Personal Use
“But it’s mine!”
That’s not some toddler speaking.
You’ve just advised an entrepreneurial client for the “Nth” time that they should not treat the corporation[i] they control, and out of which they operate their business, as their personal bank account.
Such behavior may jeopardize the limited liability protection that the corporate shield would otherwise afford a shareholder. It may also expose the shareholder to unexpected and unwelcome income tax consequences, as we’ll see shortly.
That being said, I’d wager the response was not unexpected, right? At least not in the case of a first – and maybe a second or even third[ii] – generation family-owned business.
Checks and Balances . . .
As the family grows – hopefully, together with the business[iii] – the likelihood increases that several family members will pursue careers and livelihoods in fields unrelated to that of the “family business.”[iv]
The fact that a growing segment of the family chooses not to be actively involved in, or employed by, the family’s business does not necessarily mean those family members no longer have an ownership interest in the business.[v] It’s just that their relationship to the business has changed from that of an “insider” to that of an investor; and with that change comes a change in perspective, priorities, and expectations.
In general, the investors will expect continued growth, elimination of waste and unreasonable costs, distribution of dividends, and perhaps opportunities to convert some of their otherwise illiquid equity into cash.[vi]
The insiders will want to be “fairly” compensated for their efforts, will prefer to retain earnings for reinvestment in order to grow the business and, in many cases, will disagree with the investors over when an expenditure is wasteful or a cost unreasonable.
. . . or Family Discord?[vii]
In fact, as the divide widens between the two “classes” of owners, both in terms of numbers and priorities, the “family-owned business” will start to resemble a venture that is owned by unrelated individuals.
One of the earliest manifestations of this changing relationship is found in the two sides’ divergent views on the personal use of business assets.
Where once there was a time that the insiders of the family business were less likely to object to each other’s “transgressions” with respect to their personal use (within reason) of business assets – especially if perpetrated by their parents or grandparents[viii] – the growing number of family “outside investors” may act as a check on such use.
If the insiders cannot be dissuaded, however, from continuing what the investors believe is the formers’ impermissible, or excessive, personal use of business assets, the two sides may find themselves in court, and perhaps in dissolution proceedings, or in a buyout.[ix]
Tax Considerations
Of course, the practice of using the resources of the business for non-business purposes – i.e., for personal ends – is pervasive in the world of closely held business entities, family-owned or not, and especially in entities with a small number of owners all of whom work in the business and who may, to varying degrees, engage in the practice.[x]
Having leveled this “charge” against such businesses, what are some of the misuses of business assets that may bring the owners of the business into conflict with one another, and that may also expose the participants to additional tax liability?
There are too many examples to list, and the justifications given in support of any such expenditure of company funds, or use of business assets, range from laughable to seemingly credible.[xi]
The tax consequences arising therefrom will depend upon the specific facts and circumstances of each expenditure by the business or use by the shareholder; it is likely such consequences won’t be laughable.
That being said, there are economic elements that will be present, and that must be “translated,” in every situation that involves some kind of non-business expenditure by a business or some kind of non-business use of its assets.
These will be manifested as a direct economic benefit to an individual shareholder or to someone with whom the individual has a relationship, and it will be accompanied by an economic detriment to the business, either as a withdrawal of value or as an opportunity cost.
The challenge is to determine what was intended and, failing any clear indication of intent – which is usually the case – what is the most appropriate characterization of the benefit conveyed by the corporation?
A closely related question is whether the recipient shareholder provided any consideration in exchange for the benefit.
Of course, an actual expenditure by the business, or a “conventional” use of its assets by the shareholder, is not the only way by which an owner may benefit from the use of the business’s assets; for example, where the corporation guarantees a shareholder’s indebtedness to an unrelated lender, thereby putting its assets at some risk. In such a case, it may be difficult to assign a monetary value to the benefit for purposes of determining the appropriate amount of consideration.
Compensation . . .
Thus, a non-business expenditure, such as the payment of a personal obligation, or the “consideration-free” use of a business asset, such as flying on the employer-company’s plane to the destination of a family wedding, may be treated as the payment of additional compensation to a shareholder-employee who is the recipient or beneficiary thereof; i.e., ordinary income. The same is true of the rent-free, personal use of the company’s apartment in the City.[xii]
If the amount of the additional compensation deemed to have been paid causes the shareholder-employee’s total compensation “package” to be unreasonable for the services rendered,[xiii] the corporation will be denied a deduction for the excessive portion thereof.
. . . Followed by a Gift
Where the ultimate beneficiary of the economic value that is treated as having been withdrawn from the business is someone other than the shareholder-employee – usually a member of the latter’s family – the amount of the deemed compensation may be treated as having been followed by a gift from the shareholder-employee to such other person.
