CA Income Tax: Shareholder Denied Claim Deduction for Alleged Advance Made to Corp.

CA Income Tax: Shareholder Denied Claim Deduction for Alleged Advance Made to Corp.

The sole shareholder of a corporation, which provides health and support services to very ill patients, was denied her claim on a California personal income tax deduction for an alleged advance made by her to the corporation. This deduction was denied because the taxpayer failed to substantiate that she actually made the advance. But even in the event that the advance was substantiated, the taxpayer failed to prove that this was actually a business expense deduction. In other words, she would have needed to prove that the advance was a loan in which case a loss could be claimed as a deduction. She couldn’t prove that it could not also be claimed as a nondeductible capital contribution. Moreover there was no proof provided that this wasn’t actually a debt which became worthless during the given tax year.

The reason for the denial is that during the respective tax year, the taxpayer sold the corporation to a third party. Per the terms of purchase, the corporation entered into an interim management agreement. The reason for this is that the purchaser needed to obtain the proper licensing necessary to continue the services provided. Under the terms of this interim agreement, the buyer agreed to continue paying rent to the taxpayer and incidentally owner of the property where the business was located. The corporation agreed to pay all expenses incurred prior to the final sale. But what happened was  that the taxpayer realized that the payroll expenses had not been paid prior to the sale so she claims that she advanced the corporation the funds to pay the California payroll taxes to the CA (EDD). But she failed—when trying to claim this as a deduction—to provide that she actually made the advance. The only evidence she gave was a check copy received from another business which was before the payment to the EDD. She also provided a cancelled check from the corporation to the EDD, but no attached documentation that she had funded any monies directly to the corporation to pay the EDD taxes.

Moreover, even if she had been able to establish that she had given the corporation an advance to pay the payroll taxes, she was still ineligible to claim this as a business expense deduction. A shareholder may claim a business expense deduction for expenses paid on behalf of the corporation only if it can be shown that the expenses were paid were a necessary expense to protect the shareholder’s own company. And she could not prove this either. The taxpayer refuted this denial by claiming that if the corporation failed to uphold its part of the interim management agreement, the buyer would have legally been able to cancel the purchase. At which point she would have been unable to collect the rent from the buyer. But the IRS still called foul because the amount of rent equaled at most $72,000. The advance she made exceeded $120,000. Thus, the taxpayer’s advance was much higher than any return she would have gotten from the buyer’s rent payments.

There may have been another loophole which is IRC §166 loss deduction. But she was also deemed ineligible for this because she failed to demonstrate that a legal debt existed between herself and the corporation. She had no proof of any type of loan agreement, no evidence that the corporation was used as any type of collateral in a loan agreement. Therefore the advance was determined to be an equity investment rather than a loan for which a loss deduction could be claimed. Lastly, if the taxpayer wanted to try one more avenue and claim an IRC §165(g)(1) capital loss deduction, the IRS said, “NO way.”  Again the taxpayer could not establish that her stock in the corporation became worthless during the given tax year. She could not provide any type of schedule of assets documentation which proved that the corporation was indeed of no value after the advance. She stated that her attorney had considered filing a cross-complaint in the purchaser’s breach of contract action against the corporation. This statement only further proved that the taxpayer did have the expectation of recovering some value from the corporation.

Hagerty, California State Board of Equalization, September 13, 2012 (released February 1, 2013)