IRS Suspends Tax Refunds and Tax Court Closes during Government Shutdown

In yet another administrative move designed to make the government’s partial shutdown as painful as possible for ordinary citizens, The Internal Revenue Service has temporarily stopped sending out tax refunds. Tax payments, however, continue to be due on a timely basis. The Tax Court has also suspended operations for the time being.

“Tax refunds will not be issued until normal government operations resume,” said the IRS. The IRS emphasized, however, that the underlying tax law remains in effect, and all taxpayers should continue to meet their tax obligations as normal.

“Individuals and businesses should keep filing their tax returns and making deposits with the IRS, as they are required to do so by law,” said the IRS. “The IRS will accept and process all tax returns with payments, but will be unable to issue refunds during this time. Taxpayers are urged to file electronically, because most of these returns will be processed automatically.”

In addition, the IRS noted that no live telephone customer service assistance will be available. However, most automated toll-free telephone applications will remain in operation. IRS walk-in taxpayer assistance centers will be closed, though.

While federal government offices are closed, people who have appointments with the IRS related to examinations and audits, as well as tax collection, appeals or Taxpayer Advocate cases should assume their meetings are canceled, the IRS noted. IRS personnel will reschedule the meetings at a later date once the government shutdown ends.

Corporate/Individual Tax – S-Corp Distribution Held to be Wages

Distributions from S corporation to its president were wages, not loan repayments

Glass Blocks Unlimited, TC Memo 2013-180

The Tax Court has held that distributions from an S corporation to its president/sole shareholder were taxable wages. IRS’s determination that the president was an employee was uncontested, and the S corporation failed to show that any portion of the distributions reflected repaid loans or that recharacterizing all of the distributions as wages would result in unreasonable compensation to him.

Background. 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.

Facts. Glass Blocks Unlimited (GBU) is an S corporation that, during 2007 and 2008, sold and distributed glass blocks for the real estate market in North America. During those years, Fredrick Blodgett was GBU’s president and sole shareholder.

GBU had no other full-time employees. Mr. Blodgett was responsible for all of GBU’s operational and financial decisions, and he performed nearly all of the work necessary to run the business.

GBU began to experience financial difficulties following the downturn in the real estate and construction markets, and Mr. Blodgett transferred funds to GBU in order to cover operating expenses and other costs. In 2007, he transferred $30,000. His then-fiance contributed $15,000 in 2007 and $10,000 in 2008. There was no collateral given or promissory notes issued reflecting the transfers.

For the 2007 and 2008 tax years, GBU didn’t report paying Mr. Blodgett any salary or wages, despite the fact that it distributed money to him as cash was available and when he asked for it (not less than $30,844 in 2007 and $31,644 in 2008). For 2007, GBU reported repayment of $29,132 of loans from shareholders and, on Form 1120S, Schedule L (Balance Sheet per Books), reported that it had no outstanding loans from shareholders at the beginning of the year and had a balance of $12,868 in loans from shareholders at the end of the year. For 2008, GBU reported repayment of $8,391 of loans from shareholders (a decrease in its reported loans from shareholders balance from $12,868 at the beginning of the year to $4,477 at the end of the year) and dividend distributions totaling $21,078.

Mr. Blodgett did not have any other employment during 2007 or 2008. On his 2007 return, he reported $877 of subchapter S income from GBU and $11 in taxable interest. For 2008, he reported $8,950 of subchapter S income from GBU.

IRS audited GBU’s 2007 and 2008 tax years and determined that Mr. Blodgett should be classified as an employee and the distributions should be characterized as wages for employment tax purposes. GBU didn’t object to IRS’s determination that Mr. Blodgett was an employee, but it asserted that some of the distributions represented the repayment of loans to Mr. Blodgett and shouldn’t be characterized as wages. IRS, in turn, argued that the funds were contributions to capital and the distributions were wages.

GBU also argued that if all of the distributions made to Mr. Blodgett were characterized as wages, such would constitute unreasonable compensation. In support of its argument, GBU claimed that he worked only 20 hours per work and performed only “undemanding” duties that didn’t require any training or special skills.

Transfers weren’t loans. Applying the factors outlined above, the Tax Court found that the transfers in this case were capital contributions and not bona fide loans. Notably, there were no written agreements or promissory notes, and while a portion of the transfers was reported as loans from shareholders on GBU’s Form 1120S, that factor carried little weight absent other supporting criteria. Further, not even Mr. Blodgett treated the transfer from him to GBU as a loan.

Other factors supporting the Court’s conclusion included the lack of interest, security, or a fixed repayment schedule. Mr. Blodgett withdrew funds based on GBU’s ability to pay, thus rendering repayment dependent on the success of the business rather than on an unconditional obligation.

Recharacterized wages were reasonable compensation. The Tax Court also easily concluded that recharacterizing all distributions to Mr. Blodgett as wages wouldn’t constitute unreasonable compensation to him. GBU failed to show that the salary information that it submitted was for positions comparable to Mr. Blodgett’s, Specifically, it submitted salary statistics for positions like a shipping clerk and accounts payable clerk, but Mr. Blodgett’s role was more substantial than any of the supposedly analogous positions. In effect, he performed each of those roles.