Distribution . . .
Alternatively, the business’s expenditure, or the use of its assets without the payment of fair market value consideration – for example, an interest-free loan from the business – may be treated as a constructive transfer of money from the corporation to the shareholder in their capacity as such; i.e., a distribution or dividend.
An ostensible payment of salary by a corporation may be treated, instead, as a distribution of a dividend. If, in such a case, the salary paid is in excess of what would ordinarily be paid for similar services, it is possible that the excessive payment corresponds to a distribution of earnings upon the corporation’s stock – one in which other shareholders may not be participating.
. . . Followed by a Gift
As in the case described above, where the only nexus between the ultimate individual beneficiary and the business is via the shareholder, the latter may be treated as having made a gift to such individual.
Other
There are many other examples to which a similar analysis would be applied. For instance, the corporation’s payment of excessive rent to a shareholder-employee (or family member) for the use of the latter’s building.
What is intended, what is the effect? What can be deduced from the circumstances?
Reporting
As challenging as it may sometimes be to determine the nature of the benefit provided, an equally, if not more, challenging task is how the corporation reports the expenditure.[xiv]
There are a variety of treatments. Of course, if all the interested parties agree that the benefit was intended as compensation or as a distribution of profits, the tax preparer’s job should be straightforward, aside from the issue of reasonableness as to any compensatory payment.
Then again, it is more likely that the only direction, if any, given the preparer is something along the lines of, “I don’t want to report this an income,”[xv] and “I want the corporation to deduct the expense.” (Cake, anyone?)
Enter line 26 of IRS Form 1120 (U.S. Corporation Income Tax Return) – “Other deductions.”[xvi] The “explanatory” statement required to be attached to the return in respect of these “deductions” is often much less illuminating than intended by the Form. Instead, it will often bury the cost as a nondescript expenditure among a long list of others, probably in the hope that it will go unnoticed, not only by the government but also, in many cases, by other shareholders.[xvii]
Still, there are some preparers and shareholders who will report the amount of the expenditure as a loan from the business to the owner – anything to defer the tax liability that may result from a constructive distribution[xviii] – though they rarely memorialize the indebtedness with a promissory note, secure it with collateral, or provide a maturity date, and they almost never impute interest.[xix]
Will They Ever Learn?
Notwithstanding the volumes of decisions and rulings issued by the Courts and the IRS that have delved into this subject matter, there are still many business owners who have somehow remained ignorant of the risk, or who have simply chosen to ignore it.
Although most instances involve business owners who direct the use of corporate-owned assets toward personal, nonbusiness ends, occasionally one will come across a decision in which the owner’s children – who are not yet owners themselves but who may be officers of the corporation – are found to have misused the assets of the business, as was considered in a fairly recent decision of the U.S. Tax Court.[xx]
It’s Not Mine . . . But It Is
Corp was engaged in a business. Before his father’s death, Son was only marginally involved in the business. When his father died, his mother became the sole shareholder, and Son dutifully stepped in to help her with the business. In fact, during the years in question, Son managed and operated the business whereas his mother had no role in Corp.
Although Son did not receive a paycheck from Corp, and did not own an equity interest in Corp, he used Corp’s money for his personal expenses, and otherwise treated Corp’s funds as his own; in his own words, he “didn’t really feel like there was a difference.”[xxi] For instance, he used funds from Corp to purchase several luxury vehicles – you don’t want to know – and to engage in and fund other activities not related to the business of Corp, including several investments.[xxii]
“Reporting”
Son hired someone (who was later investigated for tax crimes) to assist with Corp’s bookkeeping and to prepare Corp’s and Son’s tax returns.
Needless to say, neither taxpayer’s compliance for the years in question may be described as exemplary. Indeed, at one point, Son’s tax advisers told him that, “[w]e may need to start you on some kind of payroll because if you have a high mortgage interest, it may show up on the IRS wage and income transcript and yet you have no payroll showing you can pay for the mortgage. Remember [Corp] is a regular corporation and the income does not pass through you [sic] personal tax.”[xxiii]
In two of the years in question, draft personal income tax returns were prepared but not filed. The IRS prepared substitute returns.
The Audit
The IRS examined Corp’s tax return. During the exam, the IRS interviewed Son concerning his role in Corp. Son provided information regarding some (but not all) of the bank accounts to which he had access. Corp provided QuickBooks records to the IRS. The IRS concluded that the records were altered after the start of the examination and therefore were unreliable. It also noted that cash withdrawals for which there were no supporting records were recorded by Corp’s bookkeeper as “Loan to Shareholder.”
