tax treatment for individual paying a corporation's tax liability

[taxedtothemax]

This is a doozie. A semi-retired executive of a liquidated corporation gets cited for personal liability for sales taxes a state alleged were unpaid dating back to 2006. The individual is not a resident of that state and, in the interest of time, aggravation and cost, settled with the state to resolve the matter. Since these were sales taxes I thought there could be a way to deduct as an itemized deduction but that is likely negated by his non residency. Even though he is no longer an employee of the defunct corporation, could the settlement amount be considered a non-reimbursed employee business expense subject to the AGI limitation?
Any help is greatly appreciated.

[Nashville]

Capital Contribution

Taxedtodeath, there is a simple answer to the question, however, the tentacles on this situation go far and beyond.

He paid taxes that were technically not his own. No way can he deduct these as taxes. What has happened is that he has made a capital contribution in the amount of whatever was paid. This should be booked as a capital contribution on the books of the corporation, and if he is no longer a shareholder, it should then be treated as Donated Capital.

My guess is the corporation was in default, and the State started coming after the shareholders of record at the time the tax liability was incurred.

If this taxpayer has any recourse, it would be reimbursement from the corporation, not a tax deduction. The additional capital contribution also increases his basis as a shareholder and entitles him to a greater cost basis upon disposition. However, if he has already disposed of his stock in a prior year, I don't know how to make this work.

[Bees Knees]

TTB page 8-13 provides the following answer:

Paying Expenses of an Employer
If the expense paid by an employee is that of the employer and
not the employee, the expense might not be deductible. This
could be the case where a taxpayer is both the shareholder and
employee of his or her corporation. The shareholder employee
may pay a corporate expense, such as office rent, out of personal
funds when the corporate checkbook is low on funds. Since the
expense is a liability of the corporation and not the employee,
the expense is not deductible by the employee because it is not
an ordinary and necessary business expense under Section 162
(Brody, T.C. Summary 2004-149). However, if the corporation has
a resolution or policy in place requiring a corporate officer as an
employee of the corporation to assume certain expenses, those
expenses would be deductible by the employee, subject to the 2%
AGI limitation on Schedule A. (Craft, T.C. Memo 2005-197)

In your situation, it is claimed that the shareholder was liable for the tax. That may or may not be true, as a shareholder is technically shielded from the liability of the corporation. In order for the shareholder to deduct the expense, the shareholder would somehow have to prove that the state could legally attach the corporation’s tax debt to the shareholder.

The other possibility is what Nashville suggests – consider it a contribution to capital. Then have the shareholder take a capital loss for the zero return.

[BHoffman]

Taxedtothemax: In AZ, sales taxes are considered to be "trust" amounts and the shareholders are held personally liable. The reason behind this is that the company was not the payee, only the acting agent of the Dept. of Revenue. They simply collect sales taxes from the customer and are required to then remit them to the rightful owner - the Dept. of Revenue.

So, it is very possible that the State does have the legal right to push the liability onto the shareholder. I know that is true in the state of Arizona. This is the way employee 941 withholdings not deposited by employers are treated - as a personal liability of the shareholder.

The sales taxes are either deductible to the corporation or else they should not have been included in income.

To deduct - Sales tax collected were included in Income, and then deducted as an expense. For a cash basis taxpayer, these amounts would not have actually deducted unless paid. Is this how the corporation reported? If so, I would consider amending the corporate tax returns for possible refunds that are still within the SOL.

To accrue - Sales tax collected would be entered as a Debit to Cash and a Credit to Sales Tax Payable, and would never have been recorded in Income. Most companies record sales taxes in this way, whether they report on a cash basis or on an accrual basis.

IMHO: Cash receipts from sales taxes are not income and should not be reported as income no matter which basis is used for income tax reporting.

[Nashville]

Hypocrites

BHoffman, what a double forked-tongued state in which you dwell!! AZ creates a corporation for the protection of shareholders so they won't be held personally liability if the corporation owes money.

So I do $5000 worth of work for an AZ corporation, and now they can't pay their bills. That means I can't go after their shareholders for my $5000. Ironclad protection, I would say.

However, if they owe the state of AZ, then Arizona can go after them by redefining their debt as a "trust". They are not willing to live with the same rules they make up for my $5000 and anyone else.

For those of us on the board who live in states other than Arizona, let's hear three long "BOOOs" for AZ. And be thankful we live in the other 49 states where the above scenario can't possibly happen. Right??

Right....

[Nashville]

Whoops!!

Just have to clear the air on this one.

I received a private message from someone (whom I value highly) living in Arizona imploring me to not cast their state in such a poor light.

I hope all of you know I was trying to draw attention to everyone's state, and not just AZ. In fact, I'm not aware of a single state which allows a corporation to invoke debt protection against their governments. Certainly my state will allow a corporation to welch out on paying its creditors, unless one of the creditors is the state itself.

Apologies for AZ - not really any more guilty than other states, and I was trying to imply this in a sardonic, twisted approach.

We have government to protect us from ourselves, but who is there to protect us from government??

[BHoffman]

We have government to protect us from ourselves, but who is there to protect us from government??

Each other I always try to remember that We the People are the ones who really run this country. The politicians come and go, but the overwhelming majority of the American people are proud and strong, generous and kind, hard-working and honest.

[erchess]

NC Corp

If an NC Corp owes one of the two taxes that are not based on revenue or income but are simply fees for existing, can the sole shareholder not avoid paying by the simple expedient of there being no money in the corporate account?

[BHoffman]

If an NC Corp owes one of the two taxes that are not based on revenue or income but are simply fees for existing, can the sole shareholder not avoid paying by the simple expedient of there being no money in the corporate account?

