As tax advisers, one of the more difficult hurdles we face is convincing clients not to turn their closely-held corporations into incorporated pocketbooks. The temptation is strong for shareholders to use their corporations to pay all expenses, whether they be legitimate expenses of the business or — as is often the case — their own personal expenses.
We face an uphill battle communicating the perils of such a philosophy for one simple reason: because the odds of an audit are so remote, many corporations get away with paying the personal expenses of its owner. The owners of these corporations then invariably head off to the gym or golf course or strip club and brag to other business owners about their “tax deductible personal expenses,” which in turn causes those business owners — our clients — to pick up the phone and ask us why they aren’t getting the same tax benefits.
The reason, of course, is an obvious one. Just because an expense is incurred in a separate legal entity — like a corporation or partnership — doesn’t make it a de facto “business expense.” For example, expenses incurred by a business for a car, plane or rent that would be personal in nature if paid by an individual don’t suddenly become business expenses when the underlying asset or expense is dumped inside a corporation.
But don’t take my word for it. If you need to scare a client straight, just show them D’Errico v. Commissioner, T.C. Memo 2012-149.
In D’Errico, Joseph D’Errico was the sole shareholder of TPM, a C corporation that provided management services to D’Errico’s wholly-owned tax preparation firms. D’Errico ran just about every expense he could through the corporation, inviting scrutiny from the IRS that ultimately resulted in the assessment of some heavy tax deficiencies.
What follows is a discussion of just two of the many expenses denied by the Tax Court as personal, highlighted here because they are common areas of abuse.
TPM entered into a lease with D’Errico’s father for the use of his personal residence. In turn, TPM subleased a portion of the residence to D’Errico for his personal use. Neither the lease nor the sublease identified what portion of the property would be used by TPM for business purposes or what portion would be used by D’Errico’ personally. TPM deducted the rent expense paid to D’Errico’s father on its corporate tax return.
The IRS argued that TPM did not use the residence for business purposes. The Tax Court agreed, holding that TPM failed to prove its entitlement to deductions for the rent expenses:
Although TPM admits part of the Barton Drive home was used for Mr. D’Errico’s personal purposes, it contends that a larger portion of the home was used for business purposes. TPM failed to produce records of any business activity it performed at the property. We also note that the Barton Drive home was approximately 400 miles from Mr. D’Errico’s primary places of employment in southern California during those tax years. Considering the evidence presented, we find TPM has failed to establish that it conducted business-related activities at the Barton Drive home, and we sustain respondent’s determination disallowing deduction of the rent expenses by TPM.
TPM also purchased a Cessna airplane. D’Errico had a pilot’s license and several years of flight training at the time TPM purchased the airplane, and he testified that TPM purchased the airplane in order for him to travel quickly between TPM’s purported office in Nevada and his two active tax preparation corporations which were in southern California (a commute of approximately 400 miles).
TPM also entered into a lease agreement whereby it would rent the plane for up to 75 hours a month. The purpose of the arrangement, according to the lease, was to allow TPM to generate revenue to offset some of the plane’s costs.
On its corporate tax return, TPM deducted airplane operating expenses and depreciation. Again, the IRS argued that the airplane was not used for business purposes, and thus the related expenses were not ordinary and necessary business expenses deductible under I.R.C. § 162. And again, the Tax Court agreed:
…At the time TPM purchased the airplane, D’Errico knew that he was going to be selling [the tax preparation firms.] The only business-related use of the airplane shown by petitioners was Mr. D’Errico’s use of the airplane to travel to southern California in December 2004 to speak with the parties buying D’Errico & McCollor and D’Errico & Wedge. TPM has produced no evidence that the airplane was used in TPM’s tax management business after 2004.
D’Errico also testified that TPM entered “the business of renting * * * [the airplane] out”. To determine whether a taxpayer is conducting a trade or business requires an examination of the facts of each case. For a taxpayer to be engaged in a trade or business, the primary purpose for engaging in the activity must be for income or profit. However, a mere hope that an activity will generate profits, in the absence of any specific plan to generate a profit, is inconsistent with an allegation that the belief is in good faith. TPM has not proven that it entered into the lease agreement with Flying Start Aero with the primary purpose of making a profit. Indeed, the lease agreement itself stated that TPM was entering the agreement “with the intention of generating some revenue for the purpose of offsetting a portion of the aircraft operating costs”. The Court of Appeals for the Ninth Circuit (to which this case is appealable) has held that a profit motive does not exist where “activities represented mere attempts torecoup some of * * * [the taxpayers’] costs.” We therefore find that TPM was not engaged in the trade or business of renting out the airplane.
To make matters worse, when a shareholder’s personal expenses are paid by a corporation, the tax hit is doubly painful. Not only are the expenses disallowed at the corporate level — as they were to TPM — but the expenses are typicallly treated as constructive distributions to the shareholders, which they were in D’Errico’s case. When these constructive dividends are deemed made by a C corporation, they result in dividend income to the shareholder to the extent of any corporate earnings and profits. .