Tough tax situation

[Ringers]

A friend of mine wanted me to look over his current accountant's work. Here is the situation:

Client has 2 Sub-S corporations, one a business enterprise with client, his brother, and sister as shareholders, the other a holding company for the building leased to the business enterprise, with just client and his brother as shareholders. Both corporations are on accrual basis of accounting.

1. Since 1999, corp #1 has leased the building from corp 2, paying rent of $12000 AND accruing additional rent of $13000 each year.
2. Corp #2, although on accrual basis, has only been recording the cash received of $12000 as income.
3. The accountant advised my client NOT to depreciate the building since "it will only cause a problem when building is sold".
4. Accountant has been deducting health insurance premiums from corporation #2 for shareholders, rather than adding premiums paid to their W-2 forms.
5. For 2013, accountant prepared Financial Statements showing a $14000 profit for corp #2, but on tax return reported an $11000 LOSS. Statements and tax returns both on accrual basis.
6. Client has received notices of incorrect Federal and state 941 forms which I have already corrected
7. I have sent a letter outlining the discrepancies to the accountant, but after three weeks have received no reply.

My problem is this: Corp #1 has been showing losses for over 15 years and has expensed and accrued $165000 of unpaid rent. Corporation #2, the holding company, has not shown this rent on its books even though it is on the accrual basis also and has 2 of the 3 stockholders of corp #1. By not showing the accrued rent as income, the holding company has also shown 15 years of losses, but has not taken depreciation on the building based on accountant's recommendation.
How can I begin to bring these two corporations and the shareholders of each back into compliance when the errors span a period of 15 years? Do I need to get IRS involved from the start?

Since the potential client is a friend of mine, I cannot just run from the situation. He and his brother definitely want to get back into compliance with the IRS. Their background is not in any financial area, and they had placed complete trust in the accountant for the last 15 years.

Any comments will be greatly appreciated.

[Golden Rocket]

Each Item Separately

Each item you bring to the table has a separate discussion, so I will address the first one and maybe others later if time permits.

There is definitely a problem with accruing rental expense to a related taxpayer and not recognizing the income. The best that can be done is to accrue only the amount that is actually PAID by the due date of the return. If the recipient of the rent is an accrual-based taxpayer, the rental income would have to be accrued as well. For there to be any benefit at all (and sleazy, at best), the paying company would have to be on an accrual basis and the recipient would have to be on the cash basis.

Even an accrual-based taxpayer cannot deduct accrued expenses if they are not paid by the due of the return (or in some circumstances, by the date payable in the ordinary course of business).

So your first item is kaput and needs fixing. At a minimum, three years' worth of 1120s need amending. Additionally, I would not leave this $165,000 liability on the books for any reason, and any balance sheet liability unpaid by the due date becomes a book-to-tax adjustment for Schedule M-1.

Items #2-#7 may have problems as well, depending on the facts (which I suspect have been distorted).

[Golden Rocket]

Item #3 Allowable Depreciation

You betcher bottom-dollar depreciation is going to cause a problem when the building is sold!!! That's the only thing the accountant is right about. But it's going to cause a problem when the building is sold whether or not there has been any depreciation deducted!

It's like they never heard of "allowable" depreciation which must be recaptured even if it has never been deducted. The language says "depreciation allowed or allowable" and they mean it.

If you are ever confronted with a situation where there must be a recapture of depreciated "allowable" but never deducted, go back to the year of purchase and research to see if there were alternate lives available and select the longest life (e.g. 50 years instead of 27.5). This will minimize the damage.

[Golden Rocket]

Item #4 - Health Insurance

This may or may not be OK. If there is a section 125 arrangement with the health insurer and the corporation has not discriminated under the definition of same, it is OK to allow the deduction and not add the premiums to the W-2.

This response is the "short version" on the subject of health insurance premiums.

[Golden Rocket]

Item #5 - Book-to-tax adjustments

It is entirely commonplace for a corporation to have a different taxable income than book income. In fact, this is so commonplace that Schedule M-1 on the corporate return is designed to accommodate this very thing.

So on the face of it, your item is not necessarily wrong, but given the other circumstances you describe, it is doubtful that it is correct.

[Ringers]

Thanks for the input. I had previously told my client about "depreciation allowed or allowable" and the fact that there was unjust enrichment from the accrual vs. non-accrual of the rents. Also, there was no 125 plan in place and the deduction of health premiums was definitely a mistake (as were all the other items) by the prior accountant.

Amending the 1120-S for three years would only rectify part of the problem which extends over 15 years. What would you think the IRS position of correcting 3 of the 15 years of major accounting mistakes would be?

I asked the prior accountant in a certified letter regarding book vs. tax adjustments for 2013 and for explanations of the other incorrect items for the businesses, but I have had no response. If possible I would like him to incur the expense of filing the required forms necessary to put the client into compliance and pay all of the associated penalties prior to my taking over the business filings.

I have been in the tax/accounting business since 1973, but this accounting/tax scenario is one of the worst I have come across. It appears that many of the IRS regs were either purposely or carelessly violated to obtain unjust refunds for the client.

[Golden Rocket]

Perhaps better than we think

What would you think the IRS position of correcting 3 of the 15 years of major accounting mistakes would be?

