Potential for Abuse
Many years ago, Congress decided that taxpayers who were “related” to one another should be required to use the same accounting method with respect to transactions between them in order to prevent the allowance of a deduction to one party (using the accrual method of accounting) without the corresponding inclusion in income by the other party (using the cash method).
The failure to use the same accounting method with respect to one transaction, it was believed, involved unwarranted tax benefits, especially where payments were delayed for a long time.
Deferring the Deduction
In order to address this concern, Congress decided that accrual basis taxpayers must shift to the cash method of accounting with respect to the deduction of amounts owed to a related cash-basis taxpayer, thereby deferring the deduction until the amount owing is paid.
Thus, an accrual-basis taxpayer is allowed to deduct amounts owed to a related cash-basis taxpayer only when payment is received, and the corresponding income is recognized, by the related cash-basis party.
This rule applies to all deductible expenses the timing of which depends upon the taxpayer’s method of accounting.
S-Corp.’s Payroll Expenses
The Tax Court recently considered a case involving unusual circumstances that required it to interpret the application of this “deduction deferral” rule.
The question presented was whether this rule applied to defer certain deductions accrued by Corp., which was an S-corporation of which Taxpayers were the original shareholders.
Corp. used the accrual method of accounting for federal income tax purposes.
During the years at issue, Corp. accrued expenses for wages, vacation pay, and related payroll items (collectively, “accrued payroll expenses”) on behalf of its employees.
Approximately 95% of these amounts were attributable to employees who participated in the employee stock ownership plan (“ESOP”) that Corp. maintained during these years. During each year, some or all of Corp.’s stock was owned by related ESOP trust.
Some of these accrued payroll expenses were not expected to be paid, and were not in fact paid, until the year following the year in which Corp. made the accruals.
On its returns for the years at issue, Corp. claimed deductions for (among other things) the accrued but unpaid payroll expenses described above. Taxpayers, on their individual returns, and in accordance with the S-corporation flow-through rules, claimed flow-through deductions equal to their pro rata share of these accrued but unpaid expenses.
The IRS Audit
The IRS examined Corp.’s tax returns, and disallowed the deductions claimed for the accrued but unpaid expenses to the extent they were attributable to employees who participated in the ESOP.
The IRS contended that the ESOP trust was a “trust” within the meaning of the constructive ownership rules that are applicable in determining whether the parties to a transaction are “related” to one another, with the consequence that the trust beneficiaries – specifically, those Corp. employees who were ESOP participants – were deemed to have owned their proportionate shares of the Corp. stock held by the ESOP trust.
If Corp.’s employees, all of whom were cash basis taxpayers, were the beneficiaries of a “trust” that owned Corp. stock, they would be deemed “related” to Corp. for purposes of the “deduction deferral” rule which would require that Corp.’s deductions for accrued but unpaid payroll expenses be deferred until the year the expenses were paid by Corp. and were includible in the employees’ gross income.
The IRS then performed a follow-on examination of Taxpayers’ individual tax returns and, of course, disallowed the flow-through deductions attributable to the disallowed expenses that had been accrued by Corp.
Taxpayers petitioned the U.S. Tax Court.
Generally, an accrual basis taxpayer may deduct ordinary and necessary business expenses in the year when “all events” have occurred that establish the fact of the liability, the amount of the liability is set, and “economic performance” has occurred with respect to the liability.
A cash basis taxpayer generally reports income in the year it is actually received, and deducts expenses in the year they are actually paid.
When such expenses are owed by an accrual basis taxpayer to a related cash basis taxpayer, however, the “related party deduction deferral” rule provides that the payor may deduct the expenses only for the taxable year for which the amounts are includible in the payee’s gross income; in other words, the payor must use cash basis accounting as to those expenses.
The Tax Court’s Analysis
The Court began by noting that deductions are a matter of legislative grace, and the burden is on the taxpayer to prove entitlement to claimed deductions.
The parties agreed that the accrued payroll expenses were ordinary and necessary to the company’s business and that the requirements for the proper accrual of the expenses had been met.
The sole issue, therefore, was whether Corp. and the ESOP participants were related persons for purposes of the “deduction deferral” rule.
