IRS AGREES IN RESULT ONLY RE CORP. PAYMENTS OF SHAREHOLDER/EMPLOYEE’S PERSONAL EXPENSES

Posted by Kim Chen on May 15th, 2017

IRS has acquiesced in result only with a Tax Court holding that an S corporation’s payment of personal expenses on behalf of its sole shareholder/officer should not be characterized as wages subject to federal employment taxes. The Tax Court found that they were repayments of loans made to the S corporation, and IRS was critical of the Court’s reasoning.
Background—shareholder loans vs. capital contributions to corporation. The proper characterization of transfers by shareholders to corporations, as either loans or capital contributions, is made by reference to all the evidence, and the burden of proving that a transfer is a loan falls on the taxpayer. (Dixie Dairies Corp., (1980) 74 TC 476)
Courts have established a nonexclusive list of factors to consider when evaluating the nature of transfers of funds to closely held corporations. Such factors include:

1. The names given to the documents that would be evidence of the purported loans;
2. The presence or absence of a fixed maturity date;
3. The likely source of repayment;
4. The right to enforce payments;
5. Participation in management as a result of the advances;
6. Subordination of the purported loans to the loans of the corporation’s creditors;
7. The intent of the parties;
8. The capitalization of the corporation;
9. The ability of the corporation to obtain financing from outside sources;
10. Thinness of capital structure in relation to debt;
11. Use to which the funds were put;
12. The failure of the corporation to repay; and
13. The risk involved in making the transfers. (Calumet Indus., Inc., (1990) 95 TC 257)
That is, the inquiry before a court is “whether the transfer… constitutes risk capital entirely subject to the fortunes of the corporate venture or a strict debtor-creditor relationship”. (Dixie Dairies Corp.) Transfers to closely-held corporations by controlling shareholders are generally subject to heightened scrutiny.
Background—”wages” defined. For employment tax purposes, “wages” are defined as all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash, with certain exceptions not applicable to this case. (Code Sec. 3121(a), Code Sec. 3306(b), and Code Sec. 3401) Employment is defined generally as any service, of whatever nature, performed by an employee. (Code Sec. 3121(b))
Facts. Mr. Singer was the sole shareholder and president of an S corporation called Scott Singer Installations, Inc. (the corporation), and served as its sole corporate officer. The corporation was primarily engaged in servicing, repairing, and modifying recreational vehicles. Mr. Singer worked full time for the corporation and occasionally employed a service technician, two laborers, and an individual to help with the corporation’s Internet sales.
Between 2006 and 2008, Mr. Singer advanced a total of $646,443 to the corporation to fund business growth. The corporation struggled from 2009 to 2011 and Mr. Singer borrowed another $513,099, which he advanced to the corporation. Mr. Singer also began charging business expenses to personal credit cards. The corporation reported operating losses of $103,305 for 2010 and $235,542 for 2011. During these years, the corporation paid $181,872 of Mr. Singer’s personal expenses by making payments from its bank account to Mr. Singer’s creditors.
All of the advances were reported as shareholder loans on the corporation’s general ledgers and Form 1120S (U.S. Income Tax Return for an S Corporation), but there were no promissory notes between Mr. Singer and the corporation, there was no interest charged, and there were no maturity dates imposed. The corporation did not deduct the payment of Mr. Singer’s personal expenses on Form 1120S.
The corporation filed Form 940 (Employer’s Annual Federal Unemployment (FUTA) Tax Return) and Forms 941 (Employer’s Quarterly Federal Tax Return) and paid employment taxes on wages paid to each employee except Mr. Singer. The corporation did not report paying wages to Mr. Singer during 2010 or 2011.
On audit, IRS determined that Mr. Singer was an employee of the corporation for 2010 and 2011 and that the $181,872 in payments the corporation made on his behalf constituted wages that should have been subject to employment taxes. Mr. Singer did not object to being classified as an employee of the corporation, but contended that the advances that he made to the corporation were loans and that the payments the corporation made on his behalf represented repayments of those loans. IRS, on the other hand, argued that the funds advanced to the corporation were contributions to capital.
Tax Court’s decision. The Court concluded that Mr. Singer intended his advances to be loans, that his intention was reasonable for a substantial portion of the advances, and that the corporation’s repayments of those loans were valid and should not be characterized as wages subject to employment taxes. (Scott Singer Installations, Inc., TC Memo 2016-161)
The Court said that there were a number of factors involved when evaluating the nature of transfers of funds to closely held corporations. It believed that the ultimate question was whether there was a genuine intention to create a debt, with a reasonable expectation of repayment, and whether that intention comported with the economic reality of creating a debtor-creditor relationship. If there was a genuine intention to create a debt, the corporation’s payment of Mr. Singer’s personal expenses could be considered as partial repayment of Mr. Singer’s loans rather than as wage income.
