Thursday, September 24, 2020
Two recent Tax Court opinions provide good guidance on some important issues associated with S corporation concepts and the need to substantiate meals and entertainment expenses.
Two recent Tax Court opinions and planning points for practitioners and taxpayers – it’s the focus of today’s post
Ownership of S Corporate Stock
General principles. A “qualified corporation,” with the consent of all its shareholders, can elect to be treated as an S corporation for tax purposes. Once the election is made, the entity is treated as a passthrough entity for federal income tax purposes. I.R.C. §§1361-1366. That means that an S corporation, unlike a C corporation pays no federal income tax at the corporate level. Instead, a shareholder of an S corporation must report a pro rata share of the S corporation’s taxable income, losses, deductions, and credits on the shareholder’s personal return. I.R.C. §1366(a)(1)(A); Treas. Reg. § 1.1366-1(a). See also Gitlitz v. Comm’r, 531 U.S. 206 (2001), rev’g 182 F.3d 1143 (10th Cir. 1999); Maloof v. Comm’r, 456 F.3d 645, 647 (6th Cir. 2006). The treasury regulations further provide: “Ordinarily, the person who would have to include in gross income dividends distributed with respect to the stock of the corporation (if the corporation were a C corporation) is considered to be the shareholder of the corporation.” Treas. Reg. §1.1361-1(e)(1). In essence, whether a person is a shareholder on the date of the S election is determined by whether that person would have to report as personal income corporate profits as of the election date. Cabintaxi Corp. v. Comm’r, 63 F.3d 614 (7th Cir. 1995); Treas. Reg. §1.1371-1(d)(1). The answer to that question, in turn, revolves around whether the person would have been deemed a beneficial owner of the corporate shares. See, e.g., Pahl v. Comm’r, 150 F.3d 1124; Wilson v. Comm’r, 560 F.2d 687 (5th 1977). A beneficial owner is entitled to demand from the nominal owner the dividends or any other distributions of earnings on those shares. Id. Beneficial ownership of corporate stock is determined by state law. See United States v. National Bank of Commerce, 472 U.S. 713 (1985).
Nonprofit corporations. As a general rule, a nonprofit corporation is not considered to have owners. See Farrow v. Saint Francis Medical Center, 407 S.W.3d 579 (Mo. 2013). This is because members of a nonprofit corporation are barred from receiving residual earnings, assets or property from the corporation. See Hansmann, “Reforming Nonprofit Corporation Law,” 129 U. Pa. L. Rev. 497 (1981); see also Austin v. Michigan Chamber of Commerce, 494 U.S. 652 (1990).
In a recent Tax Court case, Deckard v. Comm’r, 155 T.C. No. 8 (2020), the petitioner created a nonstock, nonprofit corporation in 2012 and was named as its president and one of its three directors. However, the corporation never applied for recognition of tax-exempt status with the IRS. In late 2014, the corporation mailed Form 2553 to the IRS seeking to elect S status retroactively to its 2012 incorporation date. The petitioner signed Form 2553 in his capacity as president. He also signed the shareholder’s consent statement indicating that he was the sole owner of the corporation. The corporation filed an S corporate return (Form 1120S) for tax years 2012 and 2013 on which it reported operating losses of $277,967 and $3,239 respectively, and issued Forms K-1 for the losses that flowed through to the petitioner.
In May of 2015, the petitioner filed his personal returns for 2012 and 2013. Neither return was filed timely, and both claimed the losses that flowed through from the corporation. The IRS denied the losses on the grounds that the S-election was invalid. The IRS also claimed that the petitioner was not a corporate shareholder. On the latter point, the Tax Court noted that the petitioner was not a shareholder of record and the corporation was not authorized to issue stock. In addition, there was no evidence that any stock had been issued.
The Tax Court also pointed out that a nonprofit corporation generally does not have shareholders, is not owned by third parties and there is no interest in a nonprofit corporation that is similar to that of a for-profit corporate shareholder. The petitioner also did not possess shareholder rights, had no ownership, had no right to profits, no dissolution rights and no right to corporate assets upon dissolution. In essence, the corporation was a state law nonprofit corporation controlled by a board of directors on which the petitioner only had one vote out of three. The Tax Court also noted that he would be bound by the form of the transaction that he chose, and he chose the nonprofit corporate form. As a result, he had to accept the tax consequences that flowed from that choice. Clearly, the petitioner should have filed Form 1023 to achieve tax-exempt status for the corporation.