The Court also dismissed the claim that Mr. Blodgett worked only 20 hours per week. It was inconsistent with what Mr. Blodgett told the tax examiner who audited GBU, and it was further undermined by the hours posted on GBU’s website.

RIA observation: The Tax Court’s opinion doesn’t explain why GBU raised this argument. In general, unreasonable compensation is taxable to the recipient and not deductible by the payor, which is a worse result for the taxpayer. It appears as though Mr. Blodgett, who represented GBU before the Court, may have thought that only reasonable compensation would be treated as taxable wages, and the excess, if any, would be treated as loan repayments.

© 2013 Thomson
Reuters,  2395 Midway Road, Carrollton, TX  75006

Corporate Tax – Consolidated Return Deemed Filed Despite Omission of Required Forms

PLR 201324010

In a private letter ruling, IRS has confirmed that a parent corporation and its three subsidiaries filed a consolidated return even though it was later discovered that each sub failed to file a Form 1122 (Authorization and Consent of Subsidiary Corporation to Be Included in a Consolidated Return).

Facts. Before Date 1, various individual shareholders owned all of the stock in Sub 1, Sub 2, and Sub 3. On Date 1, Parent was incorporated as a State A corporation, and the individual shareholders contributed all of the outstanding stock of the Subs to Parent in exchange for Parent stock. The Date 1 transaction did not constitute a reverse acquisition under Reg. § 1.1502-75(d)(3).

Parent retained Accounting Firm to prepare its tax return for the short tax year ending on Date 2. Parent informed Accounting Firm that Parent and the Subs intended to file a consolidated income tax return. The return for the tax year ending on Date 2 was timely filed and included the items of income and deduction for Parent and each of the Subs for the entire short tax year. The return also included a Form 851 (Affiliations Schedule) that identified each of the Subs as subsidiaries that were joining in the making of the consolidated return with Parent.

On Date 3, it was discovered that a Form 1122 for each of the Subs was not filed with Parent’s tax return for the tax year ending on Date 2. The statute of limitations under Code Sec. 6501(a) has not expired with respect to the return; however, the return is currently under examination.

Parent made the following representations:

  • Except for the failure to timely file Forms 1122, Parent and each Sub were eligible to join in the filing of a consolidated Federal income tax return for the tax year ending Date 2.
  • The Subs were included on the Form 851 attached to the return.
  • The income and deductions of each of the Subs for the short tax year ending Date 2 were included in the return filed by Parent as the parent of the consolidated group.
  • Neither Parent nor any of the Subs filed a separate return for the tax year ending Date 2.

Background. An affiliated group of corporations that did not file a consolidated return for the immediately preceding tax year may file a consolidated return in lieu of separate returns for the tax year, provided that each corporation which has been a member during any part of the tax year for which the consolidated return is to be filed consents, in the manner provided in Reg. § 1.1502-75(b), to the regs under Code Sec. 1502 . (Reg. § 1.1502-75(a)(1)) If a group wishes to exercise its privilege of filing a consolidated return, it must be filed not later than the last day prescribed by law (including extensions) for the filing of the common parent’s return.

The consent of a corporation to file a consolidated return is made by the corporation joining in the making of the consolidated return for the year. A subsidiary is deemed to have joined in the making of a consolidated return for the year if it files a Form 1122 in the manner specified in Reg. § 1.1502-75(h)(2). (Reg. § 1.1502-75(b)(1)) Under Reg. § 1.1502-75(h)(2), for a group to file a consolidated return, a Form 1122 must be executed by each subsidiary. Form 1122 is not required for a tax year if a consolidated return was filed (or was required to be filed) by the group for the immediately preceding year.

If a member of the group fails to file Form 1122, IRS may under the facts and circumstances determine that such member has joined in the making of a consolidated return by such group. (Reg. § 1.1502-75(b)(2)) Factors IRS will take into account in making this determination include:

  • Whether the income and deductions of the member were included in the consolidated return for such tax year;
  • Whether a separate return was filed by the member for that tax year; and
  • Whether the member was included in the affiliations schedule, Form 851 for such tax year.

Favorable ruling. Based on the information submitted and representations made, IRS ruled under Reg. § 1.1502-75(b)(2) that each of the Subs is treated, under Reg. § 1.1502-75(h)(2), as if it had filed a Form 1122 with the Federal income tax return Parent filed for the short tax year ending on Date 2. IRS expressed no opinion concerning the tax consequences of any other aspect of any transaction or item discussed or referenced in the ruling, or about the tax treatment of any condition existing at the time of, or effects resulting from, any transaction or item that is not specifically covered by the ruling. Also, IRS noted that it had not verified any of the material submitted in support of the request for rulings, but that such material is subject to verification on examination.

© 2013 Thomson Reuters,  2395 Midway Road, Carrollton, TX  75006