I Own the Business, The Business Owns the Assets, I Own the Assets, Right?
November 04, 2019
Personal Use of Business Assets
“But it’s my business. I own it.”
How many times have you heard this response from the owners of a business entity after you’ve advised them that they should not treat the entity as their personal bank account?
Too often, I’d wager.
What’s more, the response is not limited to any particular set of owners; for example, members of the family business, who may be less likely to object to each other’s “transgressions,” especially if perpetrated by mom or dad.[i]
Indeed, the practice of using the resources of the business for non-business purposes – i.e., for personal ends – is pervasive among closely held entities regardless of their level of sophistication or the extent to which the owners are otherwise unrelated to one another.
There are too many examples of such personal use to list here, but expenditures by the business for the following uses are illustrative:[ii] the cost of meals,[iii] mortgages, education expenses, charitable contributions, car rental payments, phones, home utilities, country club dues, children’s allowances,[iv] shopping bills, apartment rent, boats, entertainment, travel costs,[v] weddings and other “social” gatherings.[vi]
The justifications offered by the beneficiary of such expenditures are also wide-ranging, though marketing, public relations, sales, client development and retention lead the pack. In most cases, however, the connection between the expenditure and the purported business purpose is usually pretty tenuous.
A less “offensive” use of business assets, and one that is less obvious to many observers, is the business’s satisfaction of an owner’s business or investment obligations; for example, where the business redeems the stock of a departing owner notwithstanding that another owner was contractually obligated to purchase such stock.[vii]
How Are They Reported?
More interesting is the variety of treatments accorded these expenditures by the preparer of the expending entity’s income tax return.
Some preparers will keep track of these figures throughout the course of the year, then add them to the owner’s salary and deduct them accordingly, without considering whether the aggregate consideration paid to the owner (inclusive of these expenditures) was reasonable for the services actually rendered.
Others seem reluctant to treat them as salary, perhaps recognizing that the total amount paid would not represent reasonable compensation,[viii] with the result that part of the deduction would be disallowed,[ix] though it is more likely because they want to avoid the imposition of employment taxes. Instead, they will add these expenditures to the “other deductions” line of the corporation[x] or partnership[xi] tax return; the explanatory statement attached to the return in respect of these deductions will often bury this cost as a nondescript expenditure among a long list of others, probably in the hope that it will go unnoticed.[xii]
Some preparers will forego the deduction – more likely where the business entity is a pass-through – and report the expenditures as cash distributions made in respect of the owner’s equity in the business entity. Such a distribution will not generate a deduction on the corporation’s or partnership’s tax return. In the case of a C corporation, the distribution will be taxable to the shareholder-beneficiary as a dividend to the extent of the corporation’s earnings and profits, then as a return of capital (stock basis), with any excess being treated as gain from the sale of the stock.[xiii] In the case of an S corporation without E&P, the distribution would not be taxable to the extent of the shareholder’s basis in the stock, with any excess being treated as gain from the sale of the stock.[xiv] Finally, in the case of a partnership, the deemed cash distribution would not be taxable to the extent of the partner’s basis in their partnership interest, with any excess being treated as gain from the sale of such interest.[xv]
Then there are those preparers who will report the amount of the expenditure as a loan from the business entity to the owner – anything to defer the tax liability that may result from a constructive distribution[xvi] – though they rarely memorialize the indebtedness with a promissory note, secure it with collateral, or provide a maturity date, and they almost never impute the interest,[xvii] let alone pay it.[xviii]
In addition to the foregoing indirect payments by the business entity which may be characterized as constructive distributions to an owner, transactions between the owner and the business entity may also result in a deemed distribution. We’ve already mentioned the payment of excessive compensation by the entity to the owner, but what about the payment of an above-market rent for the use of the owner’s (or an affiliate’s) property, or an above-market interest rate for a loan from the owner to the business? Then, there’s the above-market purchase price for the owner’s sale of property to the entity, or the below-market (“bargain”) sale of property by the entity.[xix]
Of course, an actual expenditure, or other outlay of value, by the business entity is not the only way by which an owner may benefit from the use of the entity’s assets or resources.
