Let’s say that you have a profitable business. You have a family member who has an unprofitable business. You want to help out the family member. You meet with your tax advisor to determine if there is tax angle to consider.
Here is your quiz question and it will account for 100% of your grade:
What should you to maximize the chances of a tax deduction?
Let’s discuss Espaillat and Lizardo v Commissioner.
Mr. Jose Espaillat was married to Ms. Mirian Lizardo. Jose owned a successful landscaping business in Phoenix for a number of years. In 2006 his brother (Leoncio Espaillat) opened a scrap metal business (Rocky Scrap Metal) in Texas. Rocky Scrap organized as a corporation with the Texas secretary of state and filed federal corporate tax returns for 2008 and 2009.
Being a good brother, Jose traveled regularly to help out Leoncio with the business. Regular travel reached the point where Jose purchased a home in Texas, as he was spending so much time there.
Rocky Scrap needed a big loan. The bank wanted to charge big interest, so Jose stepped in. He lent money; he also made direct purchases on behalf of Rocky Scrap. In 2007 and 2008 he contributed at least $285,000 to Rocky Scrap. Jose did not charge interest; he just wanted to be paid back.
Jose and Mirian met with their accountant to prepare their 2008 individual income tax return. Jose’s landscaping business was a Schedule C proprietorship/sole member LLC, and their accountant recommended they claim the Rocky Scrap monies on a second Schedule C. They would report Rocky Scrap the same way as they reported the landscaping business, which answer made sense to Jose and Mirian. Inexplicably, the $285,000 somehow became $359,000 when it got on their tax return.
In 2009 Rocky Scrap filed for bankruptcy. I doubt you would be surprised if I told you that Jose paid for the attorney. At least the bankruptcy listed Jose as a creditor.
In 2010 Jose entered into a stock purchase agreement with Leoncio. He was to receive 50% of the Rocky Scrap stock in exchange for the aforementioned $285,000 – plus another $50,000 Jose was to put in.
In 2011 Jose received $6,000 under the bankruptcy plan. It appears that the business did not improve all that much.
In 2011 Miriam and their son (Eduan) moved to Texas to work and help at Rocky Scrap. Jose stayed behind in Phoenix taking care of the landscaping business.
Then the family relationship deteriorated. In 2013 a judge entered a temporary restraining order prohibiting Jose, Miriam and Eduan from managing or otherwise directing the business operations of Rocky Scrap.
Jose, Miriam and Eduan walked away. I presume they sold the Texas house, as they did not need it anymore.
The IRS looked at Jose and Mirian’s 2008 and 2009 individual tax returns. There were several issues with the landscaping business and with their itemized deductions, but the big issue was the $359,000 Schedule C loss.
The IRS disallowed the whole thing.
On to Tax Court they went. Jose and Mirian’s petition asserted that they were involved in a business called “Second Hand Metal” and that the loss was $285,000. What happened to the earlier number of $359,000? Who knows.
What was the IRS’ argument?
Easy: there was no trade or business to put on a Schedule C. There was a corporation organized in Texas, and its name was Rocky Scrap Metals. It filed its own tax return. The loss belonged to it. Jose and Mirian may have loaned it money, they may have worked there, they may have provided consulting expertise, but at no time were Jose and Mirian the same thing as Rocky Scrap Metal.
Jose and Mirian countered that they intended all along to be owners of Rocky Scrap. In fact, they thought that they were. They would not have bought a house in Texas otherwise. At a minimum, they were in partnership or joint venture with Rocky Scrap if they were not in fact owners of Rocky Scrap.
Unfortunately thinking and wanting are not the same as having and doing. It did not help that Leoncio represented himself as the sole owner when filing the federal corporate tax returns or the bankruptcy paperwork. The Court pointed out the obvious: they were not shareholders in 2008 and 2009. In fact, they were never shareholders.
OBSERVATION: Also keep in mind that Rocky Scrap filed its own corporate tax returns. That meant that it was a “C” corporation, and Jose and Mirian would not have been entitled to a share of its loss in any event. What Jose and Mirian may have hoped for was an “S” corporation, where the company passes-through its income or loss to its shareholders, who in turn report said income or loss on their individual tax return.
The Court had two more options to consider.
First, perhaps Jose made a capital investment. If that investment had become worthless, then perhaps …
Problem is that Rocky Scrap continued on. In fact, in 2013 it obtained a restraining order against Jose, Miriam and Eduan, so it must have still been in existence. Granted, it filed for bankruptcy in 2009. While bankruptcy is a factor in evaluating worthlessness, it is not the only factor and it was offset by Rocky Metal continuing in business. If Rocky Scrap became worthless, it did not happen in 2009.
Second, what if Jose made a loan that went uncollectible?
The Court went through the same reasoning as above, with the same conclusion.
OBSERVATION: In both cases, Jose would have netted only a $3,000 per year capital loss. This would have been small solace against the $285,000 the IRS disallowed.
The Court decided there was no $285,000 loss.
Then the IRS – as is its recent unattractive wont – wanted a $12,000 penalty on top of the $60-plus-thousand-dollar tax adjustment it just won. Obviously if the IRS can find a different answer in 74,000+ pages of tax Code, one must be a tax scofflaw and deserving of whatever fine the IRS deems appropriate.
The Court decided the IRS had gone too far on the penalty.
Here is the Court:
He [Jose] is familiar with running a business and keeping records but has a limited knowledge of the tax code. In sum, Mr. Espaillat is an experienced small business owner but not a sophisticated taxpayer.”
Jose and Mirian relied on their tax advisor, which is an allowable defense to the accuracy-related penalty. Granted, the tax advisor got it wrong, but that is not the same as Jose and Mirian getting it wrong. The point of seeing a dentist is not doing the dentistry yourself.
What should the tax advisor done way back when, when meeting with Jose and Mirian to prepare their 2008 tax return?
First, he should have known the long-standing doctrine that a taxpayer devoting time and energy to the affairs of a corporation is not engaged in his own trade or business. The taxpayer is an employee and is furthering the business of the corporation.
Granted Jose and Mirian put-in $285,000, but any tax advantage from a loan was extremely limited – unless they had massive unrealized capital gains somewhere. Otherwise that capital loss was releasing a tax deduction at the rate of $3,000 per year. One should live so long.
The advisor should have alerted them that they needed to be owners. Retroactively. They also needed Rocky Scrap to be an S corporation. Retroactively. It would also have been money well-spent to have an attorney draw up corporate minutes and update any necessary paperwork.
That is also the answer to our quiz question: to maximize your chance of a tax deduction you and the business should become one-and-the-same. This means a passthrough entity: a proprietorship, a partnership, an LLC or an S corporation. You do not want that business filing its own tax return. The best you could do then is have a worthless investment or uncollectible loan, with very limited tax benefits.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.