Hi erchess - not sure what you mean. There would be a difference between licensing fees - fees for existing - and sales tax. The shareholder might not be held personally liable for licensing fees, but could be on the hook in your state for sales taxes collected from customers that were not properly remitted to the taxing authorities.

That is why sales taxes are not income to any business. They are amounts collected from customers, held in trust for the government, and then remitted on (usually) a monthly basis. The money never actually belonged to the business. The fact that the funds are trust amounts is probably the basis for the government holding the individual responsible and not the corporation.

In the event that there is simply no money, most governments can attach liens, garnish, and perform other distasteful acts on the individual in order to collect sales taxes that were collected and not remitted, which also is a distasteful act. If the shareholder is broke and has no assets, then I suppose it would be put in the uncollectible basket.

[erchess]

Trust Funds

Yes I'm aware that they can go after owners who knew or reasonably should have known that money being held by the company in trust for the government or other employees was not deposited as it was supposed to be. I know that Sales and Payroll taxes fall under that and I think Pension Plans and deposits to them should work the same way though I don't know whether they do.

On the other hand I was distinctly under the impression that a corporation's debts including its income and "for existing" taxes as well as its debts to lenders and suppliers can go unpaid if there is no money in the corporate account.

[BHoffman]

On the other hand I was distinctly under the impression that a corporation's debts including its income and "for existing" taxes as well as its debts to lenders and suppliers can go unpaid if there is no money in the corporate account.

That is true for the employers portion only of the 941 tax due if the company goes bankrupt. The trust amounts represented by the employee withholdings are a personal liability to the shareholder. All of the cash receipts received by a company via sales taxes are trust amounts. Therefore, all of the sales tax receipts are trust amounts, and the shareholder is personally liable.

That makes some sense to me. That money was collected and used somehow by the shareholder, whether for business or personal reasons. In any event, it was not remitted to its rightful owner - the State. So, the shareholder should be on the hook. If he files personal bankruptcy then I believe the debt may be forgiven in that proceeding but State laws probably differ.

Back to the OP's original question - I would look at the tax returns to determine if the funds collected for sales tax were ever recorded as income and amend the tax returns if possible to get a refund.

In any event, the shareholder did not remit the sales tax collected. He got caught. So now he pays the settlement amount. If you want to play the game, then play by the rules.

[taxedtothemax]

tax treatment for individual paying a corporation's tax liability

Thank you all for your responses. The facts of this case are that the corp made certain ordinary course deductions from its monthly sales and use tax returns for things such as tax exempt sales. During the corp's bankruptcy proceeding, the state attempted to conduct an audit for the periods 2006 - 2008. The state's auditor was unable to initiate his audit as the company was in the throes of bankruptcy/liquidation so all prior deductions for tax exempt sales, bad debts, etc. were rejected by the state, thus creating the alleged liability. The corp was subsequently liquidated and all business records destroyed with the permission of the bankruptcy court. All of this was after the executive had left the company so he had no way of proving that the deductions were legitimate. The corp had a history of collecting and remitting all sales and use tax collected each month and the accounting treatment was to record the collected taxes as a liability prior to remittiing to the state. At the time of the bankruptcy filing, all known unpaid sales and use, payroll, etc. taxes were paid with the court's permission to protect the officers and directors from personal liability. The stores in this state had been closed prior to the filing and there was no recorded liability on the corp's books. The state should have acted more swiftly and had it done so, would likely been paid from the DIP facility. Their failure to act, caused them not to be paid and therefore they hunted down this retired executive and held him personally liable. He settled because he believed the known amount the state agreed to was better than appealing to the tax court and the unknowns that a trial might lead to despite his belief that nothing was owed. Sometimes the best decision is the prudent one and not the just one. He's simply trying to see if there's a tax benefit that might help offset his pain.

[Snaggletooth]

Great Post

Taxtothemax, Great Thread and lots of good, possibly helpful discussion (even though it got slightly off topic). You haven't been on this forum very much, but please visit more often.

As has been inferred, only a government could ever prevail in a situation like this, with their sleazy behavior. Ordinary citizens and commercial companies are not protected.

[erchess]

Devil's Advocate here

We all know that a person can't deduct on Federal Taxes a state tax payment he didn't owe. On the other hand this taxpayer didn't just get drunk and mail a check to the state he no longer lived in. The state asserted that the defunct corp while he was a highly responsible party didn't pay its sales taxes properly and even though he felt that the allegation was false he thought it wise to reach a settlement with the state. As of the moment he reached the settlement he did owe the tax. He doesn't have to share with the IRS his belief that had he been willing to go to court he had a shot at paying less or even no tax.

So is there some provision I'm unaware of to the effect that you can't deduct State Taxes you pay because a corp in which you were responsible didn't pay its taxes before passing out of existence? Or a general provision to the effect that State Taxes you should have paid earlier but paid later only when the State grabbed you are not deductible? I'd be the last person to say there isn't such a provision but I'd like to know more about its details so I do not run afoul of it or let a client do so.

[Bees Knees]

If it were my client, I would inform him about how the courts throw out deductions for expenses that a corporate shareholder pays on behalf of the corporation. The only time it is deductible is when the shareholder is personally liable for the expense, as in the case where the employment agreement says the shareholder will pay X, Y, and Z expenses and the corporation will pay the rest. If the client still wants to take the deduction, I would probably insist on disclosing the deduction on the return to protect myself from preparer penalties for taking a position that is not support by substantial authority.

If I were an IRS auditor knowing these facts, I'd disallow the deduction, period, end of story. The taxpayer cannot prove he was liable, and I suspect the tax court would agree.