Small Business Taxes & Management

Special Report

Insufficient Funds in Account Results in Lost Deduction


Small Business Taxes & ManagementTM--Copyright 2014, A/N Group, Inc.


Small business owners frequently pay year-end bonuses to take money out of an S or C corporation. Often the consequences are just what was intended--to pay an additional salary to make up for underpayments earlier in the year or to simply take money out of the corporation.

But there can frequently be unintended tax consequences, particularly if the salary and bonus for the year is high. In this case (Vanney Associates, Inc., T.C. Memo. 2014-184) a high salary may have triggered IRS scrutiny, but other issues surfaced that made the transaction costly from a tax standpoint.


Facts of the Case

The taxpayer, Vanney Associates, Inc., was incorporated in 1987 and was a C corporation. Because the business of the corporation was architecture and interior design, the corporation was a personal service corporation (PSC) and subject to a flat tax rate of 35% on all its income (the graduated rates that normally apply to a C corporation don't apply in the case of a PSC). Robert Vanney was the corporation's sole shareholder, chief executive officer, chief financial officer, and wore several other hats in the corporation. The corporation employed 25 others, but Vanney was responsible for marketing, new business, and signing contracts. Vanney's spouse was responsible for the corporate books but employed at another company. She was an inactive CPA. She was not employed by the company but prepared payroll checks for her husband to sign.

During 2008 Vanney received wages of $12,000 a month for an annual total of $240,000. It was Vanney's practice to determine the profit remaining in the corporation at the end of the year and pay himself the remaining profit as a year-end bonus. The Vanneys testified that their intent was only to pay out the remaining profit, not to zero out the tax liability of the corporation.

On December 31, 2008, the corporation paid Mr. Vanney a year-end bonus of $815,000. After withholding and employment taxes the corporation wrote a check to Mr. Vanney of $464,183. Mr. Vanney signed the check on behalf of Vanney Associates and then endorsed the check in his own name and made it payable to Vanney Associates. He never attempted to cash the check. The payment was recorded on the books as a loan from Mr. Vanney which the corporation repaid in March 2009.

Although the corporation wrote a check for over $460,000, on December 31, 2008 the total available balance in the checking account (after adjusted for outstanding deposits and checks) was $283,033. Mr. Vanney testified he believed the corporation did not have the funds to honor the check. While the corporation could have obtained a loan, Mr. Vanney wanted to avoid the expense.

On its tax return for the year, the corporation reported no taxable income or tax and a deduction for officer's compensation of $1,055,000. The IRS disallowed $815,000 of the compensation deduction as well as $11,818 for Medicare taxes.


Tax Court Opinion

The Court noted a payment by check is known as a conditional payment because it is subject to the condition subsequent that the check be paid upon presentation to the drawee. Once the condition is fulfilled, it is generally reasonable to conclude that the payment relates back to the time when the check was given. Thus, the allowance of a deduction is dependent on proper payment of the check. The Court has previously disallowed a deduction where a check was not ultimately paid because of insufficient funds. The Court has also held that the "relation-back doctrine" is inapplicable where the payee knows the payor has insufficient funds and therefore refrains from cashing the check.

The Court went on to say that transactions between related parties are subject to special scrutiny. The economic reality of a transaction will prevail over its form, and a finding of economic reality depends on whether the transaction would have followed the same form if the parties were unrelated. The Court noted it has previously disallowed deductions where there was no economic outlay and the payments were "wholly circular".

The Court noted that Mrs. Vanney, as the bookkeeper, knew or should have known the corporation could not honor the check and Mr. Vanney testified to having at least some idea of this as well.

The taxpayer cited O'Connor (T.C. Memo. 1954-90), but the Court said in this case Mr. Vanney did not have unrestricted use of the funds. He could not cash the check or use it to pay a loan. The Court said that it previously held that although a taxpayer has possession of a check, the amount of the check may not be treated as a distribution or may not be included in gross income when the account has insufficient funds to honor the check.



While the dollar amounts may be more substantial than usual, the situation is not uncommon. Year-end rent payments by one entity to another, year-end bonuses either to related or unrelated parties, repayment of loans, etc. are common. Not infrequently, the entity is short of cash. (Keep in mind that payments between related parties are subject to strict rules.) Payments to a supplier may be disallowed if you don't have sufficent funds in the account.

Payments to related parties (e.g., your son who works for the company but whose salary is higher than an unrelated party doing comparable work) can be challenged even if there's no issue with the check.

S corporation salaries of officer/shareholders may be challenged if they're too low or too high. Distributions to shareholders have to be based on shareholdings. For example, Fred owns 60% of Madison; Sue owns 40%. During the year Madison distributes $50,000 each to Fred and Sue. An S corporation can only have a single class of stock, and an unproportionate distribution is an indication of a second class of stock. The payment of distributions at the end of the year with checks drawn on insufficient funds creates additional problems, particularly if there are sufficient funds for one or more, but not all of the checks.

Finally, the IRS and the courts are aware of "circular transactions". For example, Madison makes a distribution to its sole shareholder at the end of the year only to have the shareholder loan an equal amount back to the corporation a few days after the start of the new year. Or the reverse situation can occur, where a shareholder loans money to his or her S corporation at the end of the year to increase their basis enough to take losses, then takes a distribution early in the new year.

You may have options in these situations. Talk to your tax adviser.


Copyright 2014 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 09/19/14