Thus, the rent-free use of the entity’s car, plane or apartment should rise to the level of a deemed or constructive transfer of value from the entity to the owner. The nature of that transfer, whether as a payment of compensation or as a distribution in respect of equity,[xx] will depend upon the facts and circumstances.[xxi]
When Will They Ever Learn?[xxii]
Notwithstanding the body of case law and administrative rulings that has developed over the years in this subject area, there are those owners and advisers who have somehow remained ignorant of it, or who have simply chosen to ignore it. This was certainly the case of the taxpayer is a recent decision of the U.S. Tax Court.[xxiii]
The issue before the Court was whether Taxpayer, who failed to file a tax return for the tax year in issue, had constructive dividend income as a result of cash withdrawals, fund transfers to their personal bank account, and payments of personal and meal expenses, all from Corp’s bank account.
Taxpayer was the sole shareholder of Corp. During the year in issue, Taxpayer maintained a business checking account in their name, and another business checking account in the name of Corp.
Corp had gross receipts for the year in issue, the amount of which represented the aggregate amount of deposits into Taxpayer’s personal and Corp’s bank accounts for the year.[xxiv] Corp. did not keep books and records, so there was no way to distinguish between Taxpayer’s personal finances and those of the corporation.
Taxpayer expended Corp funds for their own use. Taxpayer made cash withdrawals from Corp’s bank account for their own use and not for corporate expenses. Corp transferred funds from its corporate account to Taxpayer’s personal bank account for their own use. Taxpayer paid the cost of personal meals by using Corp’s corporate debit card. Corp paid many of Taxpayer’s other personal expenses, including rent, travel, and childcare, among others.
The IRS computed Taxpayer’s income for the year in issue by reference to bank deposits and cash payments, plus personal and other nondeductible expenditures. On the basis of the results of that analysis, the IRS prepared a substitute return[xxv] for Taxpayer and issued a notice of deficiency[xxvi] which determined, among other things, that Taxpayer had received unreported business income, which resulted in a tax deficiency.
Taxpayer’s Bad Day in Court
Taxpayer’s petition to the Tax Court did not contest the unreported gross income stated in the deficiency notice, but argued that the gross receipts were attributable to Corp rather than to Taxpayer, personally.[xxvii]
The IRS argued that Taxpayer had received constructive dividends from Corp. The IRS posited that during the year in issue, Taxpayer “drew no distinction between” the funds of the business and their personal funds. The IRS identified various categories of expenditures in Corp’s bank statements that the IRS argued were distributions to Taxpayer – cash withdrawals, electronic transfers, personal expenses, and meal expenses – and presented evidence of those expenditures.
To determine the character of the constructive distributions, the IRS calculated Corp’s earnings and profits for the year in issue. These exceeded, the IRS asserted, all of the constructive distributions Taxpayer received from Corp. Thus, according to the IRS, these distributions represented dividends.[xxviii]
The Court observed that Taxpayer relied almost entirely on their uncorroborated testimony and non-contemporaneous documents. Taxpayer failed to explain with any detail, or to substantiate with any contemporaneous documentation or log, the amounts or business character they alleged for the expenditures at issue.[xxix] The Court stated that it need not accept a taxpayer’s self-serving testimony when the taxpayer failed to present corroborating evidence. Accordingly, because Taxpayer had the burden of proof, the Court did not accept most of Taxpayer’s self-serving testimony.
The Court explained that a distribution from a corporation to its shareholders is treated as a dividend, which is included in gross income.[xxx] “A constructive dividend arises,” the Court explained, ‘[w]here a corporation confers an economic benefit on a shareholder without the expectation of repayment, * * * even though neither the corporation nor the shareholder intended a dividend.’”
According to the Court, “[c]orporate expenditures constitute constructive dividends if (1) the expenditures do not give rise to a deduction on behalf of the corporation, and (2) the expenditures create economic gain, benefit, or income to the owner-taxpayer.”
The Court stated that an “expenditure generally does not have independent and substantial importance to the distributing corporation if it is not deductible” as an ordinary and necessary business expense.[xxxi] Conversely, the Court added, “not every corporate expenditure which incidentally confers economic benefit on a shareholder is a constructive dividend. The crucial test of the existence of a constructive dividend is whether the distribution was primarily for the benefit of the shareholder.”
In the case of the amounts withdrawn by Taxpayer from Corp’s accounts, the Court was persuaded that they were not made for Corp’s business expenditures but for Taxpayer’s personal use.
The IRS identified deposits to Taxpayer’s personal account that corresponded with certain withdrawals from Corp’s bank account. Taxpayer admitted that these amounts were deposited into their personal account and conceded that these withdrawals “were personal”, “were not proven to be for business expenses and therefore * * * [were] constructive income for” Taxpayer.