The Court considered and dismissed several arguments made by Corp. and Taxpayers, including one in which they asserted that the IRS’s position violated generally accepted accounting principles (“GAAP”) by denying a current deduction for properly accrued payroll costs. The Court replied that “[a]s has often been noted, . . . , tax accounting differs in many respects from GAAP financial accounting. Especially is that so where (as here) a Code provision explicitly requires a treatment that differs from GAAP.” Corp., the Court stated, had no greater claim than any other accrual basis taxpayer to exemption from the operation of the “deduction deferral” rule.
This rule, the Court pointed out, was designed “to prevent the use of the differing methods of reporting income and deductions for Federal income tax purposes in order to obtain artificial deductions for interest and business expenses.” It is remedial, the Court continued, requiring related persons to “use the same accounting method with respect to transactions between themselves in order to prevent the allowance of a deduction without the corresponding inclusion in income.”
Among the “relationships” that bring the rule into play is that of an S corporation and “any person who owns (directly or indirectly) any of the stock of such corporation.” Thus, S corporations and their shareholders are deemed to be “related persons” for purposes of the rule regardless of how much or how little stock each shareholder individually owns.
In determining whether a person owns shares of stock of a corporation, certain constructive ownership rules are applied, according to which stock owned, directly or indirectly, by or for a trust, shall be considered as being owned proportionately by or for its beneficiaries.
Thus, if the ESOP participants constructively owned Corp. stock in their capacities as beneficiaries of the ESOP trust, then Corp. and the participant-employees would be treated as “related persons” for purposes of the “deduction deferral” rule, no matter how small their percentage ownership.
With that, the Court turned to the question of whether the Corp. stock owned by the ESOP was owned by a “trust” of which the ESOP participants were “beneficiaries.”
The Court stated that it would ordinarily give the words Congress used their ordinary meaning, “unless doing so would produce absurd or futile results.” If a statute was clear on its face, the Court explained, then “unequivocal evidence of legislative intent would be required” before construing the statute in a manner that overrode the plain meaning of the words used therein.
After a lengthy analysis – in which the Court examined the ESOP documents, including the terms of the associated ESOP trust, and the regulations governing qualified deferred compensation plans (such as ESOPs), among other things – the Court concluded that the entity holding the Corp. stock for the benefit of the ESOP participants was a “trust” in the ordinary sense of that word. The arrangement involved a settlor (Corp.) that established a trust for the benefit of specified beneficiaries (the ESOP participants), contributed property to the trust (Corp. stock and cash), and designated a trustee to hold the property for the beneficiaries and act in their best interest.
Because the ESOP trust was a “trust” within the meaning of the constructive ownership rules, the Corp. stock held by the trust was deemed to be owned by the trust’s beneficiaries: the Corp. employees who participated in the ESOP. As a result the ESOP participants and Corp. were deemed “related persons” for purposes of the “deduction deferral” rule.
Accordingly, Corp.’s deductions for the accrued but unpaid payroll expenses had to be deferred to the year in which such expenses were actually paid by Corp. and were includible in the gross income of the ESOP participants.
Words of Advice?
The IRS and the courts have a long history of closely scrutinizing transactions between related parties. In most cases, the tax authorities are trying to determine whether a transaction was structured in such a way as to achieve a better tax (and, thus, economic) result than if the parties had dealt with one another on an arm’s-length basis.
Often, the related taxpayers can successfully defend the IRS’s attempts to re-characterize payments made between them by identifying the business reason for, and nature of, the payment, by contemporaneously documenting the flow of funds between them, and by endeavoring as much as possible to approach the transaction as if they were unrelated parties.
However, as was illustrated by the decision discussed above, there are other, statutorily-identified situations involving related party transactions, the sometimes-surprising tax consequences of which cannot be avoided if the transaction falls within the literal “criteria” of the statutory provision. In addition to the “deduction deferral” rule, another example of such a situation are the rules applicable to related party sales that characterize the gain recognized on such sales as ordinary income.
The only way to avoid stumbling onto these rules, and the resulting – and unexpected – tax consequences, is to be aware of them, which usually requires seeking the advice of a knowledgeable adviser. The transaction at issue may still be undertaken if it makes business sense to do so, but at least the related taxpayers will know how to report the tax consequences and to account for them, if possible, within the economics of the transaction.