Tax Notes logo

Form Matters When Setting Up a Business and Yet Another Retiring Colleague

Posted on June 1, 2016

Last week our blogging and longtime Villanova colleague Jim Maule (more on Jim below, who is retiring after a distinguished career) has a post on Mauled Again called Choose the Entity Carefully Because Tax Consequences Matter. The post considers the case of Aleamoni v Commissioner, a summary opinion involving a professor who in the 1980’s set up a family-held C Corp (CODES) to “handle his outside consulting work and activities…” The opinion notes that the professor “served both nationally and internationally as a consultant to numerous other colleges, universities, corporations, organizations, and governments in designing and implementing comprehensive faculty and personnel evaluation systems.” Starting in the mid-90’s he began attaching a Schedule C to his individual return that reflected as a deductible business expense the loans he made to the C Corp.

The Aleamoni case provides a useful reminder that form matters when setting up a business, as well as some useful procedural concepts, such as the IRS is free to disallow deductions in one year even though it did not challenge those positions over the course of many years. It also allows us to recognize Jim, whose blogging was one of our inspirations for starting PT in 2013.

In the years in question (2010-12), there were over $105,000 of loans that the professor made to the corporation, which he as in past years deducted as business expenses. The corporation in the those years filed Form 1120s that reported gross income and deductions that exceeded the corporation’s gross income.

As Jim states “the taxpayers argued that the advances were loans to the corporations, that the advances are deductible as business expenses, and that the failure of the IRS to disallow the deductions in audits of returns for earlier years precluded it from disallowing the deductions for the years in issue. The IRS argued that the advances are not deductible whether they are characterized as loans or as capital contributions.”

The opinion notes that the statute and the regulations under Section 162 do not define expense but that it was easy to see that the funds the professor advanced were not expenses:

Neither section 162 nor the regulations promulgated thereunder define the term “expense” other than through exemplification. But, however challenging as it may be to define what an expense is, it is possible to say what an expense is not. And in the context of the instant case it may be said that an expense is not an investment. In other words, an advance made by a shareholder to a corporation for the use of the corporation in furtherance of its business is an investment in the corporation, whether the advance is in the form of a loan (giving rise to an asset–a loan receivable–owned by the shareholder) or a capital contribution (giving rise to an increase in the shareholder’s basis in his or her stock in the corporation).

The opinion notes that if the investment were worthless, it might generate a bad debt deduction under Section 166 or a worthless stock loss under Section 165, with the characterization depending upon whether the professor’s funds were treated as capital contributions or respected as loans.

We have on occasion discussed the issues of taxpayers trying to argue against the form of the transaction. Here Jim’s post notes that the opinion suggested that the prof might have set up the entity as an S Corporation, which would have essentially allowed the prof to deduct the funds advanced to the extent that they were used on otherwise deductible expenses:

The court pointed out that if the corporation were an S corporation the amounts advanced to the corporation would be deductible by the shareholders to the extent those amounts were used by the corporation to pay deductible expenses. That approach was rejected because the taxpayers had not formed an S corporation.

Yet, the opinion, at note 5 cites a venerable line of cases, essentially stating that the taxpayer is stuck with the form that they choose:

It may be that petitioners would have benefited tax-wise if CODES, Inc. had been formed as a so-called S (or subchapter S) corporation rather than as a C corporation. See generally secs. 1361 et seq.; Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders, paras. 6.01 et seq. (7th ed. 2000). However, it was not, and as the caselaw makes clear, “[t]ax consequences are determined on the basis of what happened in fact, not what might have happened.” Noonan v. Commissioner, T.C. Memo. 1986-449, 1986 Tax Ct. Memo LEXIS 158 at *43, aff’d without published opinion, 976 F.2d 737 (9th Cir. 1992); see Commissioner v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974) (“[W]hile a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not[.]”).

Likewise, that the IRS allowed in prior years the prof to take deductions did not lead to any chance of an estoppel-type argument:

[ In Auto Club of Michigan v Commissioner] the Supreme Court held that the Commissioner’s failure to challenge a taxpayer’s treatment of an item in an earlier year does not preclude an examination of the correctness of the treatment of that item in a later year because “[t]he doctrine of equitable estoppel is not a bar to the correction by the Commissioner of a mistake of law.” Indeed, the Supreme Court has held that the Commissioner may correct mistakes of law “even where a taxpayer may have relied to his detriment on the Commissioner’s mistake.” Dixon v. United States, 381 U.S. 68, 73 (1965); see Greenfeld v. Commissioner, T.C. Memo. 1966-83 (“[A]cquiescence in a taxpayer’s treatment of an item in prior years does not prevent the Commissioner from attacking such treatment in later years.”). In short, in a tax case the doctrine of estoppel is to be applied against the Commissioner “with utmost caution and restraint” and “such situations must necessarily be rare, for the policy in favor of an efficient collection of the public revenue outweighs the policy of the estoppel doctrine in its usual and customary context.” Schuster v. Commissioner, 312 F.2d 311, 317 (9th Cir. 1962), aff’g in part, rev’g in part 32 T.C. 998 (1959).

Jim’s post sensibly advises that the decision of which entity to use is complicated and requires a consideration of many factors:

When starting a business, selecting the form in which the enterprise is conducted is an essential consideration. There are advantages and disadvantages to each of the choices. Determining which form makes the most sense for a particular taxpayer depends on the particular characteristics of that taxpayer’s characteristics. It requires examination of the particular business, the market in which it operates, the long-term and short-term probability of success, the possibility of becoming a target for acquisition by another party, the tax situation of the taxpayer, the psychological and emotional constraints on the taxpayer’s business presented by third parties, the prospects of the taxpayer’s premature death, and dozens of other factors. Making the wrong decision, which is much easier to identify through hindsight, can have significant adverse consequences. It is worthwhile for the taxpayer to consult with a professional, to avoid relying on internet advice and sound bite bits of so-called wisdom, and to remain skeptical of decisions made by robots or other forms of artificial intelligence that disregard the factors not easily reduced to bits and bytes.

Parting Thoughts and a Tip of the Hat to The Retiring Jim Maule

Good advice indeed. As I prepare for the first time to teach Taxation of Business Entities next year, I will take Professor Maule’s advice to heart, and try to inject some of his wisdom in the class. In the meantime, Professor Aleamoni is left with a sizeable deficiency.

And in the spirit of Keith’s tribute posts this past week, I note too that Jim has taken on a new role at Villanova, as emeritus professor. Jim has been a very generous colleague, and while I will miss his regular presence I am fortunate to have been able to learn from him over the years. As an example of his generosity, back in June of 2007, as I prepared to leave teaching in the tax clinic to more traditional podium tax classes, he wrote a 40-part blog series on structuring the basic income tax class (starting on June 13, 2007 and through August), in part to share his wisdom but also to make sure that students in the follow up tax class came prepared so he did not have to waste time!

For more on Jim and his retirement, he discusses his next stage in a blog post today on Mauled Again, Heading Out the Door But Coming Right Back In. We wish Jim well though as his post discusses, he will still be around, blogging, teaching and writing. Just no more (required) faculty and committee meetings.

Copy RID