A recent decision by the Tax Court should serve as a warning to people that own multiple businesses but don’t always “respect the corporate formalities” associated with each business entity. If you own more than one business and sometimes have Company A pay the expenses of Company B, or perhaps task an employee of Company A to do things for Company B, you’re headed for trouble unless your bookkeeping and accounting staff are on top of their game. Read the consolidated case of Key Carpets, Inc. v. Commissioner and Johnson v. Commissioner , decided on 2/25/16. You can also read an excellent write-up of the case by the guys at Procedurally Taxing .
But to save you some time, here’s the moral of the story: Company A must pay its own business expenses in order to take a deduction. If Company A pays one of Company B’s expenses, several things happen and none of them good:
(1) Company A does not get a deduction for the expense, increasing its net profit, thus increasing its federal income tax (if a C corporation) or the owner’s income tax (if a S corporation);
(2) Company B does not get a deduction for the expense because Company B didn’t pay the expense . . . Company A did; and
(3) Owner of Company A is charged with a constructive dividend, which is nondeductible to Company A and taxable to the owner. The transaction is deemed to occur as though Company A distributed the money to Owner, then Owner paid the expense for Company B.
We have seen people get slapped for this many times. To a layperson, the result seems ridiculous and unfair — they will say “but I paid the expense!” However, it is very important to consider who “I” is. The IRS would agree if “I” means the business owner. In the Service’s view, Company A paid a dividend to Owner, and Owner paid the expense, which means Company A isn’t entitled to a deduction for the expense or the dividend, and Owner had additional dividend income he/she didn’t pick up on their individual return. But often the business owner is conflating the term “I” to include herself, and one or more of her businesses! Remember, having a business is like having another child. You would not raid that child’s savings account, investment account, or 529 plan in order to pay your own expenses, right? You cannot do the same thing with your businesses. If Company B is short of funds, you have several options:
(1) have Company A make a loan to Company B, properly documented with a promissory note providing for a commercial rate of interest, then cause Company B to repay that Note in accordance with its terms;
(2) have Company A distribute money to Owner, either as a dividend but preferably as a bonus or salary for which Company A would receive a deduction, then Owner can loan the funds to Company B, again properly documented with a Note and repaid by Company B; or
(3) have Company B approach a commercial lending institution and borrow the funds from a third party, dealing at arm’s length.
These options are more difficult than just having Company A write a check to Company B’s creditor, but if the IRS gets involved, any of these approaches will save you time, taxes, and trouble in the long run. If you read the case above carefully, you’ll have noted that these companies got in trouble by commingling not just funds, but the labor of an employee. An employee of Company A was tasked with doing work for Company B. If you do this, the employee must be hired by BOTH companies and his or her time carefully tracked by the payroll systems for each company. Failure to do so may mean the loss of a substantial deduction by the company that pays him, and an unhappy surprise for the owner.