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Plan to Avoid Corporate Tax Through Interest Deductions Doesn't Fly in Tax Court

(Parker Tax Publishing September 2023)

The Tax Court held that a small business organized as a C corporation using the cash method of accounting improperly claimed interest expense deductions for allocations of interest to the principal of a loan extended to the company by its owner because the company did not actually make interest payments as required for a cash method taxpayer to claim a deduction. The court further found that purported interest payments from a third party to the owner were not deductible because there was no debtor-creditor relationship between the company and its owner. Short Stop Electric, Inc. v. Comm'r, T.C. Memo. 2023-114.


Short Stop Electric, Inc. sells commercial, industrial, and residential electric services. Its owner, Bob Boyum, incorporated it in Minnesota in 1989 as a C corporation. He also chose to adopt the cash method of accounting. Small businesses typically avoid the double taxation of a C corporation by electing to be taxed under subchapter S of the Code or organizing as a limited liability company and electing to be taxed as a partnership or a sole proprietorship. This case is about how Short Stop and Boyum tried to invent a third way to minimize double taxation.

Over the years, including 2015 and 2016, Short Stop reported little if any taxable income. Boyum accomplished this through what he called a revolving line of credit. He would record that he had lent money to Short Stop. However, Short Stop would not make any regular interest payments to Boyum. Instead, at the end of the year Boyum would figure out how much interest he wanted Short Stop to owe him, calculate what interest rate would generate that sum, apply that rate, and add the resulting amount to the principal of the loan. Short Stop totaled these additions to principal and claimed them as interest deductions on its returns.

Boyum and his wife reported this interest that they didn't receive on their joint returns, which in turn increased their own taxable income. Boyum started doing this years before 2015. It led to an IRS audit of Short Stop's 2006 return. During that audit, the revenue agent explained that a loan to Short Stop could not generate interest deductions on paper to offset income in cash. The agent ultimately decided to suspend the examination as a "no change" since he believed that Boyum was receptive, eager to learn, and now aware that the government did not consider his attempted transformation of retained earnings into deductible interest to be valid. However, Short Stop and Boyum continued to operate the "revolving line of credit" after the audit much as they had before.

In 2010, Short Stop lent $25,000 to an unrelated company named Fogerty Investments. Fogerty made payments on this loan in 2016, but not to Short Stop - at least not directly. Instead of repaying the loan directly to Short Stop, Fogerty sent money to Boyum. Short Stop recorded some of these payments in its ledger as interest payments from Short Stop to Boyum.

Short Stop also claimed deductions for a forklift and a plow attachment. Boyum used the plow to clear snow from the driveway to both his home and Short Stop's building, which is near the Boyums' home and shares a driveway with it. Boyum would sometimes plow his neighbor's driveway too. He used the forklift both to move snow and to move the pallets on which Short Stop received and stored some of its business supplies.

On its 2015 return Short Stop reported $45,000 in interest-expense deductions, more than $30,000 of which came in the form of additions to the principal of the loan owed to Boyum. On its 2016 return, Short Stop reported paying over $115,000 in interest to Boyum. Short Stop also reduced its tax bill by deducting the cost of the plow attachment and the forklift under Code Sec. 179. In a notice of deficiency, the IRS disallowed the interest deductions. It also disallowed Short Stop's Code Sec. 179 deductions for the plow attachment and the forklift because Short Stop did not primarily use them for business. In addition, the IRS applied penalties under Code Sec. 6662 for negligence and substantial understatement. Short Stop took its case to the Tax Court.


The Tax Court held that Short Stop's allocations to the principal of the loan from Boyum were not the payment of interest and therefore were not deductible. The court explained that for a cash basis taxpayer like Short Stop, deductible interest must be paid and not just owed. Capitalizing interest postpones an obligation to pay; it does not discharge that obligation. The court noted that this is settled law, so well settled that it did not have to analyze whether the relationship that Boyum had with his company was truly that of a creditor and debtor, or whether Short Stop used the money that it "borrowed" from him for business purposes.

The court's analysis for the payments from Fogerty was different because these payments were actually made and ended up in Boyum's bank account. The court observed that if a taxpayer's obligation is paid by a third party, the effect is the same as if the third party paid the taxpayer who in turn paid his creditor. The court therefore had to determine whether Fogerty's payment of interest directly to Boyum discharged an obligation that Short Stop owed Boyum, and for that the court had to determine whether Boyum and Short Stop had created a debtor-creditor relationship.

