Business Owner’s New House Not Deductible as CGS or Executive Compensation

Business Owner’s New House Not Deductible as CGS or Executive Compensation

Schank v. Comm’r of Internal Rev., T.C. Memo. 2015-235 (2015)

Terry and Paula Schank were the owners of TMS&P Holdings, LLC, a Nebraska limited liability company that elected partnership treatment for tax purposes; and Twin City Roofing and Sheet Metal, Inc., a closely held C corporation, in which Terry Schank was employed full time as its president and CEO. TMS&P owned properties that were leased by Twin City, which was operated as a commercial and residential roofing contractor. Mr. Schank had final decision-making authority over all business matters, including compensation and tax return preparation. At trial he testified that he was a perfectionist who found it hard to delegate, so he performed the work of 3 to 4 individuals. Prior to 2011, Twin City had never paid a dividend to shareholders, who included Terry Schank (85%), his wife Paula (5%) and two daughters (5% each).

Twin City’s revenue spiked after a May 2010 hailstorm that caused widespread damage to roofs, windows, and exteriors in Nebraska. In the following year (2011), Mr. Schank’s base salary was increased to $129,100 (from $39,900) and he received a bonus of $75,000. Additionally Twin City paid in 2011 for materials and labor worth $328,000+, to construct a new residence, barn, and boat house on land owned by the Schanks. These expenses were coded on the books of Twin City as cost of goods sold, and Twin City did not report the expenditures as compensation on the Schanks’ W-2s or pay payroll taxes.
The Schanks admitted that the construction costs should have been reported as compensation.

The barn that was constructed by Twin City was used, in part, for business purposes. Mr. Schank maintained an office there, stored company vehicles in the garage, and once held a company picnic on the grounds. There was no lease between the Schanks and Twin City.

In 2011, Twin City paid credit card bills worth $26,000+ on behalf of the Schanks, which was recorded as cost of goods sold. Twin City also purchased the Spyder, a three-wheeled motorcycle, which was titled in the name of Mr. Schank. Depreciation was deducted on Twin City’s tax return. Mr. Schank testified that he used the vehicle to travel between worksites, but did not produce mileage logs or other evidence.

TMS&P modified its lease to Twin City in 2011, providing for a lump sum prepayment of rent. The payment was deducted on Twin City’s return but was not reported by TMS&P or the Schanks as income on their returns.

The in-house bookkeeper testified that she understood the difference between personal and business expenses, but did not code the credit card payments and house construction expenses as personal because she was not instructed to do so. She did not prepare the company’s tax returns but submitted information to the accountant who did. The accounting firm worked under the terms of an engagement letter stating that the firm would not audit the company’s data or engage in fraud detection. The CPA testified that he was not aware of Mr. Schank’s new residence. Mr. Schank signed the 2011 corporate tax return containing the errors. An H&R Block franchise prepared the personal returns for the Schanks and the partnership return for TMS&P. The H&R Block agent walked the Schanks through their proprietary software to gather information for their return, and knew that they were selling their home, but he did not know they had constructed a new residence; and they did not discuss the modification of the lease.

Twin City and the Schanks were audited for 2011, with the IRS contesting Twin City’s costs of good sold (which included residence construction costs); Twin City’s credit card expenses; and Twin City’s deprecation (the Spyder motorcycle); as well as the Schanks’ failure to report these items as income. At trial, the Schanks conceded that the credit card expenses were misreported, but claimed that the residence and motorcycle were capital assets of the company.

The Tax Court held, to no one’s surprise, that the residence, barn and motorcycle were not primarily business assets. The Schanks argued that the costs of constructing their residence and acquiring the motorcycle should be deducted from business income, nevertheless, as compensation of the company’s officers under IRC 162. IRC 162 authorizes a business to deduct reasonable compensation paid to employees in exchange for their labor and services. Specifically, the Schanks argued that they had been underpaid in prior years and were entitled to compensation for the past labor and services.

Examining the company’s history, the Tax Court found that there were no corporate resolutions or other evidence that Twin City intended to “run a tab” on the Schanks’ compensation. The Tax Court also noted that the company did not pay payroll taxes; and Mr. Schank did not report the benefits that he received in 2011 as compensation on his personal tax return. Having chosen to structure the payments as he did, the Court held, Mr. Schank must accept the tax consequences. The Tax Court sided with the IRS’s position that the benefits were constructive dividends to the Schanks, and thus taxable initially at the corporate level, and also at the personal level.

In addition to the corporate tax assessed against Twin City, and the personal income tax assessed against the Schanks, and interest, the Tax Court imposed an accuracy-related penalty under IRC 6662(a). The Court rejected the Schanks’ argument that they had relied on their tax preparers, as they did not provide adequate information and did not seek advice on the specific issues giving rise to liability.