Meals and Entertainment
The Tax Cuts and Jobs Act (TCJA) changed the rules on deductible meals and entertainment. For farming and operations, the tax rules governing meals often come into play at harvest. An example would be for part-time workers that are employed at times of planting and harvest. These part-time employees may be fed lunches on the farm. Before 2018, meals were normally deductible to an employer at 50 percent of the cost of the meals. But, where the meals are provided on the employer’s premises (i.e., at the farm) and for the convenience of the employer, the meals are 100 percent deductible by the employer and the employees do not have to report any of the amount of the meals as income. The 100 percent deduction is because farm workers generally work in remote areas where eating facilities are not near, and the farm employer finds it a more productive use of time to supply meals at the farm.
Under the TCJA, the 50 percent rule still generally applies to allow an employer to deduct 50 percent of the (non-extravagant) food and beverage expenses associated with operating the business (e.g., meals consumed by employees on work travel). I.R.C. §274(k). But, for amounts incurred and paid after Dec. 31, 2017, and until Dec. 31, 2025, the TCJA expands the 50% limitation to expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer. I.R.C. §274(n)(1). That means that the 100 percent deduction for the meals provided the part-time farm employees in the above example is reduced to 50 percent. The 50 percent limitation remains in place through 2025 for meals (food and beverages) that aren’t “lavish or extravagant” and the taxpayer or employee of the taxpayer is present when the meal is furnished. I.R.C. §274(k)(2). Of course, the 50 percent cut-down can be avoided by treating the food and beverages as compensation to the employee (i.e., wages for withholding purposes).
After 2025, none of the cost of meals is deductible.
Through 2017, deductions for entertainment were generally disallowed unless they were directly related to the taxpayer’s business or directly preceded or followed a substantial bona fide business discussion. In those instances, entertainment expenses were deductible at the 50 percent level. Under the TCJA, effective for tax years after 2017, no deduction is allowed for any activity that is generally considered to be entertainment, amusement, or recreation that is purchased as a business expense. Likewise, no deduction is allowed for membership dues for any club organized for business, pleasure, recreation, or other social purposes. Similarly, no deduction is allowed associated with a facility or portion thereof used in connection with the provision of entertainment, amusement or recreation.
Recent case. A recent Tax Court case illustrates the necessity of carefully substantiating meal and entertainment expenses. In Franklin v. Comr., T.C. Memo. 2020-127, the petitioner claimed deductions for meal and entertainment costs and travel expenses. The IRS denied the deductions for lack of substantiation and the Tax Court agreed. The Tax Court concluded that the petitioner failed to provide credible evidence that the expenses were incurred in the operation of his trade or business as I.R.C. §274(d) requires. The Tax Court also held that the petitioner couldn’t claim a deductible loss associated with loans he made to a real estate development company, as well as a loss on computer software that he used in his real estate consulting business.
As for the meal and travel costs, I.R.C. §274(d) disallows a deduction unless the taxpayer has substantiating records concerning the amount, time, place and business purpose for each expenditure. Those records must be contemporaneously made. While that doesn’t mean that a log must be created when the expenditure is incurred, it does mean that records created after-the-fact must be able to be reconstructed in a credible manner so that they are essentially the same as a contemporaneous log. In addition, if business and personal travel is combined, the taxpayer must prove what the primary purpose of the trip is. The Tax Court determined that neither the petitioner’s travel log nor testimony were credible. For example, he created his travel logs created after IRS notified him that he was under audit. That disqualified them as “adequate records” under I.R.C. §274(d). He also failed to establish the business purpose for his travel by distinguishing personal aspects of the travel.
As for the computer property, the Tax Court held that an associated loss wasn’t deductible because the petitioner couldn’t establish his basis in the property. For the loans, the petitioner couldn’t establish that the debt had become worthless. Under I.R.C. §166(a)(1), a deduction is allowed for any debt that becomes wholly worthless within the tax year. Worthlessness is a fact-based determination. Worthlessness cannot be established is the collateral that secures the debt has value. These points doomed the taxpayer’s attempted deduction.
These recent Tax Court cases provide some very good teaching points on some common issues. It’s always best to learn from the mistakes of others rather than learning tough lessons first-hand.