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13 December 2017

How Not to Reduce Your Taxes (Part 1)

How Not to Reduce Your Taxes (Part 1)

We often advise clients to restructure their business entities and add new ones to help reduce their taxes and other financial liabilities. There’s nothing inherently wrong with the strategy and, in fact, the IRS extends many key opportunities for businesses to do it. However, according to the IRS, there are right and wrong reasons to restructure or start business entities. If the IRS senses your motivation is rooted in deception, be prepared to pay the price.

Business owners are often unaware that incremental changes or growth can mean they’re paying unnecessary taxes. For instance, a retail company that has grown to the point where more of the production process takes place in-house could be recharacterized as a manufacturer, which could lead to better tax breaks. (Find out other good reasons to restructure your business entity here.)

Creating a business entity for the sole purpose of reducing taxes (and not to actually conduct business), however, does not fly with the IRS. A retired executive from Texas recently found this out the hard way. He retired from his company at the time it was sold and took with him patents for a sprinkler head he had recently developed. To reduce tax liabilities from the compensation earned through these events, an attorney advised that he and his wife organize both an S corporation (S corp) and a family limited partnership. Cash and marketable securities (the patents) were transferred to the wholly owned S corp, then transferred to the family limited partnership ($1.8 million in assets total). The S corp was dissolved within the same tax year, generating a tax loss for the couple instead of the capital gain they would have originally faced.

What was overlooked is that the S corp did not exhibit what the U.S. Tax Court calls an “objective economic reality” or “subjectively genuine business purpose” other than tax avoidance. In other words, a business needs to be formed for some real business purpose and not just to avoid taxes. Here are some clues the IRS has cited to support its decision to penalize the couple (the full opinion can be accessed here):

  • The S corp existed for only four months and did not conduct any business activities. It did not have any assets, offices, facilities, employees, or expenses. It did not hold any funds to use for business operations.
  • It held only their personal assets, and they received those assets back in the liquidating distribution of the partnership interest.
  • They had constant control over the assets. While the form of ownership of the cash and securities changed, the substance did not.
  • Evidence showed that the couple understood the S corp was only being formed for tax avoidance. Handwritten notes from their initial meeting with the attorney refer to the S corp as a “vehicle to minimize tax event this year,” and other statements were made referring to the S Corp as an entity that “goes away” and that they “will form a new corp next year.”

Before creating a business entity for tax avoidance, consider the consequences. A temporary entity will raise a red flag, prompting the IRS to ask serious questions about whether the business entity was actually conducting business. For questions, feel free to contact us.

Image Copyright: artshock / 123RF Stock Photo

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