Originally published on Forbes.com Sept 18th, 2014
You can get yourself in a lot of trouble writing a check without the funds to cover it. But if you write the check to yourself and never cash it what’s the harm? And who’s going to know? Robert F. Vanney of Vanney Associates Inc. found that it can be awfully expensive. It was actually Vanney Associates that wrote the check to Mr. Vanney, but since he is the sole stockholder, chief executive officer, chief financial officer, vice president of marketing, vice president of operations, and director of human resources, it’s a lot like he wrote the check to himself.
The Travails Of The Professional C Corporation
Vanney Associates was a C Corporation. It is also a professional corporation (architecture), so profits are taxed at the maximum corporate rate from dollar one. As is typical for such corporations, any profits remaining would be paid out to the shareholder as a sort of bonus at year end. I have to say that this is one practice that I am very familiar with, although not that much recently. Near year end, there can be a temptation to kind of not be in such a rush to deposit receipts in late December. In the really old days (prior to 1986), you would want to leave enough profit in the corporation to cover whatever investment credits or job credits had been generated. It got a little tricky.
One of the problems, you could run into sometimes is that taxable profits do not equal cash flow. There might be items that were capitalized or non-deductible expenses that throw things off. In the professional corporation that had me as one of the shareholders, the non-deductibles over the years became as we say “a number”. The solution was to borrow money to pay out profits that were not supported by cash. The corporation was still fiscally sound, because there were plenty of receivables, which were mostly good, but on an income tax basis it became more and more upside down as the years went by. When we merged into a partnership, it took some fancy footwork to deal with the problems.
Mr. Vanney’s situation was actually somewhat simpler than many that I have encountered. A sole stockholder is in a much better position to control things than a professional firm with multiple partners. His bonus for the year 2008 was $815,000. It is being disallowed as a deduction to the corporation, because the corporation did not have enough in its account to cover Mr. Vanney’s net check. I have to tell you this situation makes me a little crazy.
Did The Tax Court Get It Right?
I’m not sure that the Tax Court was right to deny any of deduction, but I really question whether the whole deduction should be denied :
On December 30, 2008, Vanney Associates paid Mr. Vanney a yearend bonus totaling $815,000. After withholding and paying to the IRS the appropriate Federal income, Social Security, and Medicare taxes, Vanney Associates wrote a check to Mr. Vanney for $464,183. Mr. Vanney signed the check on behalf of Vanney Associates and then endorsed the check in his own name and made it payable to Vanney Associates. He never attempted to cash the check. Ms. Vanney recorded the payment on the books as a loan from Mr. Vanney, and Vanney Associates repaid Mr. Vanney in March 2009.
Although Vanney Associates wrote Mr. Vanney a check for over $460,000, on December 31, 2008, the total balance in Vanney Associates’ bank accounts was $389,604; the balance was $283,033 after adjusting for outstanding deposits and checks. Mr. Vanney testified that he “believe” he knew that Vanney Associates did not have the funds necessary to honor the check. However, he maintained that Vanney Associates could have gotten a loan to cover the check.
Most of that $464,183 must have been federal withholding that Mr. Vanney would have taken credit for on his 2008 individual income tax return. So I think there is a pretty good argument that he got paid at least that much.
Monday Morning Quarterbacking
When I think of the simple things that might have avoided this problem, it makes me want to cry. Mr. Vanney indicates that the corporation could have easily borrowed the money. So how much would a $200,000 loan for a month or two have cost? Considerably less than over a quarter of a million dollars in corporate tax. Alternatively, he could have taken a $400,000 bonus in early December, cashed the check and made a formal documented loan to the company. Then there would have been enough cash to pay out the balance at the end of December.
There is even a last minute solution that occurs to me. Instead of cutting a net check for $460,000, make the net check for $250,000 which is deposited in Mr. Vanney’s account to be loaned back if necessary in January. For the balance of the net pay instead of just making a book entry, have the corporation issue a negotiable promissory note. Even if the negotiable promissory note, which I think should work, does not stand up, at least, most of the deduction is safe.
Tax Geek Puzzle
The other thing that is giving me a headache about this case is how to totally unscramble this egg. It seems that even if the statute was not extended on Mr. Vanney’s 2008 Form 1040, that he qualifies for equitable relief under Section 1312 reducing his salary for 2008 by $815,000. How do you account for those withholdings though?
Other Coverage
Joe Kristan also wrote about this case. He tells about recommending an S election to someone, who said that it was not needed since they were essentially doing what Mr. Vanney did in this case. An interesting side note to this case is that the corporation was formed in 1987, so you have to wonder why it was not an S Corporation from day one.
Several years ago I wrote about a CPA firm that got into serious trouble using a C corporation in their practice. As you might expect it was quite a bit more convoluted, but it still might be worth a look.
Will There Be An Appeal?
I was surprised that the opinion did not have a more expansive discussion of the state law implications of the uncovered check. The judge just blithely says that the only thing that could be done with it would be to loan it back to the corporation. What if Mr. Vanney could find someone that would say, knowing all the facts, he would have given him close to face value for the endorsed check with the understanding that it would not be deposited until a week or two later, making the check, in effect, a negotiable promissory note.
We’ll have to wait and see.
And One More Moral
I’ve probably made as many journal entries as most accountants around my age. What tremendous power there is in wielding that mighty pencil over the green paper. Sadly my years of reading tax decisions have brought me to the conclusion that journal entries mean almost nothing to anybody other than other accountants.
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