Proper tax planning and tax preparation considerations require that all taxpayers take the necessary steps to properly document their transactions. Failure to document transactions can lead to unintended results with the IRS. Taxpayers often fail to take the necessary steps for various reasons, including the belief that they are too busy, will address it “tomorrow”, don’t want to incur a fee to address the issue with their CPA, “everyone else does it” mentality, believing that the chances that the IRS would challenge this are remote, a total disdain for documentation, or believing that they can correct the situation at a later date.
Let’s take a peek at a recent court case that discusses what happens when substantiation and documentation are lacking (Glass Blocks Unlimited v. Commissioner, Dec. 59,600(M), TC Memo. 2013-180). The president of an S Corp. was its sole shareholder and only full-time employee. In 2007 and 2008, the president transferred funds to his S Corp. to fund its operations. The corporation considered these advances as loans. During these same years, the corporation distributed funds to the president which were not reported as wages or distributions since the president considered these repayments of loans from his company to him. During these years, the S Corp. did not issue Forms W-2, Wage and Tax Statement, Forms 1099-MISC, Miscellaneous Income, or file any Forms 941, Employer’s Quarterly Federal Tax Return. The president did not report the S corporation distributions on either his 2007 or 2008 income tax returns.
While many a business person would agree that the treatment by the president and his company were proper, the IRS did not concur and found that the payments were wages. The Tax Court agreed with the IRS that the payments to its president and sole shareholder were wages subject to employment taxes, not dividends or repayments of a loan, and that the prior transfers by the president to the S Corp. were capital contributions, not loans. The Court dismissed the taxpayer’s argument that reclassifying the payments as wages would create unreasonable compensation, stating that the issue of reasonable compensation also applies with when determining whether payments are wages or some other type of distribution. The Tax Court cited David E. Watson, P.C. v. United States, CA-8, 2012-1 USTC ¶50,203, where a business paid its owner-employee an unreasonably small salary of $24,000 at the same time it distributed more than $200,000 in profits.
Reading court cases can be very educational and informative as the cases outline what the courts look at in arriving at their decision. The Tax Court considered a non-exclusive list of 13 factors described in Calumet Industries, Inc. v. Commissioner, Dec. 46,872, 95 TC 257. These factors included: the names given to the evidence of indebtedness; the absence of a fixed maturity date or other characteristics of a loan; the parties’ intent; and the risks to the parties making the advances.
There were no written agreements or promissory notes supporting the argument that the transfers were loans, the Tax Court stated, and the S Corp. did not report the 2008 transfer as a loan on that year’s return. There was no evidence that the president required interest for the use of the transferred funds, that the S Corp. provided any security on the loan, or that the parties had created a fixed repayment schedule. The Tax Court found that, because the expectation of repayment depended solely on the success of the S corporation’s business, the transfers of funds were a capital contribution, not a loan.
In summary, looking at the facts of this case illustrates what the IRS and the courts look at and how (and why!) taxpayers need to substantiate their deductions or tax transactions. The next time your CPA asks for an explanation of a transaction, requests what documentation you have to support a transaction, or proposes to make changes to your books and records, rather than finding these as an annoyance, instead thank him/her for their expert tax guidance.
Note: Because each individual’s and company’s tax situation is different, if you want to learn more about the IRS’s reasonable compensation requirements we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here. To learn more about various tax and business services, visit Tax Preparation Services and Small Business Accounting Services
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