With the year-end planning season being just around the corner, tax advisors will again be expected to suggest that their C Corporations clients try to avoid paying corporation income tax by “zeroing out” the C Corporation’s taxable income by issuing a W-2 bonus to its corporate shareholders who are also employees. It is not uncommon for the C Corporation to then “book” a loan back to the C Corporation for these shareholders – so that no actual cash changes hands in what is typically structured as a year-end transaction.
This type of technique requires consideration of “reasonable” compensation issues and disguised dividend issues. However, the Tax Court, in Vanney Associates, Inc., T.C. Memo 2014-184, recently raised another type of concern with this sort of year-end transaction.
The Tax Court ruled that this type of transaction can also fail to “zero out” C Corporation taxable income where the C Corporation professional services firm (in this case an architectural firm) year-end bonus check to the shareholder-employee could not have been honored if presented to a bank due to insufficient cash on-hand as of the date the check was given to the shareholder-employee.
Here are the facts as stated in the opinion:
In 2008 Vanney Associates paid Mr. Vanney monthly wages totaling $240,000. At the end of each year, it was the Vanney’s practice to determine the Vanney Associates’ remaining profit after paying any outstanding bills and paying bonuses to employees. After determining this amount, Ms. Vanney would prepare a check on behalf of Vanney Associates and pay the remaining profit to Mr. Vanney as a year-end bonus. The Vanneys testified that their intent behind the year-end bonus was only to pay out the remaining profit; it was not to zero out the tax liability of Vanney Associates even if that was the effect.
On December 30, 2008, Vanney Associates paid Mr. Vanney a year-end bonus totaling $815,000. After withholding and paying to the IRS the appropriate Federal income, Social security and Medicare taxes, Vanney Associates wrote a check to Mr. Vanney for $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. Ms. Vanney recorded the payment on the books as a loan from Mr. Vanney, and Vanney Associates repaid Mr. Vanney in March 2009.
Tax Court Judge Buch found that the check was never cashed because the shareholder-employee knew that Vanney Associates did not have the funds necessary to honor the check (while maintaining that Vanney Associates could have gotten a loan to cover the check).
The IRS disallowed the $815,000 bonus expense, and the Tax Court sided with the IRS, finding that Mr. Vanney, the sole shareholder of Vanney Associates, and Ms. Vanney, as Vanney Associates’ bookkeeper, knew or should have known that Vanney Associates did not have the funds to cover the bonus check to Mr. Vanney. In fact, the court noted that Mr. Vanney testified to having at least some idea of this cash-flow problem. While Vanney Associates argues that the payment was unconditional and payment occurred when Mr. Vanney took possession of the check, the Tax Court found that Mr. Vanney could not cash it at the bank, use it to pay a debt, or use it to make a loan to someone other than to Vanney Associates. In fact, Mr. Vanney’s only option to make use of the money at that time was to lend it back to Vanney Associates because the check could not be honored.
Accordingly, the whole bonus check was disallowed as officer compensation even though the C Corporation did have funds that could have covered a substantial portion of the bonus check.