Last week, we considered the proper tax treatment for a transfer of funds from a parent corporation to its foreign subsidiary. The parent had argued, unsuccessfully, that the transfer represented the payment of a deductible expense on the theory that the payment was made to enable the subsidiary to complete a project for an unrelated third party and, thereby, to avoid serious damage to the parent’s reputation as a reliable service provider.
Today, we turn to a scenario in which an individual taxpayer utilized the same argument – also unsuccessfully – to justify a deduction claimed through a wholly-owned S corporation.
The parent corporation in last week’s post had a much more colorable claim to a deduction than the taxpayer described below. Both situations, however, illustrate the significance of considering in advance the optimal tax consequences for a particular business transaction, and of planning the form and structure for the transaction in order to attain as much of the desired result as possible.
Taxpayer was a U.S. individual who owned a minority interest in Foreign Corp (“FC”). At some point, FC’s shareholders discovered that Bank had engaged in a fraudulent scheme involving FC stock, which ultimately devalued FC’s shares. A consortium of minority shareholders, including Taxpayer, instituted litigation overseas against FC and Bank for corporate fraud. The purpose of the litigation was the recovery of the minority shareholders’ investment in FC.
In return for a percentage of any recovery, Taxpayer agreed to finance a portion of the consortium’s legal fees and related expenses. Taxpayer also agreed to provide services to the consortium in exchange for an extra percentage of any recovery.
In response to “capital calls” made by the consortium, Taxpayer wired funds from their domestic brokerage account which satisfied 60% of their agreed-upon contribution to fund the litigation.
“S” Corp is Formed
The remaining portion of Taxpayer’s commitment was satisfied by two subsequent payments, one from their brokerage account, and the other from the corporate bank account of Taxpayer’s newly-formed and wholly-owned S corporation (“Corp”).
During the year at issue, Corp owned and managed four rental properties; it did not otherwise engage in any property management services for third parties.
Shortly after the formation of Corp, Taxpayer signed two documents, each captioned “Special Minutes of [Corp]”. One of these documents stated, in part:
A) money transfers into [Corp] from [Taxpayer] will be deemed loans to the Corporation[,] B) costs incurred by Taxpayer associated with the assignment of assets or otherwise transferred to [Corp] shall be treated as a loan to [Corp] whereas such costs shall not be in excess of such costs incurred up until the time of the transfer, C) money transfers out of [Corp] to Taxpayer will be deemed repayment of loans or in the event such loans have been repaid such money transfers out of [Corp] will be considered a [sic] income distribution or otherwise * * *.
This document stated that any loans were noninterest bearing and were for a term of the “greater of 20 years or Perpetual Term”.
The other document stated that Taxpayer assigned “their litigation rights for any investment made by [Taxpayer] to [Corp].” It also stated that “the business of [Corp] was to make investments, including the funding of litigation costs * * * [i]n exchange for * * * a[n] ownership interest in the litigation recovery, if any.” The document further stated that “this memo is to provide further clarity that [FC] litigation funding is being done through [Corp] and that [Corp] will earn a fair return on its investment for funding such litigation.” The document further stated: “Resolved, that [Corp] accepts litigation and the costs thereof in return for a reasonable assignment of shares necessary to cover the costs of litigation and provide for a reasonable recovery.”
None of the FC stock owned by Taxpayer was ever actually assigned to Corp, and Taxpayers remained the registered owners of the FC stock at all relevant times. Corp never submitted an application to intervene in the FC litigation, and none of the legal documents relating to the FC litigation referred to Corp.
On its Form 1120S, U.S. Income Tax Return for an S Corporation, Corp identified its business activity as the leasing of residential property. However, Corp claimed a deduction for legal and professional fees relating to the FC litigation, and reported the ordinary business loss that resulted from such deduction.
