Recent Cases Confirm That Bad Tax Planning = Bad Tax Results
Practitioners Publishing Company-February 2004- PPCnet [news@ppcnet.com]
Shareholders of closely held C corporations
commonly lease real estate, equipment, and other
property to the corporate entity either directly or
through a separate partnership, LLC, or S
corporation. (A separate entity is often used to limit
liability or to spread participation in the leasing
activity among multiple investors.) Some of the tax
advantages that can motivate these arrangements
include the following:
1. Avoiding Payroll Taxes. Rental income from
real estate is exempt from the self-employment
(SE) tax. Rental income from personal property
may be exempt from SE tax. Royalties are not
subject to SE tax unless earned in an activity
that is a trade or business.
2. Providing Retirement Cash Flow. Retaining
valuable assets outside a controlled corporation
allows a shareholder-lessor to continue to
receive cash flow from the corporation in the
form of rents or royalties, even though the
shareholder sells or is no longer actively
employed by the corporation.
3. Avoiding Corporate-level Gain. Retaining
ownership of real estate and other tangible or
intangible assets with a high probability of
appreciating in value avoids the potential for
triggering corporate-level gain when those
assets are sold or distributed [IRC Secs.
311(b)(1) and 336(a)].
Recent Farm Corporation Cases
In late 2003, the Tax Court issued four opinions, in
sequence, all addressing the same employee fringe
benefit issues with respect to four family-owned
farm corporations. These four farm corporations all
had essentially the same fact pattern because they
were all designed by an attorney who also served as
their tax preparer, as well as the taxpayers' counsel
in the Tax Court litigation.
As noted in a recent Farm Tax Network article
written by PPC authors Andy Biebl and Bob
Ranweiler, the four corporations received a mixed
result from the Tax Court [Weeldreyer v. Comm.,
TC Memo 2003-324; Schmidt v. Comm., TC Memo
2003-325; Tschetter v. Comm., TC Memo 2003326; and Waterfall Farms, Inc. v. Comm. , TC
Memo 2003-327]. The corporate-provided medical
benefits were allowed as qualified fringe benefits,
but the corporate-provided meal and lodging fringe
benefits were disallowed. Also, the accuracy-related
20% penalty was imposed.
Note: The following discussion is based on Farm
Tax Network 2003-016, titled "Farm Corporation
Fringe Benefit." The Farm Tax Network is an
email/fax network through which Andy and Bob
distribute farm tax information that cannot be
obtained from the major subscription services.
Releases are distributed as developments occur and
as needed. For further information, contact Cathy
Olson by telephone at (507)233-5200 or by email at
colson@bieblcpa.com.
In Andy and Bob's view, the taxpayer losses can be
explained by the poor design of these farm
corporations. This means that the outcome of these
cases should present little problem to the
traditionally operated family farm corporation.
Nevertheless, some important planning points can
be gleaned from these cases.
Design of the Corporations
All four farm corporations were all formed in the
mid-1990s, long after the 1986 enactment of the
Code provisions triggering double taxation (at both
the corporate and shareholder levels) on the
distribution or sale of corporate-owned appreciated
assets. Nevertheless, they all had the same
backward design: Farm real estate was placed
within the corporation, while the active farm
operations were retained personally by the farm
proprietor. Thus, the corporation's business activity
was merely that of a landlord--receiving rent from
the individual proprietor for the use of the corporate
land.
Typical tax planning is done in the opposite
manner--farm real estate is retained personally by
the shareholder(s) to not trap it within the corporate
entity. Only the active operations involving
inventory and some short-term tangible property are
placed within the farm corporation. With the active
farming operations within the corporation, the
owner's employment package of compensation and
fringe benefits are substantive and typically pass
IRS review.
Medical Fringe Benefits
The corporate documents authorized employment
of the owners and provided medical fringe benefits.
The owners typically drew very small salaries
($500–$1,000 per year) but received the corporate-
provided medical insurance and medical reimbursement plan fringe benefits. Because the compensation package was reasonable (i.e., the sum of
direct salary plus the medical fringes did not exceed
the value of the services rendered by the
individual), the court approved the medical benefits
as qualifying fringe benefits (deductible by the
corporation and tax free to the individual).
In the Weeldreyer case, the Tax Court noted that
[the IRS] stipulated that during the years at issue
Mr. Weeldreyer was an employee of Dreyer Farms .
. . . Although Mrs. Weeldreyer did not work for
Dreyer Farms, payment of her medical expenses
was based on her status as Mr. Weeldreyer's spouse.
Likewise, payment of the medical expenses for the
Weeldreyers' children was based on their status as
Mr. Weeldreyer's dependents. The derivative participation of Mr. Weeldreyer's spouse and dependents is
plainly contemplated both by the medical plan and
by section 105(b). On the basis of the record before
us, we conclude that medical payments made for
the benefit of the Weeldreyers and their children
were made under a plan for employees and not for
shareholders. Accordingly, during the years at
issue, the medical payments made by Dreyer Farms
pursuant to its medical plan (the insurance premiums
and other medical care expenditures) are excludable
from the Weeldreyers' gross income under section
105(b).
Corporate-provided Meals and Lodging
Taxpayers in the Weeldreyer case argued that the
corporation provided meals and lodging to Mr.
Weeldreyer in his capacity as an employee for the
convenience of the corporation. Consequently, the
meals and lodging expenses were excludable from
the taxpayers' income under IRC Sec. 119 and were
deductible by the corporation.
However, in view of the landlord status of the
business activity of the corporation, the court had
trouble recognizing the corporate business need for
this fringe benefit. The active farming operations
were outside of the corporation--the corporation
was only conducting a landlord rental activity.
Lacking an active farm business within the corporation,
and in view of the tenant (versus employee) status
of the individuals with respect to the farming
activity, the court quickly concluded that the food
and lodging expenses represented a taxable benefit
rather than a Section 119 tax-free employee fringe
to the owners:
Here, inasmuch as Mr. Weeldreyer farmed the
Weeldreyer farm as a tenant, and not as an employee of
Dreyer Farms, the food and lodging in question
were not furnished to Mr. Weeldreyer as a
corporate employee for the convenience of his
employer. Thus, the food and lodging expenses at
issue are not section 119(a) meals and lodging
expenses.
Andy and Bob note that it is unusual for an active
farm business to lose the Section 119 meal and
lodging fringe benefit issue. Virtually every case
decided in the past has been a pro-taxpayer victory.
However, in this poorly designed situation without
an active farm business in the corporation, the
reason for the loss is readily apparent.
They don't view these cases as presenting precedential problems for the manner in which they
typically use farm corporations--to provide an
employee fringe benefit.
Accuracy-related Penalty
The accuracy-related penalty is rarely imposed on
taxpayers who rely on the advice of tax professionals.
However, as noted earlier, the attorney who litigated
this case was also the attorney who formed these
farm corporations and acted as tax preparer.
The government attempted to disqualify the
attorney from representing the corporations because
of the potential conflict that would arise if reliance
on his advice were used as a defense against the
penalty. In response, the attorney waived that
defense for his clients in a pretrial conference call,
and thus was not able to use the standard defense
against the IRS imposition of the accuracy-related
penalty!
Concluding Thought
In summary, the Tax Court said it well: "Taxpayers
are bound by the form of the transaction they have
chosen." Thus, the best that can be learned from
these cases is the obvious point that when taxpayers
have the misfortune to be put in a badly designed
situation, they often receive a bad outcome from the
IRS.