Although stirring courtroom drama is typically limited to movies and television shows, true life Tax Court rulings often hold stimulating results for accountants. Decisions by the Tax Court can illuminate proper handling of complex matters from CPA review courses. Sometimes, an appellate district court is responsible for rendering clarity to troubling subjects. An especially complicated area of tax accounting that is often settled in court entails S corporations.
Key features of S corporations are better understood by showing how courts have ruled on shareholder actions that are challenged by the IRS. Brief descriptions of the cases read like questions on a sample CPA test. Therefore, an overview of major tax litigation involving S corporations provides considerable enlightenment.
S corporation tax cases are caused by the tax benefits available from these structures. Information in courses for CPA study delivers a foundation of knowledge about these S corporation characteristics. For example, qualification for S corporation status is dependent upon maintaining a limited number of shareholders with only one class of stock. Ownership is limited to U.S. citizens, resident individuals, estates, certain trusts, some pension plans (not IRAs), and most tax-exempt charitable organizations. Election procedures are required for S corporation status. If any of these are conditions is not met, the S election status is terminated. Corporations may request that the IRS reinstate inadvertent terminations.
The IRS imposes restrictions on how S corporations are allowed to enjoy tax advantages. The D’Errico case demonstrated the danger of using an S corporation as a tax sheltered operation for paying personal expenses. The IRS won the argument in court that the corporation’s payment of personal bills comprised disguised dividends.
The taxpayer in D’Errico also claimed to have borrowed from several S corporations. The court treated the so-called repayments as distributions, which reduced his stock basis. That limited the amount of pass-through corporate loss he was allowed to deduct against other income. This reflects the importance of S corp basis calculations during CPA exam preparation.
Taxpayers who fund S corporations with money from related entities have been the focus of both court cases and recently proposed new IRS regulations. For instance, a bona fide loan from a taxpayer’s partnership to his S corporation creates basis. However, guarantee of S corp debt by a shareholder does not create basis unless and until the guaranteeing taxpayer actually pays part of the loan.
In Welch, an S corp received funding from a non-shareholder. Lack of contemporaneous records, no payments to the lending party, and no debt collection effort doomed the taxpayer’s argument that his guarantee of the loan represented an upward basis adjustment. Conversely, the IRS lost the Maguire case, where the court allowed shareholders to contribute assets from their profitable S corporation to their unprofitable S corp, thereby increasing their basis in the latter. This allowed shareholder deduction of loss in the unprofitable corporation.
Much of the trouble for S corporations is abuse of the ability for a shareholder/employee to receive some compensation as wages plus other amounts as non-taxable distribution of earnings. The Watson case was a particularly egregious exploitation. The S corporation shareholder received only a $24,000 salary, compared to over $200,000 of distributions. The court’s judgment against Watson echoed similar trials where shareholders attempted to evade Social Security taxes by paying distributions instead of wages.
Correct use of an S corporation by shareholders commonly depends upon expertise of accountants. Plenty of elements from CPA review aid in evaluating S corporation arrangements. Watson’s litigation is notable because he is a CPA. However, Watson presents no future hazard for delivering poor advice to S corporation clientele. He was reportedly stripped of his CPA license.
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.