In an unusual case (Scott Singer Installations, Inc., TC Memo 2016-161 (Tax Ct.)), and a taxpayer victory, the United States Tax Court has ruled that personal expenses paid by a business structured as an S corporation were not compensation to the owner, but rather a repayment of amounts he had loaned the corporation earlier.
The taxpayer in this case was an S corporation named Scott Singer Installations, Inc. The S corporation was wholly owned by its sole corporate officer, Richard Scott Singer. The business was primarily engaged in servicing, repairing and modifying recreational vehicles.
The issue at trial was 1) whether Mr. Singer should be classified as an employee of the S corporation for employment tax purposes for 2010 and 2011 and 2) whether the S corporation’s payment of personal expenses on behalf of Mr. Singer should be characterized as wages subject to Federal employment taxes.
The business, originally incorporated in Florida, was later “reincorporated” in Colorado. After a number of years operating in Florida, the sole shareholder moved the business to Colorado. Later, due to a business downturn, the Mr. Singer returned the business to Florida. To fund operations and the growth of the business as it grew in Colorado and to fund the downturn in Florida, between 2006 and 2011, Mr. Singer advanced approximately $1.16 million to the corporation. In turn, the corporation paid $181,872 of Mr. Singer’s personal expenses.
Mr. Singer had reported all advances as loans on the S corporation’s general ledgers and its income tax returns for all years. The advances were not memorialized in notes or loan documents, nor was there interest charged on any of the advances. Lastly, none of the advances were accompanied by a maturity date.
The payment of personal expenses in the amount of $181,872 were treated on the S corporation’s general ledger and income tax returns as repayments of shareholder loans. As such, the S corporation did not deduct the payments made for Mr. Singer’s personal expenses as compensation.
During the two years at issue, Mr. Singer worked full time for the S corporation and the business occasionally employed a service technician, two laborers and an individual to assist with the company’s Internet sales. The proper payroll tax returns were filed and all employment taxes were paid on wages paid to each employee except Mr. Singer. The S corporation did not report any wages to Mr. Singer in 2010 and 2011.
With respect to the employee classification, the Tax Court found that an employee/employer relationship existed between Mr. Singer and the S corporation. That finding was agreed by the S corporation and Mr. Singer and should not come as a surprise to even the casual income tax observer. He served in the years at question as president of the company, and provided substantial services on its behalf.
The more interesting issue in this case, as noted above, is whether the S corporation’s payments of Mr. Singer’s personal expenses constituted wages subject to employment taxes. The Internal Revenue Service, of course argues that the payments were, indeed compensation while the S corporation argued that they were loan repayments.
The determination of the proper treatment of these payments is a facts and circumstances matter and rests with an interpretation by the Court of those facts and circumstances. The key element from which the Court makes a decision in cases of this type rests with an assessment of taxpayer “intent”. Always difficult to determine, intent often allows for some gray interpretation by the Courts.
In this matter the Tax Court sided with the taxpayer, concluding that even though there were no formal promissory notes, Mr. Singer and the corporation intended to form a debtor-creditor relationship. Therefore, the payments were not subject to employment taxes.
The language of the decision notes that transfers to closely-held corporations by controlling shareholders are subject to “heightened scrutiny”. The Opinion further notes that “the labels attached to such transfers by the controlling shareholder through bookkeeping entries or testimony have limited significance unless the labels are supported by other objective evidence”
In the Court’s analysis, they looked to the relative financial status of the S corporation at the time the advances were made, the financial status of the S corporation at the time the advances were repaid, the relationship between Mr. Singer and the S corporation, the method by which the advances were repaid, and the way the advances were accounted for on petitioner’s financial statements and tax returns.
As a result of these considerations by the Tax Court, it opined that Mr. Singer intended his advances to be loans and that his intent was reasonable for a substantial portion of the advances. Consequently, the Court found that the S corporation’s repayments of the loans are valid and should not be recharacterized as wages subject to employment taxes.
While the result is a good outcome for the taxpayer, an appearance in Tax Court could have easily been avoided by taking two simple actions in this case. First, demand note or loan agreements should have been prepared to document all advances and an interest rate should have been included. Such documentation may have led the Internal Revenue Service to “pass” on further scrutiny. Second, had the S corporation simply made the personal advance repayments directly to Mr. Singer, so that he might have made his own personal expense payments, the latter would not have run through the S corporation’s books and records and likely would have reduced Internal Revenue Service scrutiny.
Planning for advances and repayments in a S corporation scenario, or any organization structure, for that matter, can be tricky and should not be undertaken without exercising due care and obtaining a full understanding of the ramifications.
Should you have comments or questions, please contact Bob Grossman or Don Johnston.