The Court noted that the corporation consistently reported the advances as loans on its general ledgers and on Forms 1120S. The corporation also consistently reported the expenses it was paying on behalf of Mr. Singer as a repayment of shareholder loans rather than reporting the payments as deductible business expenses. The Court said this indicated that Mr. Singer and the corporation intended to form a debtor-creditor relationship and that the corporation conformed to that intention. In addition, the Court pointed out that the corporation’s payments on behalf of Mr. Singer were consistent regardless of the value of the services Mr. Singer provided to the corporation. Many of the payments the corporation made were for Mr. Singer’s recurring monthly expenses, including home mortgage and personal vehicle loan payments. The consistency of these payments, both in time and in amount, was characteristic of a debt repayment. Furthermore, the fact that the corporation made payments when it was operating at a loss strongly suggested that a debtor-creditor relationship existed: a creditor expects repayment of principal and compensation for the use of money, while an investor understands that any return of his investment depends on the success of the business.
The Court also said that Mr. Singer had a reasonable expectation of repayment of the advances when he first advanced funds to the corporation between 2006-2008. At that time, the business was well-established and successful. The Court believed that because the corporation was operating profitably and showed signs of growth, Mr. Singer was reasonable in assuming his loans would be repaid and that such intention comported with the economic reality of creating a debtor-creditor relationship.
The Court, however, did not believe Mr. that Singer had a reasonable expectation that the loans he made after 2008 would be repaid as the corporation’s business had dropped off sharply. It therefore concluded that the advances made in 2008 and earlier were bona fide loans and that advances made after 2008 were capital contributions.
IRS acquiesces in result only. IRS has now announced its acquiescence in result only as to whether the corporation’s payment of personal expenses on behalf of its sole shareholder-corporate officer constitutes wages subject to Federal employment. IRS had many criticisms of the Tax Court’s reasoning.
IRS said that the critical factor in determining the appropriate tax treatment is whether the payments are remuneration for services provided to the employer. IRS disagreed with the Court’s reasoning. Whether advances made to a corporation by a shareholder-officer are characterized as loans rather than capital contributions does not control whether a payment made by the corporation to the shareholder-officer is compensation for services and therefore properly characterized as wages. The Court failed to acknowledge that, similar to debt repayments, wages are also paid in a recurring nature and may be paid even if a business is operating at a loss.
IRS noted that there is no provision in the Code or regs that authorizes an employee to waive his or her right to receive wages, and thereby characterize payments that are made to the employee or benefits that are provided to the employee as something other than wages.
IRS said that, in focusing on the intention to create a debtor-creditor relationship and whether Mr. Singer had a reasonable expectation of repayment of the advances, the Court failed to analyze or even cite the relevant statutory or regulatory provisions governing the definition of wages for Federal employment tax purposes. Nor did the Court review its own substantial body of case law that repeatedly rejects taxpayers’ attempted characterizations of payments to officers who perform substantial services as something other than compensation for services. The Court failed to analyze why precedents concerning officer compensation were not applicable. IRS said that, for example, Smith, TC Memo 1995-410, found that payments of personal living expenses made by a wholly owned corporation on behalf of its president/employee and sole shareholder, who received no salary in the year at issue, are properly characterized as wages when they represent remuneration for employment. And, several circuit courts have also rejected arguments that officers who perform substantial services received something other than compensation for those services.
IRS said that, while none of the courts in the cases cited above found the existence of a debtor-creditor relationship, the applicable employment tax rules defining the scope of wages as all remuneration for employment does not cease to apply even if such debtor-creditor relationship is present. While IRS may recognize a payment from a corporation to its shareholder-officer who is also an employee as a loan repayment, the taxpayer must provide objective evidence that both substantiates that a bona fide loan exists between the parties and substantiates that the payment from the taxpayer to the employee was specifically in repayment of that loan and is separate from compensation paid to the employee for the performance of services for the taxpayer.
Accordingly, unless a taxpayer objectively substantiates both the existence of a loan and that payments made were in repayment of that loan, IRS will continue to assert that the payment of personal expenses by an S Corporation on behalf of its corporate officer/employee constitute wages subject to Federal employment taxes.
References: For loans vs. capital contributions, see FTC 2d/FIN ¶ K-5812; United States Tax Reporter ¶ 1664.130.

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