Tax attorneys frequently come from an accounting background. This may seem like an unrelated skill, but it often plays a pivotal role in effective tax planning.
The ability to navigate revenue and expenses and debits and credits not only ensures accurate financial reporting but also lays the foundation for strategic tax planning. Tax planning often hinges on distinguishing between various income and expense categories by applying accounting principles.
An example of this relationship between tax law and accounting is found in the recent Short Stop Elec. v. Commissioner, No. 11359-20 (U.S.T.C. 2023) case. The case involves a cash basis taxpayer who attempted to transform retained earnings into a tax-deductible interest expense through accounting entries.
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Facts & Procedural History
The taxpayer is a C corporation. It was founded in 1989 and was owned by a husband and wife.
The C corporation adopted the cash method of accounting, recognizing income upon receipt and deducting expenses when paid.
The case involves a “revolving line of credit” the owners had with the company. It worked something like this: no money changed hands. Instead, a loan was recorded on the company books as being owed to the owner. Interest was not paid to the owner of the loan. So the owner periodically computed the interest due and recorded that interest as an increase in the principal of the loan.
The corporation deducted the interest that was converted to principal. The owner recorded the interest as paid on his individual income tax return–even though no interest payments were made.
The stated goal for this transaction was to generate deductions for the C corporation and also to have a large principal balance on the loan. The goal for the large principal balance is that he could pay the amount back and receive that tax-free when he retired and, presumably, sold the business.
The IRS had audited the business in 2006 and advised that this transaction could not be used to convert “retained earnings,” into interest deductions. The taxpayer and owner continued the practice even after the audit. On audit, the IRS disallowed the interest deduction. That brings us to this case, which addressed the same issue for 2015 and 2016.
Taxation of C Corporations
The court opinion notes that the use of a C corporation was unusual: “One might regard this as an eccentric choice for a small, privately owned business because income from C corporations is taxed twice.”
C corporations are popular choices for small privately owned businesses. C corporations were popular among small privately owned businesses, partly due to the graduated tax rate they offered. Companies with limited earnings could benefit from avoiding entity-level taxes. Additionally, C corporations provided advantages like Section 1202 stock and 1244 stock benefits, the use of stock options, and potential tax savings for employee benefits. Even after the Tax Cuts & Jobs Act (“TCJA”), which introduced a flat 21 percent tax rate for C corporations, they remained a popular choice.
Setting aside the “eccentric” aspect, the court is correct. C corporations can trigger a second level of tax. The C corporation pays income taxes on any profits it has, and the shareholder pays tax on wages and dividends that they pull out of the C corporation. Subchapter S corporations, partnerships, and trusts can be used to avoid this double tax.
The C corporation also requires more effort to document expenses as the IRS often asserts that expenses by the C corporation are personal in nature and therefore dividends.
For small businesses that are C corporations, tax planning often focuses on ensuring that the entity does not generate a sizable profit to trigger an income tax. That is what this case involves.
Deducting Interest for Tax Purposes
The tax planning in this case involved an interest deduction at the entity level. To be deductible, the interest must be ordinary and necessary for the business, and actually business-related. For cash basis taxpayers, it also has to be paid. One cannot deduct what was not paid.
In this case, the taxpayer was a cash-basis taxpayer. The interest deduction was taken even though no interest was paid. The taxpayer took the position that the conversion of the interest to principal on the loan was payment. The court had little difficulty in finding that the payment of interest by issuing a note does not count as payment. Absent payment, there is no interest deduction.
The owner did report the interest payment on his individual income tax return. He could have had the corporation pay the interest to him and then contributed the funds back to the corporation via additional loans, which would have achieved the same tax treatment. This is possible as business owners can fund their business with contributions or loans. This would have resolved the payment issue and potentially met the goal of accumulating a larger loan owed by the corporation to the owner, potentially reducing taxes upon the sale of the business. For this strategy to result in tax savings, it might need to be combined with other options. The addition of more traditional and basic tax planning tools might work. Retirement plans, stock options, etc. are all possibilities.
The Cash vs. Accrual Method
The other concept highlighted by this case is the cash-basis vs. accrual method. The cash method differs from the accrual method. The key difference between cash and accrual accounting methods is the timing of when income and expenses are recognized.
In accrual accounting, income and expenses are recognized when they are earned or incurred, regardless of when the actual cash payment occurs. This means that if the interest expense meets the criteria for deduction under accrual accounting, it would be deductible when it is accrued, even if no actual cash payment has been made.
So, in the fact pattern in this court case where interest is converted into principal on the loan, if the interest expense meets the criteria for deduction under accrual accounting, the corporation could have potentially deduct it at the time it is accrued, even if no cash interest payments were made. It may make sense to look into the options for changing accounting methods in these situations.
The Takeaway
This case involves a plan to convert retained earnings of a C corporation to interest deductions at the entity level, without the actual payment of interest. The IRS and the court made it clear that, for interest to be deductible, it must meet specific criteria, including actually being paid. Accounting entries are not enough for cash basis taxpayers. It is different for accrual basis taxpayers as they can deduct interest even when payment was not made, in some instances. This underscores the importance of adopting sound tax planning strategies.
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