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Stephen G.
Stephen G., Sr Income Tax Expert
Category: Tax
Satisfied Customers: 4011
Experience:  Extensive Experience with Tax, Financial & Estate Issues
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I have a question regarding at risk basis for an S Corp. I

Resolved Question:

I have a question regarding at risk basis for an S Corp. I claimed $215K as a loss on my tax 1040 return via my K-1 from an 1120S Corp that I own. I indicated that my basis for the at risk portion of the loss is based on my Personal Guarantee I issues for the corporation for a Line of credit that was extended beyond the about of the loss ($350K). My accountant agreed and found no issue with this. I received a letter from the State of California FTB stating that the challenge my claim to the loss and cited 2 court cases which they claim indicate that the logic my accountant used and my logic for the loss are not valid. Furthermore they indicated that unless I actually came out of pocket on the PG that my loss is not relevant. the court cases they cited were Raynor v. Comm., 50 TC 762 (1968) and Duke v. Comm., TC Memo 1976-50. If they are right I will have a $40K tax liability. :-(

My question is... are they right? Did my accountant make an error? Can this be fought? If this is not in my favor, do i need to have my tax returns examined again for subsequent years?

Thanks for your help.
Submitted: 3 years ago.
Category: Tax
Expert:  Stephen G. replied 3 years ago.

Stephen E. Grizey :

Hi & thanks for using our service. I'll do my best to give you a complete & accurate answer. Please ask me to clarify anything you don't understand.

Stephen E. Grizey :

I'm afraid the California Franchise Tax Board is correct in so far as the IRS position that they quote.

Stephen E. Grizey :

Here's a link to excerpts from an article that explains the issues & surrounding methods of avoiding the problem.

Stephen E. Grizey :

Obviously the major issue is with the IRS & not the State of California. Adjustments to tax returns by either the State or the IRS flow both ways in that they inform each other of audit adjustments.

Customer:

Hi there. Thanks for taking my question and for the foundation. In an effort to head this off at the pass and avoid a full blown audit, I do have copies of checks that have paid into the corp that far exceed the amount of the loss. Unfortunately, many of the bank accounts are closed. The cost to get certified copies is not cheap. Is the best solution here to just send them copies of checks that were paid into the corp by me?

Customer:

My CPA suggested not sending them any ledgers that might open pandora's box.

Customer:

I see your point here. So the concern is if they rule against me.... then it could open the door for the IRS to come sniffing around.

Stephen E. Grizey :

The chances of prevailing on this issue are not good as if the IRS were to fold on this case, there are tens of thousands of similar cases that would be put in jeopardy.

Stephen E. Grizey :

What are the checks you wrote to the corporation for?

Customer:

Personal investments and loans to the corp to cover corp costs and expenses.

Stephen E. Grizey :

Why would you indicate that your tax basis was based on a personal guarantee if you had cash out-of-pocket invested in the S-Corp?

Customer:

We used scanners back in those days so the actual scanned checks that were deposited are all in hand. I have some of the ones cleared as front and back... I was hopeful to forward copies of all of them for the tax year and prior to the tax year (Total $800K +) to show the investments.

Customer:

My CPA said to do so. :-(

Stephen E. Grizey :

Is the timing an issue? In other words did the money go in after the losses were claimed?

Customer:

It was easier this way to gathering all the details.

Customer:

The money went in before the loss was claimed

Stephen E. Grizey :

How many shareholders are there in the S-Corp?

Customer:

Just the 1. Me.

Customer:

So from 2000 to 2007 over $2 Million was invested. $1.6 million was adjusted out and repaid. It would take quite a lot of expense to third party verify all of that... naturally... a full blown audit. Of the 2 million put in.... $800K was in checks that I have copies of.... some have front and back and others do not.... naturally would need to go to the expense of ordering them all.


 

Customer:

My CPA knew the effort it would take to go through all the $2Mill and said I have more than enough basis with the PG Debt. So just posed that as the reply. Naturally... as I see now... he was wrong.

Customer:

So now comes the clean up. :-(

Stephen E. Grizey :

What doesn't make sense is that the balance sheet submitted with the tax return would reflect the 800K +- as either capital contributions or loans from shareholder, indicating basis far in excess of the loss claimed; I fail to see why your accountant would have you get involved with claiming basis for loan guarantees when you didn't need them to substantiate basis. Were the loans repaid before year end or something?

Stephen E. Grizey :

Reply? So this was questionned & you replied with the guarantee reason?

Customer:

No, the loans were not repaid by then at all. The balance sheet did not show all the loans that were do since i was paying them directly as a PG.

Customer:

The FTB questioned the basis... my CPA sent a reply to them showing the Paid in Capital from the start of the company.... ignored all the payments from 2000 to 2007 and claimed the debts...

Stephen E. Grizey :

You didn't run the money through the S-Corp?

Customer:

I assume because he thought that the debt was more then enough to cover the basis.

Customer:

Run the money through? Meaning deposit it and take it back out? No... not at all.

