, 2012)
Sam Johnson rode the crest of the real estate financing wave and founded Johnson & Associates Mortgage Co., Inc. in 1990. The company wrote single-family residential mortgages in Alabama. Sam was the president, chief operating officer, and chief executive officer. It is unclear, but possible, that he was also the chief financial officer, accounts manager, and receptionist. In any case, as events unfolded, it is clear Sam did not rely upon financial expertise from an accountant with tax knowledge from courses for CPA licensing.
The company had a $1 million line of credit to finance its operations, but by 2001 the creditor was becoming nervous and the line of credit was replaced with a personal promissory note signed by Sam and his father, the principle stockholders of Johnson & Associates. The new promissory note called for interest-only payments until the elder Johnson’s death, at which time the proceeds of a $500,000 life insurance policy would be used to partially pay off the loan. The accounting here gets a little tricky, but nothing beyond the ability of an accountant who completed study for CPA exam completion.
Sadly, the Johnson dad died in 2003. Shortly thereafter the life insurance proceeds were used to pay down the loan and Sam signed a new $500,000 note as an individual, in his capacity as executor of his father’s estate, and as president or Johnson & Associates (he had called in sick as chief operating officer and chief executive officer that day). Upon maturity of the note, Sam dutifully paid the balance due from his personal checking account.
Almost as sadly, Johnson & Associates made no money and, in fact, experienced a loss of approximately $1 million. Sam took this loss on his personal return, reasoning that he should get the deduction because he had to personally guarantee the loan.
“Au contraire,” said the IRS, or at least that’s what they would have said if they could speak French. ”You were not a guarantor of the loans,” they are more likely to have said to Sam, “but instead you were primarily liable for each of them in your personal capacity and deductions are not permitted on account of the repayment of personal loans.”
“But we’re all really one and the same thing,” said Sam (or at least we can imagine he did). Sam insisted that the activities of himself, his father, and the company were really just one common enterprise – a contradiction of the accounting facts recognizable from any CPA review course. He “felt a moral obligation, in addition to the legal obligation” to repay the loan (an actual quote) and did not see any practical distinction between himself and the business, using the “royal we” to refer to the enterprise throughout the case. “Too damn bad,” the Tax Court said (or again, would have said if they spoke French), “The repayment of the loan does not morph into a deductible expense just because you made the payment to protect your reputation.” Now Sam is even sadder.
Background
Business deductions are only allowed for the ordinary and necessary expenses of carrying on an activity that constitutes the taxpayer’s trade or business. While it is true that the performance of services as an employee constitutes a trade or business, and that expenses incurred in that capacity are deductible (on Schedule A as miscellaneous itemized deductions subject to the 2% floor), the difference between an employee and the corporation for whom he or she works must be respected. Mitt Romney is right, at least from a technical legal standpoint – corporations are considered to be “persons” under the law. Accountants understand from their CPA courses to treat corporations as distinctive tax entities from their owners. Unlike partnerships which are, conceptually at least, really nothing more than “sole proprietorships,” the corporation’s separate legal personality cannot be conflated with that of its owners, employees, or anyone else, no matter in how many capacities they may serve.
No matter how close someone associates themselves with a corporation – even if they are the sole shareholder, director, officer, and employee, the corporation is still a distinct person. More importantly, the corporation is a distinct taxpayer, and other taxpayers may no more deduct the payment of corporate expenses on their individual returns than they may deduct their neighbor’s mortgage interest expense. When a stockholder pays corporate expenses, such payments are either capital contributions or loans to the corporation and are deductible, if at all, only by the corporation. Universal standards taught in CPA exam courses are deployed to account for these events.
Furthermore, a corporation that qualifies and elects to be subject to Subchapter S does not cease to be a corporation by virtue of that election. The term “S corporation” identifies a tax, not legal, status. The same is true of a single member limited liability company or a qualified S corporation subsidiary. Although they may be “disregarded” for purposes of tax reporting, that doesn’t make them disappear.
Like Sam, closely-held business owners often think of themselves and the corporate or corporate-like entities they own as if they were one and the same, and it behooves tax professionals to disabuse their clients of this notion. Poor Sam Johnson found this out the hard way, as have other taxpayers in a variety of different contexts. The commonly uttered phrase “I am incorporated” is the legal equivalent of “I am the walrus.” Corporations are, indeed, people my friends.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.
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