The Tax
Court in Vanney Associates Inc., TC Memo 2014-184, held that the corporation
could not deduct its sole shareholder/CEO's yearend bonus as officer
compensation because the corporation did not have the funds to cover the check
he received. Therefore, the check could not have been paid.
The
corporation is a personal service architectural C corporation that uses the
cash method of accounting. The corporation's sole shareholder, an experienced, licensed
architect, is also the corporation's CEO, CFO, vice president of marketing,
vice president of operations, and director of human resources. Although the
corporation has other employees, the shareholder is primarily responsible for
marketing, bringing in new business, and signing construction documents.
The
shareholder's wife is responsible for the corporation's books and records. She
is a CPA with an inactive license, and is also employed as vice president of
finance for an unrelated company. She prepares the payroll checks and the
shareholder signs and distributes them.
At the
end of each tax year, the shareholder and his wife determine the corporation's
remaining profits after paying outstanding bills and employee bonuses. The
shareholder's wife then prepares a check on behalf of the corporation and pays
the remaining profit to the shareholder as his yearend bonus. The shareholder
and his wife both testified that they did this only to pay out the remaining
profit, and they did not intend to zero out the corporation's tax liability,
even if that was the result.
In
2008, the corporation paid the shareholder a yearend bonus of $815,000. After
making appropriate withholdings, the shareholder received a check for
approximately $464,000. He signed the check on behalf of the corporation, and
then endorsed it in his own name and made it payable to the corporation. He
never attempted to cash the check, his wife recorded the payment on the books
as a loan from the shareholder to the corporation, and the corporation repaid
the shareholder in March 2009.
The
total balance of the corporation's bank accounts on 12/31/08 was approximately
$389,000. After adjusting for outstanding deposits and checks, the balance was
approximately $283,000. The shareholder testified that he believed the
corporation did not have the funds to honor the check. However, he claimed the
corporation could have received a loan to cover it. His wife testified that the
corporation was strong and had considerable receivables. Further, she testified
that although they considered taking out a loan for the corporation, they
decided not to because they personally did not need the money and wanted to
avoid the expenses of taking out a loan.
The
corporation timely filed its income tax return for 2008, reporting no taxable
income and claiming a deduction for officer compensation. The IRS disallowed
the $815,000 of the deduction that represented the shareholder's yearend bonus
check.
The
court noted that payment by check is a conditional payment because it is
subject to the condition subsequent that the check be paid on presentation to
the drawee. When the condition subsequent is fulfilled, it is generally
reasonable to conclude that the payment relates back to the time the check was
given. Therefore, the allowance of a deduction is dependent on proper payment
of the check. The court has previously disallowed a deduction when a check was
not paid due to insufficient funds. Further, it has held that the relation-back
doctrine is inapplicable when the payee knows the payor has insufficient funds
and so refrains from cashing the check.
Also,
transactions between related entities 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 has disallowed deductions
when there was no actual economic outlay and the payments were “wholly
circular.”
The
corporation argued that the bonus check to the shareholder was unconditional
and the payment occurred when the shareholder took possession of the check. It
relied on O'Connor, TC Memo 1954-90, PH TCM ¶54195, 13 CCH TCM 623 , in which
the court held that the essential element was that the control of property
distributed by way of a dividend must have passed absolutely and irrevocably.
The court in O'Connor also relied on the fact that the payee had unrestricted
use of the money and the amount was unqualifiedly his to do with as he wished.
The
court pointed out that this was distinguishable from the situation here. The
shareholder's wife knew or should have known that the corporation did not have
the funds to cover the bonus check, and the shareholder testified that he had
at least some idea of the same. Further, the shareholder had only a restricted
use of the check. He could not cash it at the bank, use it to pay a debt, or
use it to make a loan to someone other than the corporation. The shareholder's
only option to make use of the money was to lend it back to the corporation
because the check could not be honored.
Additionally,
the court stated that it had previously held that although a taxpayer maintains
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. Therefore, the IRS's disallowance of the portion of the
deduction for officer compensation relating to the shareholder's bonus check
was upheld.
Also, as
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