Stephen E. Grizey :

I'm a little slow...........what exactly did you do?

Customer:

:-) If the corp needed cash to cover bills... I put in $90K..... or $10K or as it was needed. When the corp had cash to reimburse me... it did. When a bill I was on a PG for was due.... I paid it personally.... sometimes I got paid back and sometimes I did not.

Customer:

As a single member S Corp..... things were a bit loose... as you can see.

Stephen E. Grizey :

Did the corporation borrow money from a bank which you personally guaranteed?

Customer:

Yes

Stephen E. Grizey :

So concentrate on that for a minute..............how much of the bank debt did you repay personally without depositing the money in the S-Coop so the S-Corp could pay its' obligation?

Customer:

OK.... The loan was for $350K. All of the money was paid by the S Corp... after i deposited money to the S Corp to cover it's obligations. I do not recall paying any of it directly to the bank.

Stephen E. Grizey :

What year are they questionning?

Customer:

2007

Stephen E. Grizey :

Was the bank loan still outstanding then & that's what you personnaly guaranteed?

Customer:

Yes

Stephen E. Grizey :

So, what you need to prove up is whatever was shown in "Shareholder Loans (from you to S-Corp) + Capital Stock + Paid in Capital less what you previously claimed in S-Corp losses...............as of 12/31/2007.

Customer:

Yes Ok.... so the amount of the loan that I PG'd is not relevant at all. Right? That is out the window?

Stephen E. Grizey :

Out the window, losing battle, too much at stake for the IRS, literally hundreds of millions of dollars in taxes; that's why they litigate; even if they lose in court on something like this, unless they "acqusie", they continue to litigate as most taxpayers settle as the court case is too expensive; when they win, like they have here, there's no way to beat them; they have unlimited resources, so even if you win, you lose............it costs so much..............

Customer:

Good point...... Do you see a problem with the fact that the returns do not show all of the loans on the balance sheet portion of the Tax returns? Not sure why they do not but for some odd reason... they do not....

Customer:

if so..... How do I prove that to them the money invested and owed to me... in an effort to avoid a full blown audit? Naturally they want third party verified... I can see getting copies of the checks that I deposited to the company.... what else can i give them?

Stephen E. Grizey :

Yeah, that's a big problem. Why wouldn't they be on the books? Did you have out-of-pocket expenses that weren't recorded; ie. that would have been booked as expense and credited to your loan account.?

Stephen E. Grizey :

Checks you deposited only show 1/2 of the transaction, if there were repayments; whatever is done needs to agree to the balance sheet.

Customer:

Perhaps..... the accountant who did this was not the best. Thus I changed CPAs in 2009 which was the last year for the business. As I look through the Quickbooks files it is clear that there are Loans that are just not in the returns.

Customer:

Perhaps I should simply have them refiled.... and reviewed by another CPA.

Customer:

But would this raise even more flags?

Customer:

Part of me wants to just call the auditor... tell him the truth... which is "I have a bad CPA" and have then redone... then again... I doubt that is what he wants to hear... I feel it will simply open a door for then to put me through a full audit. :-(

Customer:

Sorry to take up all of your time... any thoughts as to the best course of action from here?

Stephen E. Grizey :

How could you deposit money into the corporation & have it not show up? How long was the company in business? The losses you claimed would have resided in the Accumulated Adjustments Account.............the S-Corp's version of retained earnings (deficit).

Stephen E. Grizey :

Your current CPA is the one who said to get a tax lawyer? He only did the 2009 return?

Stephen E. Grizey :

Has he reviewed the situation & asked questions similar to what I've asked you?

Customer:

Right. The current CPA only did 2009. the last year in business. All the money is there and clear. It all shows up in the books. It all shows in the right area. There are General Journal entries made by the Bookeeper to reclasify some items in 2006 and 2005. The corp was started in 2000.

Customer:

He had but no.... he did not ask the questions you have... which i wish he had.

Customer:

When looking at the Due TO/From Officer account.... there are 16 pages of money in and money out.

Customer:

It appears that there may have been some adjustments that were in the wrong areas for 2007 that removed the money on loan that was due to me. Thus the reason this all comes up... and the issues with the 2007 returns.

Stephen E. Grizey :

When you say "all the money is there and clear".............what do you mean you see it being deposited into the S-Corp's bank account but it doesn't show up as an outstanding loan or in the capital account; obviously is isn't too clear.................

Customer:

Correct. I see it in the books and the bank account....

Stephen E. Grizey :

Well it is difficult to tell exactly what was going on without actually looking at the records but where did it go if it was removed from your due to/from officer account?

Customer:

I have the checks to show it going in.... and see the amounts the corp owes me. there are adjustments in the account that go to other areas in the books that do not make sense. For example..... there is $90K in.... from me.... and $80K out to an expense for automobile. Just as an example.

Customer:

In retrospect.... the $90K was put in in cash... but no cash ever came back to me. It was general journaled out by the bookkeeper.

