Tax Matters
From AICPA, Journal of Accountancy, November, 2003
Tax Cases
Bankruptcy and S Corporation Pass-Through
Although there are some signs the economy is improving, many businesses continue to fail. Recently the Tax Court considered the effect of an S corporation’s selling an asset while in bankruptcy. All S corporation shareholders contemplating filing for corporate bankruptcy need to consider the potential tax outcome of such a move.
Alphonse Mourad was the sole shareholder of V&M Management Inc., an S corporation. On January 8, 1996, the corporation filed a Chapter 11 bankruptcy reorganization petition. The court appointed an independent trustee to administer the reorganization. On September 26, 1997, the court approved the plan. The trustee sold the corporation’s main asset for $2,872,351, realizing a gain of $2,088,554. The trustee reported the gain on form 1120S and sent a form K-1 to the shareholder. Mourad did not report the gain as income and the IRS determined a deficiency. He later claimed he should not be treated as the shareholder of an S corporation following V&M’s bankruptcy petition. Mourad also argued he should not have to report the gain because he did not benefit from the sale.
Result. For the IRS. The general rule is that following a valid S election, shareholders must report and pay tax on the corporation’s income. This system of taxation continues until the S election terminates. A company’s S corporation status can end in any of three ways:
Shareholders voluntarily revoke the entity’s S corporation status.
The corporation has excessive passive income for three consecutive years.
The corporation ceases to be a small business corporation that is eligible for S status.
The first two circumstances did not apply to this case. Therefore, the court addressed whether the corporation had stopped being eligible for S status.
To be eligible for S corporation status, a corporation cannot have
More than 75 shareholders.
A shareholder that is other than an individual, estate or qualified trust.
A nonresident alien shareholder.
More than one class of stock outstanding.
Filing a bankruptcy petition—as V&M Management did—did not violate any of the above requirements. Therefore, according to the court, the company’s S election was not terminated.
As additional support, the court referred to a prior case, In re Stadler Associates Inc., in which the Florida bankruptcy court held that filing a bankruptcy petition did not terminate an S election. Although Stadler involved a Chapter 7 bankruptcy and Mourad Chapter 11, the result was the same. The differences between the two filings were in the remedies the companies sought, not the tax treatment. The court ruled that V&M’s S corporation status was still in effect and that Mourad should have included his share of the gain in income.
In rejecting Mourad’s contention that he shouldn’t be taxed on the gain because he didn’t benefit from the property’s sale, the court noted that the taxpayer previously had benefited from the single taxation of the company’s income and the pass-through of losses. Therefore, he now had to pay tax on the pass-through gain from the sale of the entity’s property, even though the taxation would be detrimental to him. The result, according to the court, would be equitable.
There was one concern the case did not raise, and therefore, the court did not deal with it. Since the corporation filed a bankruptcy reorganization plan, it likely was insolvent. In that case it could be argued the creditors were the de facto shareholders and should have reported the gain. However, it isn’t likely any court would have accepted this argument and shifted the tax to the creditors. As a result all S shareholders should be prepared to report and pay tax on any gains from asset sales during a bankruptcy reorganization.
Alphonse Mourad v. Commissioner, 121 TC no. 11.
Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.
Reasonable Compensation
Determining what constitutes reasonable compensation is a long-standing issue for C corporations. IRC section 162(a)(1) allows a deduction for reasonable compensation for personal services actually rendered. The IRS views unreasonable salaries as disguised dividends, making them nondeductible by C corporations and taxable to the shareholder. This means employee shareholders are double-taxed on such amounts.
The courts and the IRS consider many factors in determining the reasonableness of compensation, including an individual’s qualifications, the work involved, the nature of the business, the relationship between gross and net income, business conditions, salaries in relation to dividends, comparable salaries in comparable companies, the salary policy of the company in question, salaries paid in prior years and pension or profit-sharing plans. They examine all of the facts and circumstances; no single factor is paramount. A recent Tax Court decision addressed this issue.
Brewer Quality Homes sells mobile homes and is owned 50/50 by husband and wife shareholders. After the IRS conceded the wife’s compensation was reasonable (the initial deficiency notice partially disallowed deductions for both spouses), the issue before the Tax Court centered on the reasonableness of the husband’s compensation for 1995 and 1996.
In this case the factors indicating a relatively high level of reasonable compensation include the husband’s involvement in all aspects of the company since its inception, the company’s rapid growth, his personal guarantee of the company’s debt, the fact the company did not furnish that individual with a defined benefit or profit-sharing plan and the company’s ability to survive several significant economic downturns in contrast to many of its competitors.
