Scott R. Frick, CPA P.C.

From the “Don’t Try This at Home” File

Real Life Horror Story: Unintended Incorporation Had to Be Respected for Tax Purposes

Background

A recent Tax Court decision concluded that the wife of a deceased Michigan business owner owed $15,120 in federal income tax deficiencies and penalties for 2008 and 2009 after her late husband failed to correct the unintended registration of the family business as a corporation (Rochlani).  Sole proprietorship status was intended. Here are the details of the real-life tax horror story.

Facts of the Case

The married joint-filing taxpayers in this case, Manjit and Bony Rochlani, owned a Michigan ticket sales company called Ultimate Presales. Mr. Rochlani started the business in 2006 and was the proprietor. The business, Ultimate Presales, involved buying and reselling tickets to sporting events, concerts, and other events.

Without permission from his parents and while still a minor, one of the taxpayers’ sons incorporated Ultimate Presales in Michigan in July 2006, using an online legal service. The son was blissfully unaware of the tax differences between a sole proprietorship and a corporation. When the corporate paperwork from the state arrived in the mail, Mr. Rochlani asked his son if he had incorporated the business (he had), but Mr. Rochlani did nothing to unwind the incorporation. In fact, Mr. Rochlani filed annual corporate reports for Ultimate Presales.

The taxpayers and their sons traveled to various locations within the metropolitan Detroit area and around the country to buy and resell tickets. Mr. Rochlani also worked full-time as an engineer for Ford Motor Co.
The Rochlanis used their personal credit cards to pay for expenditures related to the business because Ultimate Presales did not have its own credit card. All income from the business was deposited into the Rochlanis’ personal bank accounts. (According to Mrs. Rochlani, Ultimate Presales at one time had its own bank account, but she closed it because it was never used.)

For 2008 and 2009 (the tax years in question), Mr. Rochlani prepared and filed Forms 1040. The returns reported Schedules C losses from Ultimate Presales of $41,610 for 2008 and $44,066 for 2009. Mr. Rochlani did not keep any logs or calendars for travel-related expenses or other expenses. He retained credit card statements that he later used to reconstruct expenses incurred for Ultimate Presales.  In 2010, the IRS issued the taxpayers a notice of deficiency for 2008 and 2009. The notice reflected the disallowance of the taxpayers’ Schedule C losses on the grounds that Ultimate Presales was a separate incorporated taxpayer. The unhappy taxpayers took their case to the Tax Court, but Mr. Rochlani passed away before they got there.

What the Tax Court Concluded

The Tax Court correctly determined that the main issue in this case was whether Ultimate Presales was a C corporation for federal income tax purposes or a sole proprietorship. (A secondary issue was whether the taxpayers had adequately substantiated all of the claimed deductions for Ultimate Presales.)

While the evidence clearly showed that the taxpayers’ son was not authorized or instructed by Mr. Rochlani to register Ultimate Presales as a corporation, Mr. Rochlani did nothing to undo his son’s act after it was discovered. Mr. Rochlani then compounded his mistake by filing annual corporate reports with the state of Michigan, which effectively recognized and ratified the incorporation. As a result, the taxpayers were not eligible to deduct losses from Ultimate Presales on their personal federal income tax returns.

The Tax Court further noted that to be recognized as a separate taxable entity, a corporation need not keep account books or records, maintain separate bank accounts or credit cards, or own any assets. And when the corporate form is adopted, taxpayers are not permitted to claim individual deductions for the payment of corporate expenses. A taxpayer’s choice to adopt the corporate form requires the acceptance of its tax disadvantages. Courts have held that the corporate form may be disregarded where it is a sham or unreal, but the Tax Court did not feel that was the situation in this case.

Finally, the Tax Court concluded that the IRS was justified in imposing the 20% Section 6662(a) accuracy-related penalty if the government could show that disallowing the taxpayers’ Schedule C losses resulted in substantial understatements of federal income tax (as defined by IRC Sec. 6662) for the two years in question. Bottom line: total defeat for the taxpayers. Ugh!

Moral of the Story

Clients often fail to understand that when it comes to taxes, dry paperwork usually prevails over good intentions. For this reason, you should always request that small business clients turn over copies of any and all records pertaining to their businesses. If the unwanted incorporation in Rochlani had been discovered by a tax professional before filing any federal returns that included Ultimate Presales income and deductions and before filing any annual corporate reports with the state, the whole problem could have been corrected with no tax damage done.
References:
IRC Sec. 6662.
Rochlani, Manjit, et ux, TC Memo 2015-174 (Tax Ct. 2015).

–Courtesy of ThomsonReuters