Unauthorized Incorporation of Business Precludes Deduction of Business Expenses on Form 1040.

(Parker Tax Publishing September 22, 2015)

The unauthorized act by a business owner's son of incorporating his father's business was ratified by the father when he filed corporate documents with the state; thus, expenses of the business could not be deducted on the father's personal income tax returns. Rochlani v. Comm'r, T.C. Memo. 2015-174.

Background

Manjit Rochlani started Ultimate Presales in 2006 and was the proprietor of the business. Through Ultimate Presales, Rochlani and his wife bought and resold sporting, concert, and other tickets. Without permission from his parents and while he was still a minor, the Rochlanis' son, Khushal, incorporated Ultimate Presales in Michigan in July 2006 using an online legal service. Khushal was unaware of the tax differences between a sole proprietorship and a corporation when he registered the business as a corporation. When the paperwork arrived, Mr. Rochlani asked Khushal about the incorporation but did nothing to stop or unwind the incorporation process.

Subsequently, Rochlani filed corporate annual reports for Ultimate Presales with the Michigan Department of Energy, Labor & Economic Growth. The Rochlanis used personal credit cards to make all purchases related to the business because Ultimate Presales did not have a business credit card. Further, all business expenses were paid from, and business income was deposited into, the Rochlanis' personal bank accounts.

On their Form 1040s for 2008 and 2009, the Rochlanis attached Schedule C, Profit or Loss From Business, identifying the principal business of Ultimate Presales as "Sell Goods" in 2008 and "Sell Goods and Tickets" in 2009. The Rochlanis reported Schedule C losses of $41,610 for 2008 and $44,066 for 2009. The reported business expenses included business use of their home, supplies expenses, office expenses, legal and professional expenses, advertising expenses, travel expenses, car and truck expenses, other expenses, contract labor expenses, depreciation and Code Sec. 179 expenses, and commissions and fees expenses.

Upon auditing the returns, the IRS adjusted the Rochlanis' tax liabilities to reflect the removal of the Schedules C, asserting that Ultimate Presales was a corporation. The Rochlanis took their case to the Tax Court, arguing that the court should disregard the corporate form.

Analysis

The Tax Court held that the Rochlanis could not disavow the corporate form and thus upheld the IRS's adjustments. The issue, the court said, was whether Ultimate Presales is a corporation for federal income tax purposes. To decide whether Ultimate Presales should be respected as a corporation, the court looked at whether the Rochlanis were bound by Khushal's unauthorized act of registering Ultimate Presales as a corporation.

While it was clear to the court that Khushal was not authorized or instructed by Rochlani to register Ultimate Presales as a corporation, the court noted that, upon learning that the business had been registered, Rochlani did nothing to undo what his son had done. In fact, the court observed, Rochlani ratified his son's act. Under Michigan law, unauthorized acts may be ratified explicitly or implicitly. And the unauthorized acts of an agent are ratified if the principal accepts those acts with knowledge of the material facts. While Khushal's act of incorporating Ultimate Presales was unauthorized, Rochlani thereafter respected, at least in part, the corporate form by filing annual reports with the Michigan Department of Energy, Labor & Economic Growth. In doing so, the court said, he recognized and ratified the corporate form.

The Tax Court concluded that, because Ultimate Presales was a corporation, the Rochlanis were not entitled to deduct losses from Ultimate Presales on their personal 2008 and 2009 returns.

For a discussion of the tax implications in choosing an entity in which to operate a business, see Parker Tax ¶29,500. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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