Payments by Failing S Corporation to Shareholder Were Distributions, Not Wages or Expense Reimbursements

(Parker Tax Publishing February 2017)

The Tax Court concluded that payments by a failing law firm to its shareholder were not wages as the IRS contended, and were not reimbursements for expenses as the shareholder argued, but instead were a nontaxable return of capital to the extent of the shareholder's basis. Goldsmith v. Comm'r, T.C. Memo. 2017-20.

Background

Scott Goldsmith practiced law for almost 30 years. He worked for two Minneapolis law firms but then struck out on his own. Unfortunately, his S corporation, Goldsmith & Associates (G&A), had problems from the start. Goldsmith had no personal experience, education or background in accounting or the operation of a business or financial background. He kept track of cash flow and expenses on a legal pad, but the legal pads piled up.

G&A had a fair number of clients, but mostly worked on contingency. When business is good for a contingent fee firm, costs can add up more rapidly than fees, and that's what happened to G&A. The firm had no credit and was unable to get a bank loan. Without much money coming in, Goldsmith was forced to fund its operations by taking out mortgages on his personal residence. During the years at issue, he used the proceeds to make at least 13 advances to G&A. By late 1999, one of the two mortgages went into default, and the house entered foreclosure.

Then his luck seemed to turn. A large settlement from an old antitrust case came in during 2000, and G&A received an $880,000 fee. Goldsmith took the full amount as a distribution from G&A, wrote a $700,000 check to redeem his personal residence from foreclosure, and put what was left back into the firm. But within a month, G&A was sinking again. By August 2000, it didn't have enough money to make payroll, and Goldsmith began eyeing the newly restored equity in his home.

G&A took out a five-year loan for $200,000 at an 18% interest rate, guaranteed by Goldsmith and his wife, who again mortgaged their residence to secure the loan. Within two months, the money was gone. In November 2000, G&A borrowed an additional $100,000 at 18%, again guaranteed by Goldsmith and his wife. That money lasted until March 2001. When it ran out, G&A borrowed another $50,000 at 5% per month. The next month G&A borrowed another $25,000 under the same terms. By August 2001, the money had run out again. That last associate left, the secretary left, and the office lease ended. Goldsmith packed up the records and moved G&A to the basement of his home.

By early 2002, Goldsmith had defaulted on all four of the high-interest loans. Two creditors foreclosed on his residence, and he and his wife were evicted in May 2002. In a last effort to save his home, he contracted with yet another lender on even harsher terms. But G&A continued to spiral downward, Goldsmith's license to practice law was suspended in May 2004, and in June 2005, he was indicted for failing to pay over federal income and FICA taxes withheld from employees for 12 quarters, and for failing to file a tax return for four tax years.

Goldsmith plead nolo contendere to all 16 counts and was sentenced to 33 months of imprisonment followed by three years of supervised release. After his release, he and G&A both faced a civil audit. The result was a notice of worker reclassification to G&A that determined Goldsmith was an employee, and a notice of deficiency to Goldsmith.

Analysis

Based on its determination that Goldsmith was an employee of G&A, the IRS contended that payments by G&A to him during the years at issue were wages, which meant that G&A owed more in payroll taxes and Goldsmith owed more in income taxes. Goldsmith countered that G&A made no money during those years, so it could not have afforded to pay him wages. Alternatively, any money he took out of G&A was to reimburse himself for firm expenses that he had previously paid.

The court noted that there's no rule that an S corporation has to pay its sole shareholder a wage, especially when it's bleeding money the way G&A was. The court added that the real question is one of fact: were the payments a return of capital, repayments of loans, or wages? Goldsmith had the burden of proving that the funds paid to him by G&A were to repay loans.

While the question of whether transfers to closely held corporations constitute debt or equity is based on the facts and circumstances, in Dunnegan v. Comm'r, T.C. Memo. 2002-119, and other cases the Tax Court established a list of factors to consider when making this determination: (1) the names given to the documents that would establish the purported loans, (2) the presence of a fixed maturity date, (3) the source of repayment, (4) the right to enforce payment, (5) participation in management as a result of the advances, (6) subordination of the purported loans to loans from other creditors, (7) the intent of the parties, (8) identity of interest between creditor and stockholder, (9) the corporation's ability to obtain financing from outside sources, (10) thinness of capital structure in relation to debt, (11) the use of the funds, (12) any failure to repay; and (13) the risk involved in making the transfers.

To guide it in the instant case, the Tax Court looked to Scott Singer Installations, T.C. Memo. 2016-161. In that case, the taxpayer raised money for his business from the equity in his home. When he ran out of equity and was unable to continue borrowing from commercial banks, he began borrowing from family members. The taxpayer may have wanted this to create a debtor-creditor relationship with his corporation, but the court held that those infusions of capital would be loans only if he reasonably expected to be repaid. According to the court, the taxpayer had a reasonable expectation of repayment for advances made from 2006 to 2008, but when the recession occurred in 2008 and business dropped off, he should have known that future advances would not result in consistent repayments. After 2008, the only source of capital was from the taxpayer's family and his personal credit cards. No reasonable creditor would make a loan. Consequently, the Tax Court concluded that advances made in 2008 and earlier were bona fide loans but advances made after 2008 were more in the nature of capital contributions.

Drawing a parallel between the facts in Scott Singer Installations and the instant case, the Tax Court pointed out that Goldsmith sought funding for G&A from usurious lenders because reasonable creditors would not finance the firm. Even during the early years when Goldsmith relied on the equity in his home to fund G&A, the business was running at a deficit. The year of the windfall contingent fee, 2000, was the only year that G&A made a profit. Even with that fee, G&A was failing, as shown by the reported losses in the following years and by Goldsmith's own acknowledgment.

The Tax Court concluded that the payments G&A made to Goldsmith were not wages as the IRS contended, and were not expense reimbursements as Goldsmith argued, but were distributions. According to Code Sec. 1368(b), distributions by an S corporation that has no accumulated earnings and profits are tax-free to the extent of the shareholder's stock basis, with any excess treated as gain from the sale or exchange of property (i.e., capital gain). G&A had no accumulated earnings and profits, so the payments were a nontaxable return of capital to the extent of Goldsmith's stock basis.

For additional coverage of the taxation of S corporation distributions, see Parker Tax ¶32,100.

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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