Advance Taxable to Employee in Year Paid, Not in Later Year When Employee Left With an Unpaid Advance Balance

In the case of Starke v. Commissioner, TC Summary Opinion 2015‑40, the IRS discovered that it’s not enough to determine a taxpayer failed to report income—it’s important to also be sure to have the year in which the failure occurred be the one that the agency is attempting to assess tax against.

The case involved a dispute between George Starke and his former employer.  Mr. Starke, a former NFL player, had been raising funds as an employee of the organization in question.  

He had been issued a credit card by the employer for business expenses.  Under the employer’s program, if the employee failed to show charges on the card benefitted the employer, the amount paid was treated as an advance or prepaid expense on the employee’s behalf.  The employer had charged various items to one of these two categories for Mr. Stark between 2003 and 2006.

The company had been deducting amounts from Mr. Starke’s payroll through the end of his employment but Mr. Starke testified he thought they related to taxes or healthcare expenses.  There was never a signed loan agreement between Mr. Starke and the employer.

Mr. Starke left employment in 2010 after becoming aware of an investigation into the organization’s fiscal management, testifying he had ethical concerns about continuing in his position at that time.  The employer issued Mr. Starke a Form 1099-MISC for 2010 in the amount of $83,698.45, amounts shown on the employer’s ledgers as the unpaid balance on the 2003-2006 advances.

The IRS argued, based on the 1099-MISC, that Mr. Starke had income of that amount in 2010 which he failed to report.  And Mr. Starke had not included the amount in his 2010 income so the question became simple—should he have?

And the Tax Court’s answer was no, he shouldn’t have.  The problem is one of timing.  As the Court noted:

Income can include the forgiveness of indebtedness or compensation for services. In some instances, compensation can be advanced with services to be performed later. The distinction is an important one. An advance on services to be performed in the future is taxed at the time of the advance. In contrast, income from the discharge of indebtedness is taxed at the time “it becomes clear that a debt will never have to be paid”.

The key question was whether a debtor-creditor relationship existed between Mr. Starke and the employer or not.  And Court decided that answer was no, it did not.

A transaction is tested for the existence of a debtor-creditor relationship at the date it is entered into.  To have such a relationship there must be an agreement the amount will be repaid.  But, as the Court notes:

…[T]he payments are not loans because we find no evidence that Mr. Starke intended to repay them at the time the payments were made. Although Mr. Starke incurred payroll deductions by Excel, he testified that he did not know why the amounts were being deducted. Further, there is no evidence of loan documents or any other document signed by Mr. Starke and a member of Excel memorializing a loan agreement. Even the 2005 letter from Excel's accountants that set forth a repayment plan makes clear that Excel and its accountants did not consider the payments to be loans, instead characterizing them as advances.

In fact, the IRS had actually been arguing the amounts were advances—so the Court and the IRS agreed there, but the IRS failed to note that their argument pushed the income into the years when the advances were paid (2003-2006) rather than the year they had assessed tax against (2010).

Advisers should note this case because this type of situation arises from time to time in small business.  In reality the employer should have included the amounts in Mr. Starke’s W-2 for the years when the amounts were paid.  Failing to do so will not only expose the employer to a payroll tax liability should the years be examined, but may also cause a loss of deductions in future years when the advance is “paid off” or “charged off” since the amounts should have been reported in an earlier year.