You Can’t Deduct a Check That You Know Will Bounce!
A recent decision of the U.S. Tax Court has concluded that a corporation could not deduct the owner’s bonus as the company didn’t have enough money in the bank to cover the check.
Vanney Associates, Inc. v. Commissioner ,T.C. Memo 20014-184 (Sept. 11, 2014) involved the 2008 year-end bonus paid to Robert Vanney by his wholly owned architecture firm/corporation. Mr. Vanney’s wife, a CPA with an inactive license, kept the company’s books and prepared its payroll checks. At the end of each year she determined the company’s net income and wrote a check to her husband for this amount. The Vanneys claimed their intention was not to “zero out” the tax liability of the corporation but only to pay out the remaining profit (that seems a distinction without a difference to this author). As usual, at the end of 2008 Mrs. Vanney issued her husband a bonus check in the amount of $815,000 and actually paid the applicable withholding and payroll taxes. Mr. Vanney then promptly endorsed the check back over to the company and never attempted to cash it. This was booked by Mrs. Vanney as payment of compensation, then a loan from Mr. Vanney back to the company. This odd occurrence, an employee not cashing his or her paycheck but instead loaning it back to the employer, can be explained by the fact that there wasn’t enough money in the corporate account to cover it. Mr. Vanney testified he “believed” he knew this, and his wife also testified that while they could have obtained a loan, they decided not to in order to avoid the expenses that would result. Of course the 2008 return was selected for audit and the deduction for Mr. Vanney’s bonus was disallowed.
The decision of the Tax Court was straight forward – since there wasn’t enough money in the account to cover the check then it could not have been paid and no deduction is allowed. The court noted that “[i]ncome tax deductions are a matter of legislative grace…” and that the Code allows a deduction for expenses paid or incurred during the taxable year. Where payment occurs by check any deduction is dependent on subsequent proper payment, though when the check is honored it relates back to the date the check was given. Here the check was never honored and wasn’t even presented for payment. Additionally, because this involved related entities (a corporation and its sole shareholder) the transaction was subject to special scrutiny and the economic reality would prevail over form. No deduction is allowed for payments which are “wholly circular.” The court concluded the Vanneys knew or should have known there was not enough money to cover the check, and the only option to make use of the payment was to lend it back to the company. Since Mr. Vanney couldn’t really cash the check and use the money no deduction was permitted.
The truth is that the outcome here could have easily been avoided. The Tax Court itself referenced how the Vanneys could have made this work – simply borrow the money and actually cash the check. It seems they got too cute by half in trying to avoid the cost of the third-party loan. The difference between the bank balance and the check amount on the date it was written (12/31/2008) was only about $70,000. Compare the costs for a $70,000 bank loan to $277,100, the approximate federal tax the corporation would owe on the disallowed $815,000. In retrospect they obviously made a bad choice. Here’s how the Vanneys should have structured this to produce the result they wanted:
· Corporation determines its net income and resulting bonus amount to Mr. Vanney;
· Mrs. Vanney determines cash deficiency. Corporation borrows sufficient funds and deposits same into corporate account;
· Corporation writes the check, makes the withholding and tax deposits, and delivers the check to Mr. Vanney;
· Mr. Vanney actually deposits the check into his account;
· The next day Mr. Vanney loans enough money to the corporation to allow it to repay the 3rd party loan.
So remember, economic substance matters in tax planning, especially when dealing with related parties. It’s not always good to be super-efficient, net everything out and just book or document intermediate steps. You need to actually complete the transactions the books reflect.
Of course – the real moral to this story is to avoid operating your business as a C corporation in the first place, but that’s a topic for another day.
Robert S. Jones