This is the second of two installments of this article. Read the first installment on the Tax Section blog here.
I. No Tax Basis Increase for Loan Guaranties Even After the S Corporation Loan Is Called in Full.
An S corporation shareholder may deduct his/her pro rata share of any losses sustained by the corporation, but those loss deductions are limited to the sum of (a) the shareholder’s adjusted tax basis in the stock, and (b) any corporate indebtedness actually owed to the shareholder. IRC § 1366(d)(1).
In Phillips v. U.S., TC Memo 2017-621, Mrs. Phillips was a 50% owner of an S corporation that developed and sold real estate. In 2007, after the S corporation defaulted on significant real estate loans, the company’s creditors sued Mrs. Phillips and were awarded judgments in excess of $100 million. Mrs. Phillips took the position that, once the loan obligations were reduced to judgments against her, she could increase her tax basis in her S corporation stock by the guaranteed debt. The Tax Court, however, ruled, under the economic outlay requirement, Mrs. Phillips would not be entitled to any tax basis increase for her loan guaranties until she actually made payment to the corporation’s lenders.
II. S Corp Shareholder and Wife LLC Member Not Entitled to Tax Basis for Third Party Loans.
In Hargis v. Commissioner, TC Memo 2016-232, Mr. Hargis owned 100% of several S corporations that operated nursing homes. Mrs. Hargis owned 25% of several LLCs that owned real estate and equipment leased to certain nursing home operators, including Mr. Hargis’ operating companies. Mr. Hargis was a co-guarantor of certain third-party loans to his S corporations. Also, some of Mr. Hargis’ profitable companies made inter-company loans to other unprofitable companies owned by him.
The Tax court held Mr. Hargis could not increase his tax basis in his S corporation stock by the amount of any co-guaranteed debt to the S corporations. The court also held Mr. Hargis could not increase his basis in S corporation stock by the amount of any inter-company loans. In addition, the court refused to allow Mrs. Hargis to claim tax basis for the LLC’s debt borrowed from certain third parties. The court held although Mrs. Hargis was able to verify the LLC incurred debts from third parties, she was not able to verify how those partnership liabilities were deemed to be allocated among the various LLC members for tax purposes.
Even though Mrs. Hargis presented Forms K-1 in trial, the forms did not report the total amount of partnership liabilities nor the amount of partnership liabilities allocated to her. None of the Forms K-1 showed the amount of liabilities that had been specifically allocated to Mrs. Hargis. Therefore, Mrs. Hargis was not able to establish exactly how much of the liabilities should be allocated to her for tax basis purposes.
III. Partnership’s Allocation of Losses Failed the Substantial Economic Effect Test.
In Chief Counsel Memorandum 201741018, the IRS determined a partnership’s method of allocating losses to certain equity partners lacked economic effect, and therefore the losses had to be reallocated to other partners. Because the equity partners had no obligation under the partnership agreement to restore their negative capital accounts on liquidation of the partnership, partnership losses could be allocated to the partners only to the extent of their positive capital account balances.
VI. Section 6672 Responsible Person Gets No Trust Fund Tax Credit for Non-Designated Payment of Employment Taxes.
In Gann v. U.S., 119 AFTR 2d 2017-1220, Mr. Gann was the founder and CEO of Humanity Capital, Inc. (“HCI”). HCI had underpaid its payroll tax deposits for the fourth quarter of 2006 and the first and third quarters of 2007. However, HCI made payroll tax deposits for those quarters that exceeded the amount of employee trust fund tax withholdings for those periods.
The Tax Court found Mr. Gann was a responsible person within the meaning of Section 6672. Mr. Gann, however, argued since HCI paid payroll tax amounts—above and beyond the trust fund portion of the payroll taxes—in each of the quarters at issue, he should be given trust fund recovery credit for HCI’s payroll tax deposits. The IRS, however, had applied all of HCI’s payroll tax deposits first to the non-trust fund portion of the tax liability, which resulted in trust fund liabilities for those quarters.
The court noted that when HCI made its payroll tax deposits, HCI could have made an express election to apply payments of taxes against trust fund liabilities first, by making an explicit instruction to the IRS with those payments. See Westerman v. U.S., 718 F3d 743 (8th Cir. 2013). However, absent such an election, the IRS is free to apply deposits as it sees fit.
V. No Trust Fund Designation Where Employment Tax Deposit is Paid by Wire Transfer.
In Weder v. U.S., 120 AFTR 2d 2017-6211, Boom Drilling, LLC failed to timely pay its employment taxes for the first quarter of 2008. In April 2008, an IRS representative met with Ms. Weder, Boom’s in-house CPA, and its attorney to discuss Boom’s unpaid employment taxes. After that meeting, Boom sent, via wire transfer, $300,000 to the IRS to be applied to the first quarter’s employment tax delinquencies. However, when the wire transfer was made, Boom did not provide any written instructions to the IRS as to how to allocate the transfer between the trust fund and non-trust portions of the employment tax liability.
Ms. Weder, who attended the April 2008 meeting with the IRS representative, claimed the IRS representative told her that if Boom transferred $300,000 to the IRS in partial payment of outstanding tax liabilities, the IRS would apply that amount to trust fund tax liabilities. At trial, the IRS took the position the $300,000 payment was a deposit rather than a voluntary payment of employment taxes, and such a deposit cannot be designated toward trust fund tax liabilities.
