Will They Ever Learn?
The following probably sounds familiar. You’re meeting with a new client who is being audited by the IRS. The client brings you their federal and state individual income tax returns and the income tax returns for their business entity.
You look at the client’s reported wages and dividends; you look at their Sch. E for information on their S corp. or partnership income; you notice on Part I that they own the real property on which the business operates (thankfully, through a wholly-owned LLC). You check the client’s home address and the property taxes on their home(s) as shown on their Sch. A (pre-2018, of course, at least for now). You see that the question on their N.Y. State return, whether they maintain living quarters in N.Y.C., has been answered in the negative.
Then you turn to their business returns. You review the reported wages or guaranteed payments paid to the client, at the dividends or other distributions paid to the client; you check the balance sheet for loans to or from the client, and at the line for interest received or paid (which you double check with the Sch. B on the client’s individual return – nothing); you look at the statement attached to the return that purports to describe the line on the return for “other deductions” and see that it states simply “other expenses;” you look at the explanatory statements for the lines on the balance sheet for “other assets” and “other liabilities,” and see something like “transactions with affiliate;” you check the depreciation schedules and notice the Range Rover.
Then you turn to the client. You’ve already “googled” them (you hate surprises) – thankfully, nothing exciting. “Thanks for the returns, but I’d also appreciate your books and other records, so I can check them against one another.” You take a deep breath, then ask the question, the answer to which you sometimes dread: “Is there anything I should know regarding the operation of the business that may not be evident from these returns?” “What do you mean?” or “Like what?” are the usual responses.
“Like pulling teeth,” you think to yourself. “For instance,” you say, “how do you determine your salary? Are family members employed? How do you determine the rental? Tell me about these ‘affiliates’ and these transactions. Do you have written agreements and leases? What about promissory notes for the loans on this balance sheet? Do you pay the business for the use of its apartment in the City?” You’re trying to develop a picture, and you’re finding that there is some cause for concern. You didn’t put them in this position, but you resolve that, once this audit is concluded, you will try to put them on the right course going forward.
Unfortunately, there’s always someone who doesn’t appreciate what you’re trying to do for them. Or it may be that they are so set in their ways that a voluntary change in their mode of operation is remote, at best. I imagine the taxpayer in a recent case, described below, as one such person.
Bad to the Bone?
Taxpayer was the sole shareholder of Corp, a C-corporation. On its tax returns, which were signed by Taxpayer as president of Corp, the corporation reported that it had loans from shareholders on its returns for years up to and including Year One, but it did not report the existence of any loans from shareholders after Year One, and no loans from shareholders were shown on Corp’s books and records. Corp did not file any federal tax returns after Year Four, notwithstanding that it had positive earnings and profits.
Corp paid net wages to Taxpayer in years before, and in the first few months of, Year Six. Taxpayer reported wages from Corp on his tax returns through Year Five.
Corp ceased operating in Year Six. Some of the checks issued to Taxpayer from Corp bore the preprinted phrase “Payroll Check” and taxes were withheld from these, while others were not so identified and taxes were not withheld from these.
During Years Six and Seven, Taxpayer endorsed several checks payable to Corp and deposited them into his personal account.
In Year Six, Taxpayer opened a checking account at Bank in the name of Newco. Taxpayer was the only individual with signature authority over the account, and during that year Taxpayer wrote three checks payable to himself from Newco.
Also in Year Six, Taxpayer deposited checks into Newco’s account which represented payment by Corp’s customers for services rendered by Corp.
Taxpayer filed Forms 1040 for Years Six, Seven and Eight. Taxpayer did not provide the C.P.A. who prepared the Year Six return with any verification of the reported amounts of income. The C.P.A. required Taxpayer to sign a letter acknowledging that Taxpayer had provided the C.P.A. with no verification of those amounts; that Corp had gone out of business during Year Six; and that its stock had become worthless in Year Six.
On Schedule D, Capital Gains and Losses, of the Year Six Form 1040, Taxpayer reported a long-term capital loss calculated by reference to Taxpayer’s claimed loan to Corp. Taxpayer carried over the unused portion of the long-term capital loss to the Years Seven and Eight Forms 1040.
The IRS issued a notice of deficiency to Taxpayer for Years Six, Seven and Eight, and Taxpayer timely petitioned the Tax Court.
Tax Court: Loan Repayments, Salary, or Dividends?
The Court began by noting that Taxpayer did not deny that he received payments from Corp in Year Six in the amounts the IRS determined. But Taxpayer contended that these amounts were the nontaxable repayment of loans that he had made to Corp. However, the only evidence in the record of any loans to Corp was Taxpayer’s testimony.
Taxpayer testified that the “payroll checks” he received in Year Six were actually loan repayments because Corp’s supply of general checks was exhausted. The Court disagreed, pointing out that the record showed that some general checks were written after these payments were made using payroll checks.
