How To Lose A Tax Case As A S-Corp – #smallbusiness #cpatax

Here’s a story about Ronnie Craft, who lost his court case but whose story brings up an interesting point when it comes to tax planning.

Ronnie Craft owned 50 percent of an S corporation. Both he and the other owner took salaries of $50,000 a year from the S corporation.

The corporation adopted a resolution requiring Ronnie to pay for and supply his own office space and vehicles for use on behalf of the S corporation’s business. In other words, the corporation wanted Ronnie to incur employee business expenses while promoting and taking care of the corporation’s business, but the corporation was not going to reimburse Ronnie for those expenses.

Ronnie incurred $17,604 of employee business expenses, but instead of claiming them as miscellaneous itemized deductions on Schedule A, he put them on Schedule C of Form 1040.

This was a mistake. By reporting his expenses improperly, he brought himself to the attention of the IRS.

Imagine how Ronnie’s tax return looks:

  • S corporation income from the K-1 on Schedule E
  • W-2 income from the S corporation on the first page of Form 1040
  • Schedule C income of zero, but expenses of $17,604

The naked expenses (no income) would stand out by themselves, but when Ronnie added the S corporation name as the Schedule C business name, he definitely brought himself to the IRS’s attention.

You might ask, “Why didn’t Ronnie just put the expenses on his tax return as employee business expenses, where they belonged?”

We don’t know, but we would guess that he did that before he filed his return, saw the ugly result, and decided to take his chances on Schedule C.

If you claim employee businesses expenses as miscellaneous itemized deductions on Schedule A of Form 1040, you can suffer in two ways:

  1. Lose 2 percent. Tax law takes 2 percent of your adjusted gross income and subtracts that from your miscellaneous itemized deductions.
  2. Lose the entire deduction. The alternative minimum tax (AMT) does not allow any miscellaneous itemized deductions. These deductions, which are allowed for the regular tax, are disallowed for the AMT.

The current tax reform proposals would eliminate the AMT—a tax that’s totally ugly and unfair because it taxes deductions that the regular law allows.

The real takeaway here applies regardless of what happens with tax reform, and that takeaway is to obtain good tax advice before creating a special carve-out of corporate or partnership expenses. Had Ronnie Craft known how the deductions would work on his personal return, he likely would have bargained for either a different salary or a lesser salary and corporate payment of the expenses.