The court found that under the 2009 agreement between Boyum and Short Stop that established the revolving line of credit, Short Stop had the right to borrow up to $1 million, with a maturity date of December 2019. The agreement did not specify an interest rate, but instead allowed Boyum to determine the interest rate each year. The agreement required Short Stop to make monthly interest payments or add unpaid interest to the loan principal. Along with increasing the principal, if the interest payments were not paid within 10 days of becoming due, Short Stop would be in default. Defaulting on the loan allowed Boyum to demand the principal and interest of the loan be immediately payable. The court found that Boyum routinely failed to collect interest on the loan at the end of each month and instead waited until the end of the year to decide what interest rate to charge. After deciding the rate, he allocated the interest owed retroactively to each month. Short Stop then recorded the interest payments in its ledger as funds distributed to Boyum even though they really weren't.

In the court's view, these terms were fiction in practice. Short Stop did not distribute interest to Boyum on a monthly basis, and under the loan agreement this meant that the unpaid interest was automatically capitalized. Short Stop's failure to make timely payments also triggered the default clause that would allow Boyum to demand payment on the principal and the interest whenever he wanted to (though he never did). The court said this tended to suggest that Boyum was not an actual creditor and the sum provided to Short Stop was a capital contribution. However, in the court's view the strongest argument against treating the line of credit as a loan was Boyum's intent in creating the loan. The court noted that Boyum admitted his goal was to covert as much of the balance as possible to principal. Boyum believed that when he retired or sold Short Stop, he could take money out of the corporation as repayment of loan principal, and thus avoid paying tax on what would otherwise be a capital gain. He also thought it benefited Short Stop because recording some portion of the retained earnings as interest paid would create deductions that offset taxable income. The court noted that Boyum was expressly told by the IRS during the 2006 audit that the Code did not permit him to relabel equity as a "revolving line of credit" in order to make retained earnings deductible, and the court said it was difficult to believe that Short Stop's continuing to do so was motivated by anything other than a desire to shelter income from tax. The court therefore concluded that Short Stop was not entitled to interest expense deductions either for the additions to the principal amount of the purported loan from Boyum or for the payments from Fogerty to Boyum directly.

Next, the court considered whether Short Stop was allowed to take Code Sec. 179 deductions for the plow attachment and forklift. Code Sec. 179 allows a taxpayer to deduct the full cost of an asset in the year of purchase, even it will use the asset for years to come, subject to certain dollar and income limits. The court found that Short Stop did not use the plow attachment predominantly for business uses, as the use was not only divided between plowing the Boyums' residence and their business, but also their neighbor's driveway. However, the court thought it was more likely than not that Short Stop used the forklift predominantly in its business and determined that Short Stop used it 70 percent for business purposes. Thus, the court concluded that Short Stop could expense 70 percent of the forklift's cost for 2016.

The court upheld the IRS's penalty determination. Short Stop claimed that it relied on advice from Mike Mischke, a licensed CPA, when it took its positions on its 2015 and 2016 tax returns. The court noted Mischke's testimony that he did not advise Short Stop to take the position that it could deduct the interest. Further, the court found that Mischke never gave advice to Short Stop on the Code Sec. 179 deductions. Therefore, the court concluded that Short Stop did not show reasonable reliance on the advice of a tax professional. The court further determined that Short Stop failed to show the deductions were reasonable and claimed in good faith. The problem, in the court's view, was that the IRS explained during the 2006 audit that claiming interest deductions by increasing the principal of a shareholder "loan" did not work. It was unreasonable, in the court's view, for Short Stop to keep doing what it did in reporting interest paid that it never paid. The court also found it was unreasonable for Short Stop not to substantiate its Code Sec. 179 deductions, given the company's history of taking unreasonable reporting positions and failure to rely on Mischke's advice.

For a discussion of the rules for determining whether payments constitute interest, see parker Tax ¶83,505. For a discussion of the Code Sec. 179 expensing election, see Parker Tax ¶94,701. For a discussion of accuracy-related penalties, see Parker Tax ¶262,120.

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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