In a recent BLOG on Procedurally Taxing, Leslie Book, Professor of Law at Villanova University of Law describes what happens when an owner of one business paid the expenses of another business he owned.

This is what happened in the consolidated case of Key Carpets v Commissioner. In this case, Ray Johnson conducted his business through two closely held C corporations, Key Carpets and Clean Hands. The IRS examined Key Carpets and Johnson’s individual returns for the years 2007 and 2008. Unfortunately for Johnson, Key Carpets paid expenses that were related to Clean Hands’ business, and as such generated constructive distributions to Johnson which did not give rise to ordinary and necessary expenses under Section 162.

The case, which ended up in U.S. Tax Court, involved employees of Key Carpets who provided services to Clean Hands and were paid by Key Carpets. The IRS (and the Tax Court largely agreeing) determined that the payments were constructive distributions from Key Carpets to the owner which were then determined to be taxable dividends to the owner.

To add insult to injury, the Tax Court slapped substantial understatement penalties on both the corporate and individual underpayments. As the opinion makes clear, form matters, especially when working with closely held corporations and distributions between related parties. There was some planning here that was left on the table that would have mitigated these consequences, but by choosing to run his businesses in this manner Johnson bought himself and his carpet business sizeable tax problems.

Tax advisors and preparers need to be careful with small businesses, especially as shareholders may not necessarily carefully distinguish entities or appreciate that deductibility may be connected to formal ownership of intangible assets.  Payment of certain expenses related to another entity can generate a deemed distribution to shareholders and the loss of a deductible expense for the business.