Not Exactly Clean Hands: Tax Court Reminds Us That Who Pays Matters Matters When Trying to Deduct Expenses

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As we are knee deep in filing season I suspect that many preparers are experiencing the joy of clients who may not always respect the form in which their businesses are conducted. Life is messy, and sometimes entrepreneurs are not careful when it comes to keeping track which entity should be paying what expense. What may be an ordinary and necessary expense for one corporation is not for the other; moreover with related parties and a sole or closely held corporation one entity’s payments of the other entity’s expenses can generate constructive distributions to the shareholder.

That is what happened in the consolidated case of Key Carpets v Commissioner. In that case, Ray Johnson conducted his business through two closely held C corporations, Key Carpets and Clean Hands. The IRS examined Key Carpets and Johnson’s individual returns for the years 2007 and 2008. Unfortunately for Johnson, Key Carpets paid expenses that were related to Clean Hands’ business, and as such generated constructive distributions to Johnson which did not give rise to ordinary and necessary expenses under Section 162.

I will discuss the case below.

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Johnson and his wife were the sole shareholders in Key Carpets, which sold carpets to realtors. Johnson started it in 1994 and it was successful; in the years before the court it had over 2 million dollars in gross receipts.

In 1995, Johnson formed another corporation, Clean Hands. The opinion describes what seems to me a pretty cool idea to track hand washing among employees:

Johnson originally incorporated Clean Hands because he intended to reserve the name for a hand washing monitoring system that Key Carpets had begun to develop. The initial hand washing monitoring system was intended to work by dispensing soap when a person activated the system using a radio frequency identification (RFID) badge. The initial hand washing monitoring system would then record the individual’s name in a database for future reference.

Until about 2006 Key Carpets had about 5 or 6 employees who helped work on the hand sanitation project. While not precisely clear from the opinion, Key Carpets had an ownership interest in the RFID/radio frequency dispensing system.

In 2006 Johnson hired a computer technician to help with the hand washing project, and that employee (who had a BS in Physics and long history as a computer programmer) was an employee of Clean Hands because Johnson wanted the employee to essentially work on the project full time. Here is where things go off the rails for Johnson. Shortly after the employee started, Johnson realized that the RFID/radio frequency dispensing system was not feasible. He and the employee turned their attention to a voice activated dispensing system and discontinued working on the radio frequency soap dispensing. Unlike the RFID system, Johnson personally owned the voice activated dispensing system patent, and Key Carpets had no direct interest in that type of soap dispensing system.

In the years in question the employee did some work for Key Carpets’ business, including troubleshooting computer problems and administering its email network. Key Carpets’ office was in a warehouse, and Clean Hands also had space in the same warehouse. Clean Hands paid the salary of its computer technician (about $100,000 on 2007 and $90,000 in 2008) on its account but it also billed Key Carpets for developing the hand washing system and also providing IT services in the form of the employee’s troubleshooting and email network administering. In essence, Key Carpets was the source of all or most of the cash that Clean Hands used to pay the employee’s salary.

There were two main issues at trial: the deductibility of Key Carpets’ payments to Clean Hands and the consequences of those payments to Johnson himself. On the first issue, the Tax Court found that most of the payments had nothing to do with Key Carpets’ business and were thus not deductible as ordinary and necessary business expenses:

Mr. Johnson owned all the stock of Clean Hands, and he owned the patent on the voice-activated hand washing monitoring system. Key Carpets received no benefits from the payments for the development of the system. Therefore, the expenses were not ordinary and necessary. Key Carpets may not deduct the amounts paid to Clean Hands for the development of the voice-activated hand washing monitoring system.

The Tax Court did find credible that the employee did spend time troubleshooting and administering Key Carpets’ email and computer network and thus allowed Key Carpets to take a partial deduction. The IRS and the taxpayer fought over how much. In 2007, the employee kept a log and IRS looked to a two-month sample to argue that only 5% of the employee time should be allocated to Key Carpets’ business. The Tax Court found that the employee testimony was convincing and concluded that 15% (an hour and twelve minutes a day, assuming an 8 hour work day) was a more reasonable estimate in light of that testimony and the nature of Key Carpets’ business and the proximity of the employee to the carper business.

In addition to the corporate deficiency, there was an additional consequence to Johnson personally of Key Carpets paying Clean Hands. The court concluded that the payments that were not deductible were essentially constructive distributions to Johnson. The Tax Court noted a number of cases where courts have found that a payment can constitute a constructive payment to the shareholder if the payment was primarily for the benefit of the shareholder. To argue that the payment was not for the shareholder’s benefit you have to find an independent reason for the corporation to make the payment. That Key Carpets lost on the 162 issue sealed the fate on this, as the Tax Court noted that “an expenditure generally does not have independent and substantial importance to the distributing corporation if it is not deductible under section 162.”

In effect, by causing Key Carpets to pay Clean Hands, Johnson avoided Key Carpets making formal distributions to Johnson and then Johnson turning around and making capital contributions to Clean Hands. Depending on the earnings and profits of Key Carpets (and note 15 in the opinion says that the parties would work the E&P computations out) those payments would either constitute dividends to Johnson or a return of capital in his Key Carpets investment.

Parting Thoughts

To add insult to injury, the Tax Court sustained the substantial understatement penalties on both the corporate and individual underpayments. As the opinion makes clear, form matters, especially when working with closely held corporations and distributions between related parties. There was some planning here that was left on the table that would have mitigated these consequences, but by choosing to run his businesses in this manner Johnson bought himself and his carpet business sizeable tax problems. Preparers need to be careful with small businesses, especially as shareholders may not necessarily carefully distinguish entities or appreciate that deductibility may be connected to formal ownership of intangible assets, and that payment of certain expenses related to another entity can generate a deemed distribution to shareholders.

 

 

 

 

About Leslie Book

Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.

Comments

  1. How would a scenario unravel if the above case were such that Key Carpets was organized as a sole proprietorship with a distinct EIN and the owner was also a 50% member of a LLC (assume Clean Hands was the LLC in this ex.) Same deal, Key Carpets paying expenses of Clean Hands. Same results?

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