The balance of the cash withdrawals after the amounts Taxpayer deposited into their personal account corresponded closely to the amount Taxpayer claimed was used to pay for business-related expenses. At trial, Taxpayer provided receipts purporting to prove this fact; however, the Court found these receipts very “problematic”, stating that they “indirectly but convincingly underscore[d] the personal character of the withdrawals.”
In fact, the Court expressed its belief that Taxpayer fabricated the receipts. Rather than substantiating a deductible business purpose for the cash withdrawals, these “manifestly bogus receipts,” the Court continued, “revealed a deceptive intention and showed that the actual purpose of the cash withdrawals was other than the false proffered business purpose.”
Therefore, the Court found that the entire amount withdrawn from Corp’s bank account – both the portion that was deposited into Taxpayer’s personal account and the portion for which the false receipts were produced – created income for Taxpayer, did not give rise to deductions by Corp and, therefore, were a constructive distribution.
Taxpayer conceded at trial that they transferred cash from Corp’s bank account into their personal bank account. Taxpayer made no argument that this electronic transfer served a corporate purpose; and in their post-trial brief, Taxpayer conceded that this payment constituted “constructive dividends.”
At trial, the IRS entered schedules into evidence showing that during the year in issue, Corp paid many of Taxpayer’s personal expenses. Taxpayer admitted that Corp’s bank account was used to pay for all of Taxpayer’s groceries for that year, a gym membership, and various other personal expenses.
Taxpayer conceded the personal character of all of those amounts, except for an amount which was attributable to certain payments by Corp for the monthly rental of Taxpayer’s personal residence. Taxpayer contended that these residential rental payments were business expenses of Corp because Taxpayer used part of the residence for business.
Unfortunately for Taxpayer, the Court was not convinced, finding that Taxpayer had established no business-related use of a home office. Thus, it concluded that Corp’s payments for Taxpayer’s personal residence were personal expenditures.
The Court also found that the IRS had successfully carried its burden of showing that Taxpayer received a personal economic benefit from Corp’s payment of certain of Taxpayer’s travel expenses. Taxpayer, the Court observed, failed to enter a receipt, a log, or any other evidence of their trip into the record. Thus, the lodging expense was not a business expense.
Finally, the IRS was able to establish that Corp paid many of Taxpayer’s meal expenses which, the Court stated, were generally non-deductible personal expenses.
In summary, the Court concluded the IRS had proven that Taxpayer received distributions from Corp that were primarily for Taxpayer’s personal benefit and not for deductible expenses of Corp.
The IRS next contended, and the Court agreed, that Corp had sufficient earnings and profits to characterize the constructive distributions Taxpayer received as dividends.[xxxii]
Let’s Be Careful Out There [xxxiii]
The “transitive law” of mathematics and logic,[xxxiv] as expressed in the title of this post, has no place in governing the relationship between business owners and their business entities. In fact, it can only lead to trouble, as many owners who have applied this basic rule have learned over the years, much to their dismay.
In general, the business entity is treated as a separate taxpayer from its owner. The premise underlying transactions between taxpayers is that they will treat with one another at arm’s length.[xxxv] However, where the parties are related, the IRS and the courts will scrutinize the transaction more closely to ascertain whether its terms depart from the arm’s length standard, and if so, why. As in the case of the Taxpayer, above, the IRS will look at the facts and circumstances of the transaction in order to determine the appropriate tax treatment for any such departure; for example, a constructive distribution.
In light of the foregoing, except where the entity has elected to be disregarded for tax purposes,[xxxvi] the transaction of any activity between the entity and its owners has to be undertaken with care – the arm’s length standard must be considered, and the likely tax consequences have to be accounted for in advance.
However, even where the owner engages in an activity with a disregarded business entity,[xxxvii] they must not be misled into thinking that the “neutral” consequence of that activity for tax purposes will necessarily carry over for all other purposes. For example, if the owner freely moves property in and out of their single member LLC without considering the arm’s length standard and without exchanging adequate consideration therefor with the LLC, they risk opening the doors for the LLC’s creditors to reach the owner’s other assets. Creditors understand the law of transitivity.
[i] Most parents of means know they wield the power of the will, or revocable trust, and their kids know it too. If a child complains, perhaps too vehemently, a phone call, a few taps on a keyboard, and voila, Jack or Jill is out of the will.