Customer:

The list goes on.... naturally it is not easy to see all of this and know the details. I suppose my question is..... the business is closed.... but... should I have the books reviewed by a CPA... and refile the 2007 to fix the errors... as there appear to be some.

Customer:

Is that the right solution or will that create more issues.

Customer:

BTW - I never got an 80K automobile :-)

Customer:

Seems I just had the wrong bookkeeper / Accountant.

Stephen E. Grizey :

Well, that goes the wrong way...............ie you put the money in.........debit cash 90k credit due you 90k...............next record your auto expense debit auto expense 80k cerdit due you 80k............so the problem you have is you're not an accountant so you can't pick up on these things & really don't understand what the implications of what you say are..........like that example.........you make it worse............80k in auto expense is never going to be allowed even if you travelled across the country 10 time...........

Customer:

You are 100% correct.

Stephen E. Grizey :

So, the point is, Is it CA that's looking for 40k in taxes & interest & penalties?

Stephen E. Grizey :

If that's the case you'll have 100k + for the iRS................

Customer:

It looks a bit greek to me... and yes.... that is right... they are looking for $38K from CA.... and when the IRS sees it.... that is another issue. :-( If I have the books reviewed by a professional... then maybe they can review it and minimize the problem. We were fully audited by a CPA firm in 2005 so 2000 to 2005 all is well. In 2006 we had a new CPA and bookkeeping team that did not do us justice from 2006 to 2008. Thus the concerns in 2007.

Stephen E. Grizey :

So I'd have the books redone, the tax returns amended & get all the correct figures, particularly if you believe that you can support a basis sufficient to support the deductions you claimed in 2007, 2008 & 2009..................if it costs you 10k to get it done, and you're right...........it will be a lot cheaper than paying taxes, interest & penalties..............

Customer:

I agree.... so the State will not get upset if I refile 07 to 09? Honestly... that is what needs to be done.... but I need to fine a GOOD CPA who can do this the right way.

Customer:

I do not want any more issues. :-( I do not suppose you know anyone who can handle this is California for me?

Stephen E. Grizey :

No, you'll just have to tell the CA auditor that you have reviewed the books & records & they don't properly reflect the business activity, you're not an accountant & you've hired one to straighted out the records & get the correct figures; don't tell him/her this until to engage a CPA...........so you can give the auditor a name............you may need to go to one that has a decent staff because you don't need a CPA for all the accounting work.........and you'll never get a small firm to do it now..........it is the worst possible time; everyone is doing tax returns, tax work, etc., etc. Your existing CPA may be able to recommend someone if he can't take on the project himself............

Stephen E. Grizey :

Where are you in California?

Customer:

Laguna Niguel, CA. (Orange County)

Stephen E. Grizey :

Between San diego & LA?

Customer:

Yes, that is correct.

Stephen E. Grizey :

No. I know a firm in San Francisco. But here's one way to find a competent CPA for a problem like this..............Get ahold of the CA Society of CPAs...............they have an online referral service.............BUT..........instead of using that method..........speak to the Director or a]

Stephen E. Grizey :

or whatever they all him

Stephen E. Grizey :

Find out who the chairman of the Federal Tax Committee is

Stephen E. Grizey :

He'll be a CPA somewhere in CA

Customer:

Stephen.... thanks so much for your help. You have really help guide me and put me in the right direction. That is exactly what I am going to do. I'm going to find a good firm..... engage them.... tell the FTB who they are... and redo the 07 - 09 returns and refile them. It may cost me now to redo books for a business that is over but it may save me in the long run. Thanks so much for your guidance. My only hope is to find a team or someone like you who really knows what they are doing here. Great advise.

Customer:

Thank you so much!!

Stephen E. Grizey :

Call him up & make sure you get through to him..........tell him a CPA from Massachusetts referred you to him for a reference

Customer:

I will... how can I find him?

Stephen E. Grizey :

Give him my name if you want............just say he met you at a seminar he won't know the difference

Customer:

Gotcha

Stephen E. Grizey :

Give him a brief summary...............you got a S-Corfp...........Ca is auditing you..........significant $ to you involved.........tell him I said you need someone familar with C-Corps & has the ability to either redo or supervise someone to redo the books.......ask him for a referral ======go from there............

Customer:

Understood.

Customer:

Thanks so much.

Stephen E. Grizey :

You see what I said about how to find him right?

Customer:

Nothing showed up in the chat window on that

Stephen E. Grizey :

?Please remember to Accept. I'll be here if you need more help. just ask for me "Steve G" ususlly works........

Customer:

except .Get ahold of the CA Society of CPAs...

Stephen E. Grizey :

Good lluck

Customer:

Thanks

Stephen E. Grizey :

Right. Look around the Accept is there somewhere

Stephen G., Sr Income Tax Expert
Category: Tax
Satisfied Customers: 4011
Experience: Extensive Experience with Tax, Financial & Estate Issues
Stephen G. and other Tax Specialists are ready to help you

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