Small Business Taxes & ManagementTM--Copyright 2015, A/N Group, Inc.
Things can get complicated quickly for business owners with just a modest expansion of a business or when more than one entity is involved. You buy the office you use and rent it to your corporation. Or you set up a second entity for another business. Even a second line of business operating out of the same entity can be an issue in some cases. Tax law requires you to observe the formalities of entities and transactions. In most cases it's not very difficult, nor costly, to do so. For example, lending money to your S corporation? Put the loan on the books, pay interest, sign a formal note, etc. Failure to do so could have unintended and complex tax consequences. In many cases there can also be adverse legal and business consequences.
The facts below come substantially from a recent Tax Court case, but we've simplified them and taken some liberties to make them easier to understand. We'll use the names of our usual fictitious parties--Fred, Madison, Chatham, etc.
Fred has a engineering consulting practice that does business through Madison Engineering Inc. Madison leased a spectrometer for a 60-month term. The spectrometer was to be used largely for analysis work for third parties, rather than for Madison itself. The lease was secured by a $500,000 life insurance policy on Fred naming the lessor as beneficiary. The lease provided that Madison could not assign or dispose of its rights or obligations under the lease or enter into any sublease without the lessor's written consent. The lease also included an option to purchase the spectrometer at less than fair market value. At the end of the 60-month term, the lease was extended for another 18 months. Madison was the signatory on the lease renewal agreement.
Madison paid $9,000 for construction of a room to accommodate the spectrometer. The work included special electrical work and a reinforcement of the floor.
In 2013, Fred formed Chatham Analysis LLC with two other individuals to manage the work to be done by the spectrometer. Fred was the managing partner of Chatham. Fred and his wife asserted that he had personally guaranteed the lease of the machine and claimed a nonpassive loss deduction from Chatham of some $290,000. Because Fred did not provide a copy of the guaranty, the IRS determined that he did not have enough basis in Chatham to cover the entire loss and disallowed $270,000 of the deduction. The IRS also determined that he and his wife received a $9,000 constructive dividend from Madison Engineering for 2013 for the construction work performed. Fred maintained separate books for Madison and Chatham. Madison reported the income generated by the spectrometer, while Chatham claimed depreciation deductions for the spectrometer. Madison also claimed deductions related to the unit including salaries of two employees involved in the operation, repairs and maintenance of the unit and the office shared by Madison and Chatham, rent on the shared office, payments on the lease and expenses for operating the spectrometer.
The IRS claimed that Madison improperly included the gross income and business expenses of Chatham on its corporate tax returns. Fred testified that Madison, not Chatham, paid the lease, paid for training and employment of technicians, was the sole tenant of the office space where the unit operated, and made the downpayment and paid the construction costs related to the spectrometer. The IRS contended that Madison and Chatham were separate and distinct entities and the expenses and income related to the spectrometer should be allocated to Chatham.
There were a number of issues here and we'll deal with them in no particular order.
Lease or Purchase?
Madison signed a "lease" with the spectrometer manufacturer. The terms of the lease were for 60 months with a purchase option at the end for less than the then fair market value. Although there are no specific provisions in the tax laws governing the differentiation of true leases and conditional purchases, the substance of the transactions, not the form, will govern the nature of the lease. With respect to the transfer of equipment, courts have stated that factors indicating that a conditional purchase more likely exists include: (1) the lease term extends throughout the equipment's entire useful life; (2) the sum of the rental payments approximately equals the cost of the equipment; and (3) the lessee has an option at the end of the agreement to purchase the equipment at a nominal or below-market price.
In this case the "lease" satisfied all three conditions. That meant the agreement was actually a conditional purchase for tax purposes. While the manufacturer had title, Madison was, in effect, purchasing the equipment. The result was that Madison could not deduct the lease payments. Instead, for tax purposes, Madison could depreciate the cost of the equipment and deduct any imputed interest. The bottom line effect can be positive or negative. If bonus depreciation or Section 179 is available the deductions can be much larger in the early years if the transaction is viewed as a purchase. That's particularly true for short-lived equipment such as computers and other hi-tech gear. In theory, the total deductions over the life of the lease/equipment should be the same either way.
But the tax consequences of making a mistake here can be costly. Once Madison filed its tax return characterizing the transaction as a lease it could no longer make an election as to the depreciation method. In some cases you may want to use a slower method in the early years to take more in deduction in later years when you may be in a higher bracket.
In this case the companies were double dipping. Madison was deducting the lease payments while Chatham was deducting depreciation. You can't have it both ways. In this case the proper approach was only to deduct depreciation. The question remains, who gets the depreciation deduction. And even if the taxes even out in the long run, you could end up with penalties.