[ii] Interestingly, these events have their counterparts in the world of tax-exempt private foundations: acts of self-dealing, which are addressed under IRC Sec. 4941.
[iii] I know restaurant owners who have rarely stepped into a supermarket.
[iv] In the form of compensation to the kids, who don’t even work for the business.
[v] One individual explained to me that they won’t attend a destination wedding unless one of their vendors, customers, or prospects is located nearby. Honest. Hmm.
[vi] Do you remember the scene from Ghostbusters when the accountant, Louis Tully (Rick Moranis), is hosting a party in his apartment?
Hey, this is real smoked salmon from Nova Scotia, Canada, $24.95 a pound. It only cost me $14.12 after tax, though. I’m giving this whole thing as a promotional expense. That’s why I invited clients instead of friends.
[vii] See, e.g., Rev. Rul. 69-608.
[viii] IRC Sec. 162; Reg. Sec. 1.162-7.
[ix] At least in the case of a corporate taxpayer; guaranteed payments made by a partnership to a partner for services rendered by the partner are not subject to a standard of reasonableness in order to be deductible.
[x] IRS Form 1120 or Form 1120S.
[xi] IRS Form 1065.
[xii] This drives me crazy.
[xiii] IRC Sec. 301(c), Sec. 316. The dividend would be taxed at a 20% federal tax rate under IRC Sec. 1(h), and at a 3.8% federal surtax on net investment income under IRC Sec. 1411.
[xiv] IRC Sec. 1368(b).
[xv] IRC Sec. 731(a), Sec. 741, Sec. 751. The partner’s capital account should likewise be adjusted.
Of course, when most people hear about a constructive distribution in the case of a partnership, they think of the deemed distributions of cash to a partner when the partner’s share of partnership liabilities is reduced. IRC Sec. 752.
[xvi] I’m sure you’ve seen this: a shareholder with very substantial amounts owing to a corporation that has plenty of unappropriated retained earnings but that has never declared a dividend.
[xvii] Using the applicable federal rate in accordance with IRC Sec. 7872.
[xviii] In fact, such loans are rarely repaid, or otherwise “eliminated,” before the sale of the business or the death of the debtor-shareholder.
[xix] Each of these scenarios may be viewed as a transfer pricing issue that requires the application of the arm’s length standard under IRC Sec. 482 and the regulations promulgated thereunder.
[xx] What about a deferred payment of the rental amount? How would this be determined in the absence of an agreement? Based on market rates? There’s no denying that value has been provided.
[xxi] How many of you have struggled with the tax treatment of a corporation’s guarantee of a shareholder’s indebtedness to a third party?
[xxii] Apologies to Peter, Paul and Mary, Where Have All the Flowers Gone?
[xxiii] Santos v. Comm’r, T.C. Memo. 2019-148.
[xxiv] Meaning, Corp’s receipts were sometimes deposited into its account, and sometimes into Taxpayer’s account. Talk about intermingling.
[xxv] IRC Sec. 6020(b).
[xxvi] IRC Sec. 6212.
[xxvii] In other words, the deficiency was Corp’s.
[xxviii] IRC Sec. 301(c)(1) and Sec. 316.
[xxix] IRC Sec. 6001 requires that “[e]very person liable for any tax imposed by this title, or for the collection thereof, shall keep such records, render such statements, make such returns, and comply with such rules and regulations as the Secretary may from time to time prescribe.” Taxpayers are thus required to keep records and maintain them as long as they may become material. Reg. Sec. 1.6001-1(a), (e).
[xxx] IRC Sec. 316. I.e., paid out of the corporation’s earnings and profits.
[xxxi] IRC Sec. 162.
[xxxii] IRC Sec. 301(a), Sec. 301(c)(1), Sec. 316. According to the Court, a dividend is first paid from earnings and profits of the current taxable year, and if the current earnings and profits are insufficient, the dividend is paid from accumulated earnings and profits.
[xxxiii] Sergeant Phil Esterhaus, from Hill Street Blues.
[xxxiv] aRb, bRc, then aRc, where R represents a particular relationship.
[xxxv] For example, the hypothetical willing buyer and willing seller standard that governs most valuations of property, or the transfer pricing rules under IRC Sec. 482.
[xxxvi] Reg. Sec. 301.7701-3.
[xxxvii] For example, a single member LLC that has not elected to be treated as an association for tax purposes.