The IRS position may be less onerous than the enormity of this phony expense might otherwise imply. It is they who established the 3-year statute, and if going back further worked in the taxpayer's benefit there is no question they would stop at three years. It would therefore be my position that only 3 years be amended. In terms of a local CPA "They only get a shot at it for 3 years".

That's not entirely true either. There is no time limit on fraud, but the burden has to be on them to prove fraud, not on the taxpayer, and certainly not YOU.
I do think fraud is probably involved in this phony accrual scheme, but you may not ever know where it came from and certainly don't need to get involved in that.

After filing the amendments, there still exists a liability on the balance sheet of some $120,000. I would write this off as a book-to-tax adjustment. This may or may not raise a flag with the IRS, and if they wish to examine the circumstances, then get ready. But I would let the govt initiate any reason to elongate their statute, and not involve myself with that part of it.

You are obviously familiar with these oddities in your own right, by bringing them forth as an issue. Roland Slugg is one of our more knowledgeable board members, maybe he will add some comments.

[TXEA]

Relative to the rent, the related party rules will disallow the deduction to the company paying the rent. I think the paying entity needs to remove the deduction from the last three open years via amended return. As for the accrual of rent expense ( assuming the accrual was made for tax purposes) remaining on the books, relief from an accrued liability generally is an ascension to wealth and would be an income item (canceled debt). Someone needs to pay the tax. I would not try to wash this through M-1. Either make them pay the liability and the other S-corp pick up the income or get it off the books the same way it was placed on the books (page 1, Form 1120-s).

The depreciation issue has been adequately addressed. Allowed or allowable will require recognition of allowable depreciation at any eventual sale. Need to file Form 3115.

As for the health insurance, the only way to deduct the premiums is to reimburse the shareholders for the premium or for the company to pay the premium directly. Such reimbursement or payment to the shareholders appears in box 1 of Form W-2 and is subject to FITW only (no SS or Med Tax). By the way, this may be changing under the ACA for 2014 under the DOL non-discrimation rules if the S-corp has more than one employee.

It is my understanding that more than 2% shareholders may not participate in a Sec 125 plan under any circumstance. I would be curious if someone has authority stating otherwise.

As for the accountant not responding to your questions, there is no benefit to him/her doing so. In addition, they would need a signed 7216 disclosure document from the officer of the respective S-corps to communicate with you regarding the returns.

[ChEAr$]

This may or may not be OK. If there is a section 125 arrangement with the health insurer and the corporation has not discriminated under the definition of same, it is OK to allow the deduction and not add the premiums to the W-2.

This response is the "short version" on the subject of health insurance premiums.

I'm betting that HI premiums were never added to the W2's.

[Roland Slugg]

If everything you described is true (and I'm not implying it isn't), you seem to have unearthed a rather extreme case of incompetence.

On an overall basis the status quo may not be as bad as it first seems. Yes, Corp #1 deducted more rent that it should have, but offsetting that, at least to some extent, is the fact that Corp #2 failed to deduct depreciation that it could have. Yes, I understand that the shareholders of C1 and C2 aren't exactly the same, so the offsets don't affect the shareholders equally.

It's interesting to consider how the improperly deducted rent will eventually play out. Absent fraud, the excess rent deducted more than three years ago will remain, well, deducted. So what's the journal entry on C1's books to correct that? Assuming that the three open years are corrected ... rent and depreciation both ... the rent accrued more than three years ago would be removed from the books by debiting the liability and crediting ... what? Not income, so it must be retained earnings or some other capital account.

Depreciation should also be corrected going back to the three open years, via an automatic change in accounting method, with no deduction for all the previous years more than three back. This means that if the building is sold before it's fully depreciated, the taxable gain will be higher than the book gain by the never deducted depreciation.

Thus, if the excess rent deducted by C1 amounts to, say, $130,000, and the depreciation NOT deducted by C2 amounts, say, to $125,000, then when all is said and done, the net difference is only $5,000. If and when the building is sold, however, the gain will be based on allowable depreciation, so it will be higher than the book gain and all in one year. But that year may be many years downstream.

I'd like to offer two points related to other things mentioned in the OP:

1. I would not have written to the previous accountant. IMO you should limit your verbal and written communications with your friend/client and, if asked to do so, with his other shareholders.

2. "Do I need to get IRS involved from the start?" I wouldn't. Agree on a plan of action with your client, then, proceed to prepare the amended returns and the change of accounting method. Since both are S Corps, with two or three shareholders each, it would probably be a good idea to request a meeting with all three affected individuals. Review the situation for all of their benefit, then seek unanimous approval to go ahead and prepare the amended returns ... at least for both corps, and perhaps the individuals' personal returns as well.

[Ringers]

Thank you all for the advice.

Thank you all for the comments!! I was on vacation for the last 18 days and have been out of touch. Would you suggest that I have my client ask the original accountant to reimburse him for the costs of amending as well as for penalties and interest that IRS and Illinois will charge? The tax and penalties will be substantial since the rent accrued will be about $70K more that the unclaimed depreciation.

[Burke]

Reimburse cost for amending? Yes. And payment of penalties? Yes. Probably not the interest, which was for the use of the money. That doesn't particularly mean that he will get either.