In Uncategorized on 02/26/2016 at 00:20

Today’s Tax Court tale gives us a replay of an old story: a well-established, profitable business married via a common controlling shareholder to a struggling start-up.

Kay Carpets, Inc., 2016 T. C. Memo 30, filed 2/25/16 is the moneyed spouse, as the family law types say, and Clean Hands Co, Inc., the struggling start-up. Ray Johnson and wife Geraldine wholly own Kay, and Ray solus owns Clean Hands.

Ray is inventive. Aware that food service establishments must monitor employee handwashing to comply with health codes, Ray starts with a RFID badge system that dispenses soap and monitors uses. That doesn’t go over, so he tries a voice-operated system.

The old joke “I don’t know about the others, but I use the spoon” clearly doesn’t work.

Ray hires a six-figure computer geek with an impressive resumé, first to work on the RFID with Kay, and then to work on the voice at Clean Hands.

The geek also did some work on Kay’s own computer systems.

Of course, no way could Clean Hands come up with the geek’s heavy-duty wage packet. So Kay paid Clean Hands for work on its own systems, and also for work on the voice system.

Ray owned the patent on the geek’s work (work for hire, y’know). And as sole shareholder of Clean Hands, if the device took off, Ray was the lead beneficiary.

“Mr. Johnson did not present any credible evidence that Key Carpets owned the voice-activated hand washing monitoring system. His testimony that Key Carpets owned the voice-activated hand washing monitoring system was vague, unclear, and not credible. Mr. Johnson’s testimony contradicts his statements that he owned the patent on the voice-activated hand washing monitoring system. Additionally, the parties stipulated that Mr. Johnson was the sole owner of Clean Hands. Although Key Carpets had an ownership interest in the initial RFID badge-activated hand washing system, Key Carpets had no interest in the new voice-activated system that the computer technician developed as a Clean Hands employee. The Court therefore finds that Key Carpets did not own the voice-activated hand washing monitoring system.” 2016 T. C. Memo. 30, at pp. 12-13.

Key Carpets got no benefit from any of the geek’s work on the voice system. While IRS only wants to allow Key Carpets a minuscule part of the geek’s pay as ordinary and necessary, Judge Paris goes with the geek’s 15% estimate.

The rest is a constructive distribution to Ray. It’s not a dividend unless Kay Carpets has earnings and profits, those undefined and elusive little devils, and while IRS and Ray agree on some numbers, the rest depends upon Judge Paris’ opinion.

Judge Paris gives us a quick review.

“A dividend is any distribution a corporation makes to its shareholders out of earnings and profits. Sec. 316(a). The distribution is first made out of the earnings and profits for the current taxable year. See id. When current earnings and profits are insufficient, the distribution is made out of accumulated earnings and profits. See id. When a corporation does not have sufficient earnings and profits for the entire distribution to constitute a dividend, the remaining amount is not a dividend but reduces the adjusted basis of the shareholder’s stock in the corporation. Sec. 301(c)(2). The amount of the distribution that is not a dividend or does not reduce basis is generally treated as gain from the sale or exchange of property. Sec. 301(c)(3); see also sec. 1001.” 2016 T. C. Memo. 30, at p. 19.

And the payments weren’t a loan. No paperwork.

Now while Ray used his accountant to prepare his and the corporations’ returns, that doesn’t help with the chop.

“Petitioners argue that they acted with reasonable cause and in good faith because petitioners provided all records to their accountant and had a reasonable basis for the business deductions. However, petitioners did not act in good faith, because their positions run contrary to established law. Mr. Johnson testified that he provided all records to his accountant on whom he relied to prepare his corporate and individual returns, but petitioners did not offer any evidence about whether they sought advice from their accountant about the deductions or whether the Key Carpets payments to Clean Hands constituted constructive distributions. Because petitioners’ positions run contrary to established law and petitioners have not shown that they reasonably relied on their accountant to do anything more than prepare tax returns, petitioners have not met their burden of proving that they acted in good faith with reasonable cause, and the Court sustains the section 6662(a) accuracy-related penalty. 2016 T. C. Memo. 30, at pp. 26-27. (Footnote omitted, but read it; because there’s substantial understatement, negligence doesn’t matter).

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