The examination regarding Corp prompted the IRS to open an examination of Son’s tax returns for the same periods. The IRS again interviewed Son, this time concerning his individual tax returns examination. When Son failed to respond to Information Document Requests from the IRS, the agency secured bank records for his known accounts and performed bank deposits analyses. The agency determined that Son made about $20 million of deposits into his personal accounts of funds withdrawn from Corp’s PayPal and other Corp accounts. The IRS concluded that these were unreported taxable deposits.
The IRS also determined, from its analysis of Corp’s bank accounts, that Son paid personal expenses directly from such accounts; for example, transfers were made to a title company, to a landscaper, to a pool company, to a contractor, and to auto dealers. Payments were also made in satisfaction of the real property taxes on Son’s home.
The Service also determined through the bank deposits analysis that Son transferred money from Corp’s bank account to fund Son’s investment in other ventures.
The Court’s Decision
Gross income includes “all income from whatever source derived”; basically, “all accessions to wealth over which the taxpayer has complete control.” The Court explained that “a gain constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it.”
A taxpayer has control, the Court continued, “when the taxpayer is free to use the funds at will.” The use of funds for personal purposes, the Court stated, indicates dominion and control, “even if these funds are in an account titled in a name other than the taxpayer’s.”
In the present case, because the taxpayer (Son) failed to maintain books and records establishing the amount of his gross income, the IRS was authorized to determine the taxpayer’s income by any method that clearly reflected income.[xxiv]
According to the Court, the bank deposits method used by the IRS – which was supported by bank account statements and deposit records, including checks and withdrawal slips from bank accounts over which Son had signatory authority and exercised control – constituted prima facie evidence of income that Son received, but did not report, income for the years in issue. Thus, it was Son’s burden to prove that the bank deposits analysis was unfair or inaccurate.
Instead, Son argued that the bank accounts were Corp’s, not his; because he did not own Corp, the income could not have been his.
The Court rejected Son’s argument,[xxv] finding that he ran the business, had control over the business’s accounts, and considered them no different from his personal accounts. Indeed, at trial, Son testified that he “didn’t really feel like there was a difference” between Corp’s bank accounts and his personal bank accounts. Moreover, when questioned how Corp paid him for his work, because he received no paycheck, Son testified that he “used the money from [Corp] for personal expenses.”
These admissions, the Court stated, supported the IRS’s characterization of Son’s withdrawals from Corp’s accounts as taxable income, at least to the extent not otherwise explained. In the absence of any evidence to the contrary, the record established that Son viewed Corp’s funds as “money to be used” and spent it as he wished, including on personal expenses.
With that, the Court sustained the IRS’s determination with respect to Son’s unreported income.
Be Careful Out There
Son didn’t have a leg to stand on; and his mother – who owned all of Corp’s stock – seems to have had been ignorant of, took little interest in, or exercised very little influence over, Son’s activities with respect to Corp and its business.
The “transitive law” of mathematics and logic,[xxvi] as paraphrased in the title of this post, has no place in guiding the relationship among business owners, their families (as in the case of Son), and their business entities. In fact, it can only lead to trouble, as many owners who have applied this basic rule have learned over the years, much to their detriment.
Instead, these parties should consider the following question in assessing the transactions and flow of value among them: how would an unrelated investor react to these actions?
The business entity should be treated as a separate person from its owners and other related persons. The premise underlying any transactions between them is that they should treat with one another at arm’s length,[xxvii] and they should be prepared to demonstrate the existence of such a relationship to the IRS.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
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[i] Or LLC, for that matter.
[ii] You’ve probably heard of the “three-generation” rule for family-owned businesses – the first generation starts and builds the business, the second maintains it, and the third, having no interest in continuing the business, squanders it or sells it. Although several studies support the “rule” to some extent – and I’m certain that the personal experience of many of you generally confirms it – this article from Harvard Business Review describes the rule as a “myth”: https://hbr.org/2021/07/do-most-family-businesses-really-fail-by-the-third-generation.
[iii] The pie keeps pace with the ever increasing number of mouths at the table.
President Lincoln, in an entirely different context (referring to those who sought political appointment), described the problem as follows: “there are too many pigs for the teats.”
[iv] It’s usually a natural development – folks have different interests and strengths that don’t align, or are incompatible, with those of the business. Then again, some folks just don’t get along. To some degree, it’s attributable to poor “recruiting” efforts within the family and to the absence of a well-considered succession plan.
[v] Under many shareholder agreements, a shareholder who elects to no longer be employed in the business is required, or is deemed to have offered, to sell their shares to the corporation (a redemption) or to the other shareholders (a cross-purchase).
[vi] Perhaps through annual buybacks – the corporation will have to “make a market” for its equity.
