It is important to keep accurate books and records. Accurate books and records can result in significant tax savings. This is particularly true for entrepreneurs who own more than one business. When one or more of these businesses are taxed as a C corporation, the stakes can be even higher. The Nzedu v. Commissioner, T.C. Summary Opinion 2019-22, case provides an example.
Facts & Procedural History
The taxpayer engaged in three separate business activities. One activity was conducted using a corporation and two were conducted using a limited liability company (“LLC”). All of the entities were owned by the taxpayer-husband.
The taxpayer thought he had filed an election for the corporation to be taxed as an S corporation. The IRS didn’t receive the form. Another form was sent which listed a 2015 effective date.
The taxpayer filed his individual income tax return for 2013. On the tax return, he reported a loss for the one of the LLCs on his Schedule C and then a flow through loss from the corporation (that he thought was an S corporation) on his Schedule E. Later, the taxpayer filed an amended return to add the loss from the omitted LLC as a Schedule C business.
The question for the court was whether the flow through loss was allowable and whether the Schedule C expenses were allowable for the LLC omitted from his tax return.
The S Corporation Election
An S corporation is created when the taxpayer files an election to be an S corporation. This is done by filing the Form 2553.
Taxpayers can also set the effective date. Many taxpayers make the S corporation election effective as of the current year. The Form 2553 is then attached to the income tax return filed for the year.
But the election also can be made late in some circumstances. The rules for late S corporation elections are set out in Revenue Procedure 2013-30. The abbreviated version of these rules is that the late election can typically be made retroactive back 3 years and 75 days. To qualify, the taxpayer has to show that it filed returns, etc. consistent as an S corporation. The IRS would then have six months to examine the tax return and notify the taxpayer that the Form 1120S (the S corporation income tax return) was not processable.
The court did not allow the flow through deductions, noting that there was no evidence that the S corporation election was filed for 2012. There was no mention of the applicable revenue procedure or a late election. The result was that the corporation was taxed using its default classification, i.e., as a C corporation.
It is not clear what tax planning was involved. Presumably the taxpayer preferred the corporation be taxed as an S corporation so that the loss would not be available to offset the taxpayer’s other income. The court opinion notes that the taxpayer-wife is a doctor. Maybe the S corporation loss would have been available to offset her income from being a doctor.
Paying Expenses for Another Taxpayer
The C corporation can poses other problems for taxpayers. One of these problems comes up in cases like this were the corporation pays expenses for another business.
It is common for entrepreneurs who have multiple business entities to pay expenses from joint accounts. It is also common for taxpayers to have some expenses that are inadvertently paid by the wrong entity.
When the legal entities are disregarded entities or flow through entities, this can have less of an impact. Regardless of entity, the expenses typically all eventually end up on the same income tax return–the individual’s personal income tax return.
But the C corporation is treated as an entity separate from its owner for Federal income tax purposes. It reports its items of income and expense on its own income tax return.
When there is a tax loss rather than a profit, the expenses can be trapped in the C corporation. When this happens, it is imperative that the taxpayer make a timely correction–be it a transfer of funds to correct the issue or, at a minimum, an accounting entry to reflect offsetting obligations (see this article on joint interest accounting for C corporations like this).
The Tax Loss is not Actually Lost
Absent a transfer or accounting entry, one should expect the IRS to argue that the expenses were incurred by the C corporation. This is what the IRS attorney did in this case. The IRS attorney argued that the taxpayer was not entitled to deduct the losses on his personal return for the LLC omitted from the originally-filed tax return, as the expenses were paid by the corporation.
The court did not find the evidence presented sufficient to show what expenses were and were not paid by the corporation. Thus, it concluded that the taxpayer was not entitled to the loss on his personal income tax return.
While this result may seem harsh, it is probably just a timing issue. The taxpayer’s C corporation will eventually be able to take the loss for the omitted expenses. But also, now that the tax rates for C corporations are lower than the tax rates for many individual taxpayers, the taxpayer would lose out on the difference between the two.