Taxpayer claimed a loss on their Form 1040, U.S. Individual Income Tax Return, Schedule E, Supplemental Income and Loss, that included the ordinary business loss reported by Corp on the Schedule K-1 issued to Taxpayer.
The IRS disallowed most of the legal and professional fees deduction claimed by Corp.
The primary issue before the Tax Court was whether Taxpayer was entitled to a pass-through deduction for certain legal and professional fees that Corp claimed on its corporate income tax return.[i]
Taxpayer claimed that these fees were deductible as ordinary and necessary business expenses of Corp, but the IRS disagreed.
The Code allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business”.
According to the Court, Taxpayer did not show that either their first or second payment represented expenses “paid or incurred” by Corp so as to support a deduction. Taxpayer wired both of these payments to the consortium from their personal account, in partial satisfaction of their personal commitment to contribute toward the consortium’s FC-litigation expenses.
The Court assigned little significance to the “Special Minutes” pursuant to which Taxpayers purportedly assigned their interest in the FC-litigation and the related costs to Corp. The Court explained that transfers between a corporation and its sole shareholder are subject to heightened scrutiny, and the labels attached to such transfers mean little if not supported by other objective evidence. The record, the Court continued, contained no objective evidence to suggest that this paperwork altered in any way Taxpayer’s relationship to the consortium or their personal obligation to the consortium for the legal expenses in question. Indeed, the Court observed that all the evidence showed that the consortium continued to invoice Taxpayer, and not Corp, for payment of Taxpayer’s commitment even after the year at issue. Corp never submitted an application to intervene in the FC-litigation, and none of the legal documents relating to the FC-litigation referred to Corp.
The Court was also not impressed by Taxpayer’s assertion that their two wire payments represented “loans” to Corp pursuant to the “Special Minutes”; neither payment could be characterized as a “transfer into” Corp under the terms of the “Special Minutes”, and there was no objective evidence of a bona fide expectation of repayment. In any event, one of the payments was made nine days before Corp was even incorporated.
Unlike the other two payments, the third payment was in fact made by Corp. The IRS did not argue that this payment was not “paid or incurred” by Corp. However, the IRS asserted, and the Court agreed, that this payment was also not deductible because Taxpayer failed to show that it was an ordinary and necessary business expense of Corp.
The Court pointed out that the legal and professional fees at issue were the expenses of Taxpayer rather than of Corp. A taxpayer, the Court stated, generally may not deduct the payment of another person’s expense.
The Court conceded, however, that an exception to this general rule may apply if a taxpayer pays someone else’s expenses in order to protect or promote his own separate trade or business. This exception typically applies only where the taxpayer pays the obligations of another person or entity in financial difficulty, and where the obligor’s inability to meet their obligations threatens the taxpayer’s own business with direct and proximate adverse consequences.
“[T]he showing a corporation must make to deduct the expenses of its shareholder is a strong one,” the Court stated. “The test is sometimes expressed as having two prongs:” (1) the taxpayer’s primary motive for paying the expenses must be to protect or promote the taxpayer’s business, and (2) the expenditures must constitute ordinary and necessary business expenses for the furtherance or promotion of the taxpayer’s business.
The Court determined that Taxpayer did do not meet either prong of this test. As to the first prong, Taxpayer did not show that the expenses in question were incurred primarily for the benefit of Corp, and that any benefit to Taxpayer was only incidental. The benefits to Taxpayer were obvious: The costs were incurred to recover their investment in FC. Treating the payments as business deductions of Corp, rather than as miscellaneous investment expenses of Taxpayer, would have resulted in more favorable tax treatment for Taxpayer. By contrast, the business justification for Corp to pay these expenses was not at all obvious. There was no suggestion, for instance, that any payment of the expenses by Corp would have been motivated by any genuine consideration to avoid adverse business consequences that might result if Taxpayer were unable to meet their financial obligations.