[vii] As opposed to concord, which was so important to the Greeks and Romans that they had goddesses dedicated to the concept: Harmonia and Concordia, respectively.
[viii] At the end of the day, a child or grandchild knows that if they complain or insist too strongly or too loudly, all it takes (in addition to the usual formalities) is a phone call (or email), and a few taps on a keyboard, for them to be written out of a will or revocable trust.
[ix] For example, see New York’s BCL, Sec. 1104-a(a)(2), under which shareholders may present a petition of dissolution on the grounds that the property or assets of the corporation “are being looted, wasted, or diverted for non-corporate purposes by its directors, officers or those in control of the corporation.”
[x] Think about the types of add-backs you’ve encountered in the context of selling or purchasing a business. These are expenses paid or incurred by the target business that are typically discretionary, or non-operating. From the buyer’s perspective, they are also non-recurring. For purposes of determining the true revenues and value of the business, these expenses are added back.
[xi] The justifications offered by the beneficiary of such expenditures are also wide-ranging, though marketing, public relations, sales, client development and retention lead the pack. In most cases, however, the connection between the expenditure and the purported business purpose is usually pretty attenuated.
The following are examples of the expenditures I’ve encountered; they are probably representative: (1) no/low interest loans to shareholders or family members; (2) groceries (I know some restaurant owners who have never shopped for food for their homes); (3) apartment rents (ostensibly to be “closer” to the business and for entertaining customers or prospects); (4) tuition (the shareholder’s child is being groomed as a successor in the business); (5) charitable contributions where there is no clear connection to the business, or to satisfy a shareholder’s charitable pledge (for the public image of the business and its leadership team); (6) car rental payments (ostensibly for business use); (7) phones (the same); (8) country club dues (ostensibly for customer/prospect/employee entertainment); (8) season tickets (same); (9) no-show jobs for spouses, children, and other family members (to participate in retirement and insurance plans); (10) planes (ostensibly to visit customers and business locations); (11) travel costs (to vacation locations not far from where a customer or prospect may be located); (12) weddings (where the guests include many customers and colleagues); (13) the payment of excessive rent for the use of a shareholder’s or family member’s property; (14) the payment of consideration to acquire property from a shareholder in excess of fair market value of the property; and (15) other “social” gatherings – do you remember the scene from the 1984 movie, Ghostbusters, when the accountant, Louis Tully (Ri ck Moranis), is hosting a party in his apartment?
“Hey, this is real smoked salmon from Nova Scotia, Canada, $24.95 a pound. It only cost me $14.12 after tax, though. I’m giving this whole thing as a promotional expense. That’s why I invited clients instead of friends.”
[xii] Notwithstanding Mamdani, there’s still only one.
[xiii] IRC Sec. 162; Reg. Sec. 1.162-7. The allowance for the compensation paid may not exceed what is reasonable under all the circumstances. One may assume that reasonable and true compensation is such amount as would ordinarily be paid for like services by like enterprises under like circumstances.
[xiv] Let’s assume the tax preparer is not aware of any shareholder’s use of business assets, or that they have been told to ignore such use as de minimis and nit worth the effort of valuing. I’m certain most of you have encountered both of these scenarios.
[xv] In the case of wages, the shareholder-employee is also thinking about employment taxes.
[xvi] The entry is on Line 20 of Form 1120-S for S Corporations = and on Line 21 of Form 1065 for partnership tax returns.
[xvii] Drives me nuts. When I confronted a tax preparer about this “practice” many years ago, he told me I was too concerned with “theoretical niceties” whereas he was being practical.
[xviii] I’m sure you’ve seen this: a shareholder with very substantial amounts owing to a corporation that has plenty of unappropriated retained earnings but that has never declared a dividend.
[xix] Using the applicable federal rate in accordance with IRC Sec. 7872. Query how often such “loans” are repaid.
[xx] Chernomordikov et al. v. Commissioner, docket numbers 35205-21 and 35297-21, in the U.S. Tax Court.
[xxi] Query whether the IRS considered treating the withdrawals of value from the Corp as gifts by mom; then again, was she even aware of Son’s activities?
[xxii] For example, Son was also involved in other businesses, including one that “flipped” homes and developed land into residential property.
[xxiii] You can’t make this up.
[xxiv] IRC Sec. 6001; IRC Sec. 446(b); Reg. Sec. 1.446-1(b)(1). The reconstruction of income “need only be reasonable in light of all surrounding facts and circumstances.”
[xxv] The Court added that it “did not find Son’s testimony to be credible.”
[xxvi] aRb, bRc, then aRc, where R represents a particular relationship.
[xxvii] For example, the hypothetical willing buyer and willing seller standard that governs most valuations of property, or the transfer pricing rules under IRC Sec. 482.