Whether a taxpayer or an S corporation the taxpayer used to own, but which was now owned by an ESOP, actually made charitable contributions was one of the matters at issue in the case of Zavadil v. Commissioner, TC Memo 2013-222. The Tax Court’s decision limiting his deduction to the amounts he had actually repaid the corporation (not ones where his repayment was immediately paid for by a new corporate advance) for deductions made in the year in question was sustained on appeal by the Eighth Circuit (Docket No. 14-1053, 2015 TNT 137-14)
The taxpayer remained as the corporation’s CEO and on its board of directors following his sale of the stock to the ESOP.
Various charitable contributions were paid by the corporation at Mr. Zavadil’s direction and then charged against his open advances account. Mr. Zavadil officially paid off the advances account each month, but often he did so by getting an advance from the corporation in the amount he owed for the previous month and then paying that balance back to the corporation.
Mr. Zavadil claimed the amounts paid to the charities as deductions on his personal returns.
The IRS objected to Mr. Zavadil’s claiming the deductions. First, they argued that the corporation was not acting as Mr. Zavadil’s agent in the same way as corporations had in the cases of Skripak v. Commissioner, 84 T.C. 318, and Weitz v. Commissioner, TC Memo 1989-99 since in those cases the corporation had contributed assets advanced by the taxpayers. The Tax Court did not accept this view in full, noting that the mere fact the corporation advanced the funds was not a problem so long as either Mr. Zavadil actually repaid the corporation or there was a valid debt owed by Mr. Zavadil to the corporation.
The IRS also objected, noting that the use of “circular funding” where Mr. Zavadil repaid his advances by taking an advance meant the actual economic risk was borne by the corporation. The Tax Court agreed in concept here, but did note that Mr. Zavadil had not always taken funds out to repay the balance due—until June of 2005 Mr. Zavadil had, from time to time, brought the balance owed to the corporation to zero. The Tax Court allowed Mr. Zavadil the contributions through that date.
However the Court noted that Mr. Zavadil had circular transactions for each month following that date. The Court concluded that due to the circular nature of the cash flow, the actual economic risk of making the contribution was borne by the corporation. The Tax Court also held that Mr. Zavadil failed to show there was a bona fide debt due from him to the corporation, so the Court denied all deductions from that point forward.
On appeal the taxpayer argued that, despite the fact that he would be immediately advanced the funds at the beginning of the following month to cover his check repaying his balance due, because he was required to eventually reimburse the company for the balance due. He argued the Tax Court’s finding that the amounts did not represent bona fide indebtedness represented clear error that the Court of Appeals should reverse.
The appellate panel disagreed. The panel held:
The court's finding that Zavadil did not incur bona fide indebtedness to American Solutions for ledger balances between July and December 2005 was not clearly erroneous. There was no written agreement between American Solutions and Zavadil that required repayment, no evidence that interest was charged, no sign of collateral to secure payment, and no record of a due date. See RolwingMoxley Co. v. United States, 589 F.2d 353, 355 (8th Cir. 1978) (per curiam); Caligiuri v. Comm'r, 549 F.2d 1155, 1157 (8th Cir. 1977); Rife v. Comm'r, 356 F.2d 883, 888 (5th Cir. 1966). The tax court was not required to credit Zavadil's say-so in the face of conflicting circumstantial evidence. See Blodgett v. Comm'r, 394 F.3d at 1036; Banks v. Comm'r, 322 F.2d 530, 537 (8th Cir. 1963).
That Zavadil repaid all funds in the first half of 2005 did not necessarily show that he was obliged to do so, especially when there was no evidence that he did so in the second half. The court permissibly declined to accept accountant Carlson's testimony, given that the system of advances undermined the claim that Zavadil actually repaid the company in full at the end of every month. The requirement imposed by creditors that the company show a zero ledger balance at the end of each month did not exclude the possibility that American Solutions nonetheless bore the economic burden by reimbursing Zavadil for some or all of his end-of-month payments through advances at the beginning of the next month. And the company's obligation to make installment payments to Zavadil in exchange for his sale of the company does not establish that Zavadil was required to repay the advances. Zavadil points to no evidence that the company deducted the advances from its installment payments on the note, or that the note was designated as collateral for the advances. It was not clear error for the tax court to find Zavadil's evidence wanting.
Clients are at times less than careful in separating personal from business payments, and quite often end up with “ledger accounts” like that for Mr. Zavadil. This case makes clear that this may produce real problems if the clients makes payments out of that account for which the taxpayer wishes to claim a deduction on his/her own personal return.
The fact that the books show a “balance due” will not save the deduction unless the taxpayer can show a true bona fide indebtedness, something that, as the above explanation notes, may be difficult to do if the parties seem fine with solely creating a paper debt but not taking the actions a true creditor would take to insure repayment.
While this would normally not have been a problem if Mr. Zavadil had remained a 100% owner of the corporation, that was no longer the case. As well, if the entity had been a C corporation even being a 100% shareholder would not have helped the owner who had a similar problem.
As well, advisers must be aware that while repaying such advances is very helpful in showing bona fide debts, it is not really helpful if such repayments are accomplished solely by having the entity advance the taxpayer the funds to repay the debt. That is, an exchange of checks that produces no real change in the situation is likely to be ignored by the courts and the IRS.