Loans to S Corporations
Employing Family Members: A Higher Standard
New IRS Attack on Expense Reimbursement Plans

Loans to S Corporations

In 2005, the IRS lost an important tax court case on how Scorporation shareholders can use loans to support the deductibility of their Scorporation losses. In reaction, the IRS has now issued proposed regulations that may restrict the ability of Scorporation shareholders to claim pass-through losses from an Scorporation in their Form1040. When these regulations become final, it will represent an important change, and those affected will need to operate differently to continue claiming their share of the Scorporation losses.

The Brooks Case

In that 2005 tax court case, the shareholder had made a series of open account advances to his Scorporation. The shareholder maintained a running loan account of advances to and from the Scorporation. These were not evidenced by separate written notes, but rather simply tracked as a single ongoing open account debt.

An Sshareholder is allowed to deduct his or her share of the Scorporation losses only to the extent of the shareholder’s cumulative investment in the corporation, whether in the form of stock purchases or loans to the corporation. For that reason, a loan to an Scorporation can be very important if that Scorporation is running in the red

In the Brooks case, the shareholder was using this open account debt to have sufficient investment in the Scorporation to claim all of the pass-through losses. The tax law in this area focuses on the shareholder’s investment as of the last day of the Scorporation year, usually December31. In the facts of the Brooks case, the taxpayer borrowed money from a bank and advanced it as open account debt to his Scorporation shortly before year-end. This provided sufficient investment in the corporation to allow the annual use of the losses. 

But the corporation repaid the shareholder advance early in the next year. Normally, this would result in the recognition of gain from repayment of that debt. To avoid this, the shareholder again advanced money to the corporation shortly before the end of the subsequent tax year, on the premise that the loan was all one debt under its open account status. As a result of this in-and-out series of transactions in an ever-increasing amount, the shareholder was effectively able to use losses based on nothing more than very temporary year-end advances to the Scorporation.

New IRS Rules

To prevent open account debt from being used to create a near perpetual tax deferral, the IRS has issued proposed regulations that will limit the use of new open account debt to an aggregate $10,000 limit. If an Sshareholder’s open account advances exceed $10,000 at any point in time, that open account debt is treated for tax purposes as a separate debt instrument. As a separate debt used to support tax losses at year-end, any repayment of that loan would trigger gain to the shareholder. It could not be “covered up” at the end of the subsequent year with a further advance to the Scorporation.

While these new IRS rules will only impact Scorporation shareholders who have been using a revolving open account debt to support the tax deductibility of losses, the rules will have serious tax implications to those affected. The good news is that the proposed regulations are not yet final, so there is some time for tax planning. If you or your business associates may be in this position, please contact us so that we can address a strategy to react to these pending new rules.

Employing Family Members: A Higher Standard

Many small businesses do not use formal written employment agreements, particularly for part-time workers. But if that person on the payroll for occasional duties is a family member, a recent tax court case suggests that the formalities can be very important. And the tax consequences can be significant, because it is usually not only a wage that it is in question, but one or more tax deductible employee fringe benefits such as health insurance or a medical reimbursement plan.

The Francis Case

In a recent Tax Court case, the husband was a proprietor who worked full time in the family business (Francis, TC Memo 2007-33). His wife was engaged by the business for part-time duties (maintaining books and records, occasional errands for the business, telephone services, etc.). There was a written employment agreement, specifying that she would receive annual compensation of approximately $2,000, plus a fringe benefit health plan that covered the family health insurance costs and also reimbursements up to $8,000 annually for out-of-pocket medical expenses.

These spousal employment and fringe benefit plans can be very tax-efficient. If done properly, the employer-employee relationship allows the business to deduct the health insurance and other medical benefit payments as a direct business expense, often saving both income tax and self-employment Social Security tax. But the value of those benefits is tax free to the family employee.

In this case, the Tax Court was wary of the reality of the arrangement, stating that “We apply close scrutiny to the facts in a family situation.” Based on the IRS examination, the court noted that the taxpayers had failed to prove that the total compensation paid to the spouse was reasonable. For the year under consideration by the court, the direct wage plus fringe benefits amounted to about $12,000 in value. But the court noted that the couple had failed to document the actual services performed by the spouse for the business. There was no record of the dates nor the hours that the employee had worked, there was no hourly rate of pay established, and no evidence that the compensation package was comparable to similar employment by similar small businesses in their area.

The Lessons

This case emphasizes the importance of documenting the nature and extent of services of a spousal or other family member employee. The employment agreement should refer to the required hours of work by the employee and the hourly rate of pay used to arrive at the total compensation package. Additionally, the family member should complete some type of time record, similar to other employees, detailing the hours worked and the services performed.

Family employment accompanied by fringe benefit plans can be both very tax-efficient and lucrative. But given the benefits involved, the IRS and the courts apply a high standard of evidence to establish the legitimacy of the arrangement. If you have family employment arrangements that should be reviewed, or are interested in considering whether your facts may present an opportunity in this area, please contact us.

New IRS Attack on Expense Reimbursement Plans

Most businesses have occasions where employees are required to travel, and as a result the business reimburses those workers for their out-of-pocket expenses. If done properly, the business has a tax deduction for its expenditures, but the employee has received a nontaxable reimbursement. No wage reporting or payroll taxes come into play.

To meet IRS rules on expense reimbursements, employers generally have two choices: they can reimburse actual expenditures incurred by each employee, or they can use IRS standard allowances. To simplify recordkeeping, many employers have moved to these IRS standard allowances, such as the current 48.5¢ per mile business mileage rate. For out-of-town travel costs, there are several choices for standard per diem allowances to reimburse meals and lodging. For example, a full day of out-of-town overnight travel can result in a $45 per day meal allowance, or even a $58 per day amount in specified high cost locations. Similar standard amounts exist for lodging costs. As an alternative, employers may use the federal government meal and lodging per diem amounts, which are specific to each travel locale. 

In late 2006, the IRS issued a tough new ruling, holding that employers who do not follow either actual reimbursement or IRS- approved standard allowances, and are found to be reimbursing employees at a rate greater than those allowances, will have their reimbursements recharacterized as wages. This interpretation was particularly aimed at the trucking and construction industries, where apparently employees have been receiving meal allowances that are based on miles traveled and that are in excess of the various IRS-approved per diem amounts. When this occurs, the onus falls entirely on the employer. The IRS recharacterizes the entire reimbursement (not just the excess) as wages, and charges the employer with all delinquent payroll taxes and penalties.

But in recent administrative guidance, the IRS has taken a more reasoned approach. Where employers have used expense allowance arrangements that do not properly comply, the IRS has indicated that its examiners will not impose wage treatment in prior years unless there has been a pattern of abuse or evidence of intentional noncompliance. And further, for periods beginning in 2007 and after, the IRS will only tax employer reimbursements in excess of the federal per diem limit as wages, unless the employer plan evidences a pattern of abuse or the employer has no system for tracking whether excess payments have occurred to employees.

The consequences of an out-of-compliance expense reimbursement arrangement can be very serious, so please let us know if you have any questions regarding your specific expense reimbursement policies.

If you have any questions concerning the tax issues discussed here, please contact us at info@marg.com.