Here is the Court:
While a taxpayer is fee to organize [her] affairs as [she] chooses, nevertheless once having done so, [she] must accept the tax consequences of her choice, whether contemplated or not, and may not enjoy the benefit of some other route [she] might have chosen to follow but did not.”
This is the tax equivalent of “you made your bed, now lie in it.” The IRS reserves the right to challenge how you structure a transaction, but – once decided – you yourself are bound by your decision.
Let’s talk about Stuller v Commissioner. They were appealing a District Court decision.
The Stullers lived in Illinois, and they owned several Steak ‘n Shake franchises. Apparently they did relatively well, as they raised Tennessee walking horses. In 1985 they decided to move their horses to warmer climes, so they bought a farm in Tennessee. They entered into an agreement with a horse trainer addressing prize monies, breeding, ownership of foals and so on.
In 1992 they put the horse activity into an S corporation.
They soon needed a larger farm, so they purchased a house and 332 acres (again in Tennessee) for $800,000. They did not put the farm into the S corporation but rather kept it personally and charged the farm rent.
So far this is routine tax planning.
Between 1994 and 2005, the S corporation lost money, except for 1997 when it reported a $1,500 profit. All in all, the Stullers invested around $1.5 million to keep the horse activity afloat.
Let’s brush up on S corporations. The “classic” corporations – like McDonald’s and Pfizer – are “C” corporations. These entities pay tax on their profits, and when they pay what is left over (that is, pay dividends) their shareholders are taxed again. The government loves C corporations. It is the tax gift that keeps giving and giving.
However C corporations have lost favor among entrepreneurs for the same reason the government loves them. Generally speaking, entrepreneurs are wagering their own money – at least at the start. They are generally of different temperament from the professional managers that run the Fortune 500. Entrepreneurs have increasingly favored S corporations over the C, as the S allows one level of income tax rather than two. In fact, while S corporations file a tax return, they themselves do not pay federal income tax (except in unusual circumstances). The S corporation income is instead reported by the shareholders, who combine it with their own W-2s and other personal income and then pay tax on their individual tax returns.
Back to the Stullers.
They put in $1.5 million over the years and took a tax deduction for the same $1.5 million.
Somewhere in there this caught the IRS’ attention.
The IRS wanted to know if the farm was a real business or just somebody’s version of collecting coins or baseball cards. The IRS doesn’t care if you have a hobby, but it gets testy when you try to deduct your hobby. The IRS wants your hobby to be paid for with after-tax money.
So the IRS went after the Stullers, arguing that their horse activity was a hobby. An expensive hobby, granted, but still a hobby.
There is a decision grid of sorts that the courts use to determine whether an activity is a business or a hobby. We won’t get into the nitty gritty of it here, other than to point out a few examples:
- Has the activity ever shown a profit?
- Is the profit anywhere near the amount of losses from the activity?
- Have you sought professional advice, especially when the activity starting losing buckets of money?
- Do you have big bucks somewhere else that benefits from a tax deduction from this activity?
It appears the Stullers were rocking high income, so they probably could use the deduction. Any profit from the activity was negligible, especially considering the cumulative losses. The Court was not amused when they argued that land appreciation might bail-out the activity.
The Court decided the Stullers had a hobby, meaning NO deduction for those losses. This also meant there was a big check going to the IRS.
Do you remember the Tennessee farm?
The Stullers rented the farm to the S corporation. The S corporation would have deducted the rent. The Stullers would have reported rental income. It was a wash.
Until the hobby loss.
The Stullers switched gears and argued that they should not be required to report the rental income. It was not fair. They did not get a deduction for it, so to tax it would be to tax phantom income. The IRS cannot tax phantom income, right?
And with that we have looped back to the Court’s quote from National Alfalfa Dehydrating & Milling Co. at the beginning of this blog.
Uh, yes, the Stullers had to report the rental income.
Why? An S corporation is different from its shareholders. Its income might ultimately be taxed on an individual return, but it is considered a separate tax entity. It can select accounting periods, for example, and choose and change accounting methods. A shareholder cannot override those decisions on his/her personal return. Granted, 99 times out of 100 a shareholder’s return will change if the S corporation itself changes. This however was that one time.
Perhaps had they used a single-member LLC, which the tax Code disregards and considers the same as its member, there might have been a different answer.
But that is not what the Stullers did. They now have to live with the consequences of that decision.
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.