On the other hand the factors indicating a relatively low level of reasonable compensation include excessively high percentages of compensation to gross sales and taxable income; the company’s failure to maintain a compensation policy for the husband (who thus could set his own pay since he controlled the company); bonuses given to him on an ad hoc basis without any prescribed formula and many times his regular salary; the company’s omission of dividends in two recent years even though profits were higher than in two previous dividend-paying years; and the company’s average return on its equity being below that of comparable businesses.
The IRS contended that part of the husband’s compensation represented disguised dividends because
If the company had a good year, so did the husband.
The ad hoc bonus and absence of a compensation plan reflected an intent to pay dividends rather than salary.
In a C corporation, double taxation of retained earnings and dividends occurs, giving the company an incentive to pay higher compensation.
To evaluate the reasonableness of compensation, both the company and the IRS brought in expert witness testimony. The court was not persuaded by much of it. Nevertheless, in its deliberations the court used some of the data, particularly the Robert Morris Associates (RMA) statistics concerning executive compensation as a percentage of sales.
Result. Partially for the IRS. The court concluded that factors taken from the RMA 90th percentile were appropriate for determining reasonable compensation. By applying these factors and making other adjustments for nonsalary considerations, the court arrived at levels of reasonable compensation that exceeded those of the IRS but were less than the deductions the corporation took. Thus, the court deemed part of the payments to be noncompensation, resulting in tax deficiencies for the years in question.
This decision reinforces the need for proper planning to help ensure the deductibility of executive salaries in a closely held business. It also emphasizes the need for careful consideration of appropriate entity choice and possible alternatives to C corporation status.
Brewer Quality Homes Inc., TC Memo 2003-20, July 10, 2003.
Prepared by William J. Cenker, CPA, PhD, KPMG Professor of Accounting and Robert Bloom, PhD, professor of accounting, both at the Boler School of Business, John Carroll University, University Heights, Ohio.
Losses Trust Deducted Were Not From Passive Activity
IRC section 469(a)(1) defines a passive activity as one involving the conduct of any trade or business in which the taxpayer does not materially participate. In section 469(a)(2), the statute describes a taxpayer as any
Individual, estate or trust.
Closely held C corporation.
Personal service corporation.
In general, the IRS will treat a taxpayer as materially participating in an activity only if that taxpayer is involved in the operations on a regular, continuous and substantial basis.
The Mattie K. Carter Trust was established in 1956 under the will of Mattie K. Carter. Benjamin Fortson, the trustee since 1984, manages its assets, including the Carter Ranch, which the trust has operated since 1956. The ranch covers some 15,000 acres and includes cattle-ranching as well as oil and gas interests. At the times in question the Carter Trust employed a full-time ranch manager and other employees who performed essentially all the ranch’s activities. Fortson also devoted a substantial amount of time and attention to ranch activities.
The Carter Trust claimed deductions for losses it incurred in connection with the ranch operations for 1994 and 1995 of $856,518 and $796,687, respectively. In April 1999 the IRS issued a deficiency notice disallowing the deductions because of section 469’s passive activity rules. The Carter Trust paid the disputed tax in full plus interest and made a timely refund claim, which the IRS denied. The trust then sued for a refund in district court.
The court considered the question of whether the Carter Trust materially participated in the cattle-ranch operations or was otherwise “passively” involved. The IRS argued a trust’s “material participation” in a trade or business, within the meaning of section 469(h), should be determined by evaluating only the trustee’s activities. The IRS proposed to disallow the losses in full for both tax years because the trustee, Fortson, failed to meet the IRC’s material participation requirements. The IRS classified the losses as “passive activity losses.”
The Carter Trust said it—not the trustee—was the taxpayer, and material participation should be determined by assessing the trust’s activities through its fiduciaries, employees and agents. The trust also said that as a legal entity, it could participate only through the actions of those individuals. Their collective efforts on the cattle-ranching operations during 1994 and 1995 were regular, continuous and substantial.
Result. For the taxpayer. The court found the IRS’s contention that the trust’s participation in the ranch operations should be measured by referring to the trustee’s activities had no support within the plain meaning of the statute. The court said this position was arbitrary and subverted common sense and, in the absence of case law or regulations, the IRS should not create ambiguity where there was none.
The court held it undisputed that the Carter Trust, not its trustee, was the taxpayer. The trust’s participation in the ranch operations entailed an assessment of the activities of those who labored on the ranch, or otherwise conducted ranch business on the trust’s behalf. Their collective activities during the times in question were regular, continuous and substantial enough to constitute material participation.
The court concluded the losses the Carter Trust had sustained were not passive within the meaning of section 469. The IRS had improperly disallowed the ranching losses as passive activity losses, and the trust was entitled to a refund of the overpaid taxes with interest.
Mattie K. Carter Trust v. United States, 256 F Supp 2d 536 (Tex. 2003).
Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, Tennessee, and Tina Quinn, CPA, PhD, associate professor of accountancy, Arkansas State University, Jonesboro.