The court stated any oral statements made by the IRS representative are not binding on the IRS since published revenue procedures clearly provide any voluntary employment tax payment designations must be made in writing. See Rev. Proc. 2002-26. Since there was no written designation that accompanied the payment, the IRS was free to apply the payments as it desired.
VI. Doctor Assessed $4.3 Million Penalty Under Section 6672 for Making $100,000 Loan to his Medical Practice.
In McLendon, 118 AFTR 2d 2016-5464, Dr. McLendon was the owner of a family medical practice. In 1995 the medical practice hired Richard Stephen as its CFO. In May 2009, Dr. McLendon learned over $10 million of payroll taxes were owed to the IRS. Ultimately, Mr. Stephen pled guilty to embezzling funds from the medical practice. Upon learning of the unpaid payroll taxes, Dr. McLendon immediately closed the practice and turned over its remaining assets to the IRS to pay towards the outstanding tax liabilities. However, at that time, Dr. McLendon also made a $100,000 loan to the practice so it could meet its payroll for the period ending May 15, 2009.
The IRS assessed a $4.3 million tax penalty against Dr. McLendon. The District Court held, notwithstanding Dr. McLendon’s good Samaritan acts, his using unencumbered funds to pay creditors other than the IRS made him liable for the full $4.3 million tax penalty.
VII. Tax Court Suggests Some LLC Pass-Through Income May Be Exempt from Self-Employment Tax.
In Castigliola v. Commissioner, TC Memo 2017-62, Mr. Castigliola was a member of a law firm that operated as a professional limited liability company. The company was a member-managed LLC formed under the laws of Mississippi. The LLC had no written operating agreement. Each year the LLC paid its attorneys guaranteed payments that were commensurate with local legal salaries as determined by a survey. Any profits of the LLC in excess of the guaranteed payments were distributed among the members based on the members’ agreement among themselves. Mr. Castigliola and his partners paid self-employment tax on the guaranteed payments, but took the position their distributive share profit payments were not subject to self-employment tax.
In determining whether the distributive share profit payments were not self-employment income due to the limited partner exclusion of Section 1402(a)(13), the court noted general partners of a limited partnership have both management power and unlimited personal liability, while limited partners lack management authority and enjoy immunity from partnership debts. The court noted because the PLLC was a member-managed LLC, each of the members had the authority to participate in management decisions. In fact, the members testified all the members participated equally in all decisions relating to the PLLC. The court concluded, therefore, the members could not avail themselves of the limited partner exception of Section 1402(a)(13).
Interestingly, the court never stated LLC members are always subject to self-employment tax on LLC income. If the LLC had been a manager-managed LLC and if Mr. Castigliola had not been a manager, perhaps the court would have reached a different result.
VIII. Surgeon’s Investment in Surgical Center Generates Non-Self-Employment Income.
In Hardy v. Commissioner, T.C. Memo 2017-16, Dr. Hardy was a surgeon who purchased a minority interest in a surgical facility owned by an LLC. Mr. Hardy claimed his distributive share of the LLC income should not be subject to self-employment tax. Patients of the medical facility paid three types of fees: (a) the fees of the surgeon, (b) the fees of the anesthesiologist, and (c) the fee to the surgical facility for use of the facility’s equipment and staff.
The Tax Court agreed with Dr. Hardy that, as a minority investor in the surgical center, he was acting more as a limited partner/investor. All the fees paid to the surgical center were paid by patients, and Dr. Hardy’s distributive share of the LLC income was not based on the number of surgeries he performed at the center. In addition, Dr. Hardy was not involved in the day-to-day business activities of the LLC.
The court distinguished its decision in Hardy from its earlier decision in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011). Renkemeyer involved partners who were lawyers in a limited liability partnership. There, the court ruled because the revenue was derived from the legal services performed by the partners in their capacity as partners, they were not acting as investors in the law firm, and thus their distributive shares of partnership income were subject to self-employment tax. In Hardy, however, Dr. Hardy received distributions that were based on fees paid by patients to use the surgical center facility.
IX. Financial Planner Could Not Avoid Self-Employment Tax by Running Commissions Through his S Corporation.
In Fleischer v. Commissioner, T.C. Memo 2016-238, Mr. Fleischer formed an S corporation called Fleischer Wealth Plan (“FWP”). Previously, Mr. Fleischer entered into a representative agreement with LPL Financial Services to serve as an independent sales contractor for LPL. During the tax years at issue, Mr. Fleischer received commission income from LPL, and LPL issued Mr. Fleischer a Form 1099 in his individual name. Mr. Fleischer, however, reported all the sales commissions from LPL on FWP’s Form 1120S. As a result, Mr. Fleischer avoided self-employment income on the income from LPL.
The Tax Court ruled, under the “who earned the income” test, the proper focus is who controls the earning of the income. Johnson v. Commissioner, 78 TC 882 (1982). Under that test, for a corporation, rather than its service provider-employee, to be the “controller of the income”, two elements must be present: (a) the individual providing the services must be an employee of the corporation that in turn controls the employee and (b) there must exist between the corporation and the end user some type of contract or similar agreement recognizing the corporation as controlling the service provider.
Here, the agreement between Mr. Fleischer and LPL was clearly between only them. The contract between LPL and Mr. Fleischer never made any mention of FWP. Therefore, it was Mr. Fleischer, not his corporation, who earned the income from LPL.
Keith A. Wood is an attorney with Carruthers & Roth, P.A. in Greensboro.