Whose Equipment is it Anyway?
Madison signed the lease on the equipment and was responsible for payments on the lease. Only Madison was entitled to the depreciation deductions because only the taxpayer who suffers the economic loss of his investment by virtue of the wear and tear or exhaustion of the property, the one who has the economic benefits and burdens of ownership, can claim the depreciation.
Had Fred leased the equipment in his own name he could have contributed the property to Chatham. Well he could have done that were it not for the clause in the lease prohibiting the transfer without approval of the manufacturer/lessor. Most leases will contain such a clause. Equipment that's purchased subject to a lien may also be difficult to transfer without permission.
This is not an unusual situation when it comes to small businesses. The business owner purchases the equipment in his own name but it's used by the business. Sounds like it's all in the same pot, but that's not the way the IRS views it. This isn't a problem for a sole proprietorship--the business and the owner are one in the same. But a corporation or a partnership will run afoul of the rules. The depreciation deductions would belong to the owner, as would the interest on the loan or any lease payments (in the case of a true lease).
The dilemma commonly arises when a business owner can't buy the equipment in the company name often because of credit issues or when the business owner purchased the equipment before the corporation or partnership is in existence. Tax law recognizes the second issue, allowing a tax-free transfer of equipment. Most states also contain sales tax exemption for such transfers.
You may have other options, such as retaining ownership of a vehicle and having the company reimburse you for the business use. Or having the company reimburse you for the purchase. To maintain flexibility make sure any lease contracts or loan agreements allow you can transfer ownership. Talk to your tax advisor to avoid a costly mistake here.
Basis in Chatham Analysis, LLC
S corporations, partnerships and LLCs are pass-through entities. The income and losses pass through to the owners. Utilization of the losses is limited by the owner's basis (investment). For S corporations that means owner's equity capital and loans made by the shareholder directly to the entity. For partnerships and LLCs it includes liabilities of the partnership for which the partner is liable. A partner's basis also includes the amount of any guarantees of partnership loans. Thus, if the partnership borrows money, a partner's basis increases (based on his ownership percentage). On the other hand, the reduction of a partnership liability reduces a partner's basis. The increase in basis is one of the big advantages of partnerships, but it can come back to haunt the partners.
Normally, the contribution of a lease to a partnership would not increase its liabilities for tax purposes. In this case the lease was really a conditional purchase. Thus, if the unit had been contributed, the spectrometer would be an asset on Chatham's books and the liability for the payments would be liability on its books. But that wasn't the case here. Moreover, since the equipment wasn't contributed to Chatham, Fred's personal guarantee of the lease payments didn't count towards his basis in Chatham.
Madison paid $9,000 for construction work on the space for the spectrometer. The Court noted that when a corporation pays the personal expenses of a shareholder without expectation of repayment, there may exist a constructive dividend distribution that is taxable to the shareholder. That's often the case in a regular corporation when the IRS disallows a deduction, e.g., unsubstantiated travel and entertainment. Whether a constructive dividend exists turns on whether the distribution was primarily for the benefit of the shareholder. The existence of some benefit to the corporation is not enough to permit a corporate deduction; the Court must weigh the benefit to the shareholder and the corporation, and "where the business justifications put forward are not of sufficient substance to disturb a conclusion that the distribution was primarily for shareholder benefit" a constructive dividend will be found. The determination of whether the shareholder or the corporation primarily benefits is a question of fact. To avoid constructive dividend treatment, the taxpayer must show that the corporation primarily benefited from the payment of the expenses. The question comes down to is the expenditure a deduction to the corporation? The Court found the IRS sufficiently established an evidentiary foundation to shift the burden to the taxpayers on this issue. Since the taxpayer is the sole shareholder of Madison, and he is a member of Chatham, the entity that manages the spectrometer. The Court held the taxpayer was a beneficiary of the expansion and received unreported income through his interest in Chatham, regardless of whether Madison benefited from the expansion.
The dividend was income to the taxpayer, and not deductible by Madison. Since Madison was a regular corporation, the result was costly. But even if it was an S corporation or LLC there would be a distribution from the entity. Whether or not that would trigger immediate tax consequences would depend on the circumstances.
Putting assets (and liabilities) on the proper entity is important. While it seems like a lot of busy work for lawyers and accountants, the IRS takes the issue seriously. You can also run into problems with liability for the equipment, breaching of loan agreements, etc. This is not the time for shortcuts. Talk to your accountant or tax advisor.
Copyright 2015 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. 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
--Last Update 05/22/15