Taxpayer contended that he made several loans to Corp. However, he claimed a long-term capital loss resulting from only one of them on his Year Six return. Corp reported outstanding “loans from shareholders” on earlier returns, but none after Year One. The Court stated that it did not understand why Taxpayer would have claimed a loss resulting from only one loan if, in fact, he had lent far more than that, or why Corp did not report such outstanding, as it had done in the past, if the loans were genuine.
The IRS interviewed Taxpayer regarding whether he had received wages that were not reported on his return. Taxpayer told the IRS that the only loans he made to Corp were made in the early 1990s. The IRS also interviewed Taxpayer’s bookkeeper and reviewed Corp’s books and records with the bookkeeper. The IRS did not find any record of loans from Taxpayer to Corp after Year One. Moreover, Taxpayer testified that it would not make sense to draft a promissory note to himself when taking money out of his account and depositing it into Corp’s account, because it would be “basically out of one pocket and putting it into another.” Based on the forgoing, the Court concluded that Corp did not have outstanding loans to Taxpayer during the years at issue and that its payments to Taxpayer were salary.
The Court next considered certain other amounts received by Taxpayer from Corp in Years Six and Seven, which the IRS characterized as dividends. Taxpayer did not dispute receiving the payments, but contended that they were loan repayments rather than constructive dividends as claimed by the IRS.
The Court explained that a dividend is “any distribution of property made by a corporation to its shareholders” from its earnings and profits. Funds distributed by a corporation over which the taxpayer/shareholder has dominion and control, the Court explained, are taxed as dividends to the recipient to the extent of the earnings and profits of the corporation. A constructive dividend arises, the Court continued, where a corporation confers an economic benefit on a shareholder without the expectation of repayment, even though neither the corporation nor the shareholder intended a “formal” dividend.
In Year Six, Taxpayer opened a bank account in the name of Newco. The account was controlled solely by Taxpayer. According to the Court, the record revealed no purpose for Newco other than to serve as a conduit to transfer money from Corp to Taxpayer.
About halfway through Year Six, Corp made its final wage payment to Taxpayer. Shortly before that, Taxpayer deposited the first in a series of checks made payable to Corp by Corp’s customers into his own bank account. A while later, Taxpayer deposited checks payable to Corp into Newco’s account. Then Taxpayer wrote checks to himself from the Newco account. The sum of these checks was characterized by the IRS as constructive dividends to Taxpayer. The checks payable to Corp that Taxpayer deposited into his own account and the checks payable to Corp that Taxpayer deposited into Newco’s account represented an economic benefit to Taxpayer, and constituted constructive dividends for Year Six, and the checks written to Corp which Taxpayer cashed or deposited into his account in Year Seven were constructive dividends to Taxpayer for Year Seven.
In determining the amount of the dividends received by Taxpayer, the Court observed that Corp had earnings and profits at the end of Year Four, the last year for which it filed an income tax return. The Court also noted that there was no evidence in the record to show any change to Corp’s earnings and profits before Year Six. Thus, the Court concluded that the distributions were fully taxable.
Finally, the Court considered the long-term capital loss that Taxpayer reported on his Year Six return. His claim for entitlement to that deduction was based on his claim that Corp owed him money.
The C.P.A. who prepared Taxpayer’s Year Six tax return was unable to verify the existence of the claimed loans and asked Taxpayer to sign a statement that the return was based entirely on amounts provided by Taxpayer and his representation of the amounts of outstanding loans.
The Court found that there was no credible evidence that Taxpayer made loans to Corp after Year One, or that there was any outstanding debt from Corp to Taxpayer in Year Six, when Taxpayer reported the loss. Therefore, the Court concluded that Taxpayer was not entitled to the loss claimed for Year Six, or to the capital loss carryforward deductions claimed for the two succeeding years.
Know Your Client
I mentioned something about “googling” the client earlier. It wasn’t a joke. What does the “public record” tell you about the client and their character? We have all encountered clients or potential clients – fortunately, relatively few – who will “shop around” for an answer until they get the right one; i.e., the most favorable, though not necessarily the correct one.
Or we have seen clients like the Taxpayer, who will put anything in writing so as to induce their tax return preparer to sign a return that presents information that cannot be verified and is probably suspect.
At times, the prospect of landing a client, or the pressure to retain one, may feel irresistible. That’s when you need to check that the antennae are functioning properly.
Consider your professional duties and obligations; in particular, given the story of the Taxpayer, the duty to exercise due diligence in preparing and filing tax returns and other documents/submissions with the IRS, and in determining the correctness of representations made to the IRS.
In general, you may rely in “good faith,” and without verification, on information furnished by your client, but you cannot ignore other information that has been furnished to you, or which is actually known by you. You must make reasonable inquiries if any information furnished to you appears to be incorrect, incomplete, or inconsistent with other facts or assumptions.
Related to the duty of due diligence is the directive that you not sign a tax return, or advise a client to take a position on a return, that you know or should know contains a position for which there is no reasonable basis, or that lacks substantial authority, or which is a willful attempt to understate tax liability, or which constitutes a reckless or intentional disregard of rules or regulations.
By following these basic rules, you protect yourself and our system of self-assessment.