As to the second prong, Taxpayer did not show that the legal expenses in question represented ordinary and necessary business expenses in the furtherance of the business of Corp. The Court explained that the proper focus of its inquiry, as applied to legal expenses, is on the origin of the subject of the litigation and not on the consequences to the taxpayer. The origin of the claim was Bank’s alleged fraudulent activity that devalued the FC shares that Taxpayer held as a minority shareholder. Taxpayer – not Corp – joined the shareholder litigation group against Bank. The litigation and Taxpayer’s obligation to fund the litigation arose before Corp was ever created.
At all relevant times, the FC shares were registered in Taxpayer’s name. As Taxpayer testified, the purpose of the litigation was to secure judgment in favor of the FC shareholders and recover their investment.
Taxpayer contended that, in the “Special Minutes,” they assigned all their FC-litigation rights to Corp, and that the prospect of a payout to Corp from the FC-litigation constituted a legitimate business activity of Corp as to which the legal expenses should be deemed an ordinary and necessary business expense.
The Court again rejected the “Special Minutes” because they were not supported by any objective evidence. In any event, Taxpayer’s argument focused improperly on the potential consequences of the FC-shareholders’ lawsuit – a potential payout in which Corp would allegedly share – rather than upon the origin and character of the underlying claim. Moreover, the absence of any reliable documentation defining the role of Corp in the litigation, or guaranteeing it a share of any future recovery, further supported the conclusion that Taxpayer engaged in the FC-litigation in their personal capacity as an investor in FC, and not on behalf of Corp.
In the light of these considerations, the Court assigned little credence to Taxpayer’s assertions that Corp engaged in “litigation funding” as a business and that Taxpayer lent money to Corp to fund the litigation. In the first instance, for an activity to constitute a trade or business, “the taxpayer must be involved in the activity with continuity and regularity and * * * the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” During the year at issue, the FC-litigation was Corp’s only claimed “litigation funding” activity. The Court was not convinced that Corp was involved in any “litigation funding” activity with the continuity and regularity necessary for that activity to constitute a trade or business. Similarly, even if Taxpayer provided advisory services to the FC-litigation through Corp, as Taxpayer alleged, the record did not show that Corp provided such services with the continuity and regularity necessary for that activity to constitute a trade or business.
The Court found that Taxpayer failed to show that any of the disputed fees were paid or incurred by Corp as ordinary and necessary expenses in carrying on its trade or business. Accordingly, the Court sustained the IRS’s determination that these items were not deductible by Corp, and thereby increased Taxpayer’s income tax liability.
[Query why the IRS did not also argue – to add insult to injury – that Corp’s satisfaction of Taxpayer’s obligation should be treated as a constructive distribution by Corp that reduced Taxpayer’s basis for their Corp stock?]
Here I Go . . . Again[ii]
The scenarios in which a closely held business, its affiliates and their owners will transfers funds or other property to, or on behalf of, one another are too many to enumerate. That these transfers often occur without being properly documented – except, perhaps, with a book entry similar to “intercompany transaction” – if at all, is troublesome.
Unfortunately, the frequency of cases like the one described above indicates that too many taxpayers make such transfers without an appreciation either for their tax consequences and the attendant economic costs, or for the importance of accurately documenting the transfers.
When they do realize their error – whether before, or during, an audit – the related parties sometimes scramble to “memorialize” what they “intended,” which results in an obviously self-serving and forced “reconciliation” of what actually occurred with what was reported on a tax return.
Under these circumstances, it should not be difficult to understand a court’s reluctance to accept a taxpayer’s after-the-fact explanation for a transfer, or to underestimate the importance of treating with a related party on as close to an arm’s-length basis as possible.
[i] An “eligible small business corporation” that elects S corporation status is generally exempt from corporate income tax. Instead, the S corporation’s shareholders must report their pro rata shares of the S corporation’s items of taxable income, gain, loss, deduction, and credit. An S corporation item generally retains its character in the hands of the shareholder.
[ii] Apologies to Bob Seeger.