Business owners and their advisers often fail to recognize how perilous S corporations can be. The Sixth Circuit decision in the case of Robert and Kimberly Broz upholding an $18 million deficiency for the years 1996 to 2001 provides some useful lessons.
Journal Entries Are Not All They Are Cracked Up To Be
The lesson for business owners is that it is a very bad idea to use multiple entities without respecting the implications of each entity. Don’t rely on your accountant to straighten every thing out with journal entries. I spent much of the early part of my career making journal entries to move tax effects around among multiple related entities. For the last decade or so, I have at least looked at every federal tax decision and have reached a painful conclusion. The only people who think accountant’s journal entries mean anything are other accountants. Listen to the Sixth Circuit:
Accounting entries that are not contemporaneous with the actual funding advances do not establish the bona fides of the back-to-back loans at the time the advances were made.
In other words, if Mr. Broz wanted the loans to his S corporation to be from him, it would have been best if there had been a check from him to the corporation, a note executed to him by the corporation and regular payments by the corporation to him. This would have entailed a little extra work up front, but obviated the need for post year-end entries that a judge would not respect.
You Can’t Ignore Your Entities
Owners of multiple S Corporations and their advisers remind me of parents, usually fathers, who accidentally pour the orange juice on the Cheerios and then tell the kid to eat it since it is all going to the same place anyway. Besides the basis and at-risk problems, Mr. Broz’s other problem was with amortization deductions. Some of his entities owned FCC licenses that produced amortization deductions under 197. The problem was that the entities that owned the licenses did not do anything themselves. Since they did not have their own trades or businesses, they could not have amortization deductions.
The Tax Court held that an entity must be considered in isolation and not in conjunction with related entities when determining whether the entity is actively engaged in a trade or business; therefore, RFB’s activities had no bearing on whether each Alpine entity was actively engaged in a trade or business. The Tax Court found that because RFB operated the only functioning on-air networks, while none of the Alpine entities operated a functioning network or conducted any other activity for which it was formed, none of the Alpine entities was actively engaged in a trade or business.
There are times where this concept can work in the taxpayer’s favor. A taxpayer might isolate trading dealer type activity in one entity and investor activity in another. The IRS might attack that with a substance over form argument, but you don’t get to do the same thing, since it was you that chose the form.
Basis And At Risk
Quite understandably these concepts get confused. The Sixth Circuit ended up ruling that it did not have to consider the at-risk issue, because in the case of the S corporation, it found that there was no basis. In the case of other flow-through entities, where there would be basis, the Court had ruled that there was no trade or business, so there were really no losses to consider.
Jumping Through The Hoops
If you want to seriously reduce your individual tax liability, the best thing to do is to get a whopping big negative number on one of the lines on the front of your return that go into figuring gross income. All the goodies after that are pretty well,hedged by a lot of restrictions. Much of the complexity in the tax code that drives us crazy is collateral damage from the war against the tax shelters that were designed to produce those negative numbers. The easiest way I have to think about it is that to post the negative number, you have to jump through a series of hoops. The Broz cases illustrates a couple of them. The hoops in order are for-profit, allocation, basis, at-risk, passive activities.
With respect to the amortization deduction, the Court ruled that there was no business there, so Mr. Broz did not make it even through the first hoop for some of his losses. Allocation is about who the loss gets allocated to. That can be very complicated in partnerships, but it is simple in S Corporations – absent a special election it goes per share per day. Allocation was not an issue in this case. Basis is where partnerships shine over S corporations. A partner has basis in the partner’s share of the partnership’s liability.
An S corporation shareholder does not have basis in the liabilities of an S corporation, unless the S shareholder was the one who loaned the money. Ironically an S corporation shareholder can be at-risk in a real economic sense, if not technically, but not have basis by personally guaranteeing the debt of the S corporation. It does no good though since the previous hoop of basis was not jumped through. Passive activity limitations did not enter into this particular case at all, so there was no need to consider those rules.
Should It Be Easier ?
The only defense of the current rules, no small matter to the child of parents who lived through the Depression, is that it gives people work – specifically people like me. Being a good citizen and all, not to mention maybe not having to work as much, I’m all for having unified rules for S Corporations and partnerships, which I discuss here.
You can follow me on twitter @peterreillycpa.
Afternote
Relative to the trade or business issue, it is interesting to not that the Court of Claims took a different view in the case of Hard Rock Cafe founder Peter Morton’s deductions for his jet. It allowed the concept of multiple S corporations being considered a “unified business enterprise” for purposes of determining profit motive.