Here is a potentially valuable lesson for your S-Corporation clients which comes from a recent Tax Court case involving a mortgage broker.
In the case of Bradford J. Sarvak v. Commissioner, TC Memo 2018-68 the Petitioner has a real estate mortgage broker's license. He incorporated Emery in California in 1993, and during the years in issue he was Emery's sole shareholder and president.
Emery was a mortgage broker business that brokered home loans for residential buyers. It acted as an intermediary between borrowers and lenders. It did not hold any loans itself. As of the date of trial Emery was no longer actively doing business.
Emery elected to be treated as an S-Corporation for Federal income tax purposes, and for the years in issue it filed Forms 1120S, U.S. Income Tax Return for an S-Corporation. On its return for 2011 Emery claimed a deduction for bad debts of $363,210. Emery's general ledger reflects that in 2011 it wrote off four debts totaling $1,088. The remaining $362,122 of the claimed bad debt deduction for 2011 was attributable to a write off for advances made to one William Boehringer.
Petitioner has a real estate mortgage broker's license. He incorporated Emery in California in 1993, and during the years in issue he was Emery's sole shareholder and president. Emery was a mortgage broker business that brokered home loans for residential buyers.
It acted as an intermediary between borrowers and lenders. It did not hold any loans itself. As of the date of trial Emery was no longer actively doing business.
Emery elected to be treated as an S-Corporation for Federal income tax purposes, and for the years in issue it filed Forms 1120S, U.S. Income Tax Return for an S Corporation. On its return for 2011 Emery claimed a deduction for bad debts of $363,210. Emery's general ledger reflects that in 2011 it wrote off four debts totaling $1,088. The remaining $362,122 of the claimed bad debt deduction for 2011 was attributable to a write off for advances made to Boehringer.
As Emery's president and shareholder, petitioner authorized distributions to himself during the years in issue. At the time of the distributions he had access to all of Emery's financial information. In 2011 petitioner received total distributions of $1,651,455. In 2012 he received distributions of $2,007,699.
For the years in issue Emery reported ordinary business losses of $258,370 and $453,441, respectively. Petitioner claimed Emery's losses on Schedules E, Supplemental Income and Loss, Part II, Income or Loss From Partnerships and S Corporations, attached to his Forms 1040, U.S. Individual Income Tax Return.
He engaged the same firm of certified public accountants (CPA firm) to prepare Emery's returns and his individual returns for the years in issue. Emery's in-house bookkeeper provided the information that the CPA firm used to prepare Emery's returns, and she reviewed the returns that the CPA firm prepared for Emery. Petitioner looked at Emery's returns, but he did not meet with anyone at the CPA firm to go over the returns or their contents.
For the years in issue Emery reported on its returns the distributions to petitioner. It issued Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc., for petitioner that reflected the distributions and reported them as “[i]tems affecting shareholder basis”.
Petitioner did not report any amounts of the distributions that he received from Emery for the years in issue on his individual returns. On those returns he reported income tax liabilities of $41,735 and $1,991, respectively.
Respondent's revenue agent Shelly S. Gordon conducted an examination of petitioner's income tax returns for the years in issue. In the course of the examination Gordon proposed accuracy-related penalties under IRC §6662(a) for petitioner. She prepared a Civil Penalty Approval Form (penalty approval form) that she forwarded to a group manager, who was her immediate supervisor. The group manager signed and dated the penalty approval form and approved the proposed penalties for petitioner on March 27, 2015.
On September 4, 2015, respondent sent to petitioner the notice of deficiency upon which this case is based. The respondent determined adjustments to Emery's income for the years in issue. The adjustments determined for Emery flowed through to petitioner and were reflected in the notice of deficiency as increases to income reported on Schedules E.
The Respondent disallowed the full amount of Emery's claimed bad debt deduction for 2011 and then the Respondent disallowed for both years in issue deductions that Emery had claimed for commissions, automobile expenses, and travel, meals, and entertainment.
The parties have stipulated Emery's allowable deductions for those expenses. In addition to adjustments determined for Emery, respondent determined in the notice of deficiency that petitioner had unreported long-term capital gains for the years in issue.
In short, petitioner presented no persuasive evidence that he had reasonable cause or acted in good faith with respect to any portions of his underpayments for the years in issue. The record reflects that even after respondent's concessions regarding Emery's expenses petitioner's understatements of tax are substantial in the light of our holdings.
The available facts also demonstrate that petitioner disregarded applicable provisions of the Code and regulations in reporting his taxes for the years in issue. For example, he failed to attach a statement of facts to Emery's return for 2011 to substantiate the claimed bad debt deduction, as required under IRC§.166-1(b)(1), Income Tax Regs. He also failed during the years in issue to maintain books or records sufficient to calculate his basis and to compute his tax liabilities with respect to the distributions that he received from Emery.
The short story is the accuracy related penalty was assessed. The moral of the story is you can’t take more in distributions than you have in basis in an S-Corporation and you certainly can't write them off as a bad debt.
About Craig W. Smalley, EA
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as representation before the IRS regarding negotiations, audits, and appeals. In his many years of practice, he has been exposed to a variety of businesses and has an excellent knowledge of most industries. He is the CEO and co-founder of CWSEAPA PLLC and Tax Crisis Center LLC; both business have locations in Florida, Delaware, and Nevada. Craig is the current Google small business accounting advisor for the Google Small Business Community. He is a contributor to AccountingWEB and Accounting Today, and has had 12 books published on various topics in taxation. His articles have also been featured in the Chicago Tribune, New York Times, Yahoo Finance, Nasdaq, and several other newspapers, periodicals, and magazines. He has been interviewed and been a featured guest on many radio shows and podcasts. Finally, he is the co-host of Tax Avoidance is Legal, which is a nationally broadcast weekly Internet radio show.