Attorney-at-Law

THE PERILS OF SUB S

In Uncategorized on 04/10/2019 at 17:31

Judge Morrison points up a problem with the pass-through Sub S structure in Thomas J. Francel, 2019 T. C. Memo. 35, filed 4/10/19. That’s Doctor Thom, as he’s a successful plastic surgeon with lots of income, a good part of which comes in the form of cash and cashiers’ checks.

But Doctor Thom’s income flows through from his Sub S, which his bookkeeper and wife are looting. They siphon the cash and checks through an account unknown to trusty CPA, with wife grabbing all and investing in house improvements, car restoration and her drug addiction.

Bookkeeper goes undercover for IRS, and FBI raids the place. Wife goes down, serves 10 months, pays restitution, judicially separates from, but remains married to, Doctor Thom, and eventually moves back in with him.

Doctor Thom wants innocent spousery for a tiny deficiency and the heavy-duty accrued interest on the restitution. Of course, Doctor Thom and wife filed MFJ for years at issue.

There’s a jurisdictional joust, because Doctor Thom’s innocent spousery gets tangled up with a NITL that he was dealing with at Appeals. So there’s a question when Appeals issued a NOD on innocent spousery, if at all, but anyway Doctor Thom is safe. Procedure geeks can read it all.

So Judge Morrison can decide the shoot-down of his innocent spousery, and use de novo review rather than abuse-of-discretion as in a lien or levy CDP.

Here’s where the Sub S wrecks Doctor Thom.

“We need not determine whether the unreported cash fees could be characterized as the embezzlement income of Francel’s wife.  Even if the unreported cash fees were the embezzlement income of Francel’s wife, this does not preclude the fees’ also being income to the medical practice.  When an employer earns income and an employee embezzles the proceeds of the income, both the employer and the employee face income inclusions.  The employer may deduct any loss that it realizes from the embezzlement.  Sec. 165(a), (e); sec. 1.165-8(a)(1), (d), Income Tax Regs.  This deduction is allowed for the year in which the employer discovers the loss, sec. 165(e), or, if in the year of discovery the employer has a claim for reimbursement that has a reasonable prospect for recovery, the year in which it can be ascertained with reasonable certainty whether the reimbursement will be received, secs. 1.165-1(d)(3), 1.165-8(a)(2), Income Tax Regs.

“The medical practice earned the unreported cash fees because it provided the services that generated the fees and received those fees for those services.  The medical practice received the unreported cash fees:  Its receptionist collected the fees from the patients.  Thus, even if the fees were misappropriated from the medical practice by [bookkeeper] and Francel’s wife, the medical practice was required to report the fees as its income.  (Francel does not argue that the medical practice is entitled to loss deductions for the years [at issue], and the record does not establish that the practice is entitled to one.)  Although an S corporation, such as the medical practice, is required to file a return reporting its income, sec. 1.6037-1(a), Income Tax Regs., it is not subject to income tax, sec. 1363(a).  The income of an S corporation is included in its shareholder’s income.  Sec. 1366(a), (c).  Therefore Francel, the sole shareholder of the medical practice, was required to include the fees in his income.  The erroneous items of income on the Francels’ joint returns–the service income of the medical practice corresponding to the unreported cash fees that passed through to Francel as the owner of the medical practice–are attributable to Francel.  Because the fees were unreported, the fees gave rise to understatements of tax on the couple’s joint return.  Therefore, the second requirement of section 6015(b) relief is not met.” 2019 T. C. Memo. 35, at pp. 42-43. (Citations omitted).

The second requirement is that the items giving rise to the tax are those of the non-requesting spouse, but these are not.

And if that weren’t bad enough, “The fourth requirement, that it be inequitable to hold Francel liable for the…deficiencies, see sec. 6015(b)(1)(D), is not met.  The deficiencies are attributable to the Francels’ failure to report the unreported cash fees on their joint returns, which in turn is attributable to the medical practice’s failure to report the proceeds on its tax returns.  Francel benefited from the unreported cash fees because his wife spent some of the cash on Francel’s house and car.  See sec. 1.6015-2(d), Income Tax Regs. (providing that a relevant factor in determining whether it is inequitable to hold a spouse liable for deficiencies on a joint return is whether the spouse ‘significantly benefitted, directly, or indirectly, from the understatement’ and defining a ‘significant benefit’ as ‘any benefit in excess of normal support’).  Today Francel still lives in the house that was improved by the unreported cash fees.  He still owns the car that was restored with the unreported cash fees.  His accumulated wealth is attributable in part to the unreported cash fees and to the unpaid tax from the [years at issue].  In our view the equities are against relief.” 2019 T. C. Memo. 35, at pp. 44-45.

Sub S is a great tool for adroit tax and asset protection planning. But its insulation is not impermeable.

Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this: