How to Get Trapped with Someone Else’s Problems

I had a client recently buy a corporation containing an operating business, against my advice.
Once I got to look at the corporate records, I noted a number of problems that could cost my client a lot of money.

Let’s start with the understanding that, in order to deduct any business expense from income, it must be BOTH ordinary and NECESSARY.

So, the very first thing I ran into is that there is no corporate action to declare the stock of the corporation Sub-Chapter S stock, even though the Seller claimed to have been filing Sub-S for many years. NOTIFICATION of corporate action declaring the stock Sub-S stock is done on Form 2553 and the IRS does not ask for the minutes of the corporate action. However, in an audit, they will certainly look.

The problem, of course, comes when the auditor figures out that there is a problem and that he now has the power to demand anything he wants to ask, because all he has to do is declare the Sub-S election invalid (or, worse, fraudulent), all the way back to the mid-1980’s, which, then, makes all those profits that dropped to the bottom line of the corporation and were distributed to shareholders on K-1s taxable to the corporation-at least, the last ten years’ of them.

The next problem was that whatever attorney worked on the sale “forgot” that the corporation must approve such a sale. No such approval was ever executed.

Then there was the problem of the note. A former shareholder/owner had lent the corporation about $80,000. There were no loan documents in the corporate records and no record of a payoff in the financial books of the corporation. Thus, it is very possible that the corporation still owes the guy $80,000, plus interest.

Further IRS problems popped up when I noticed that the corporation had purchased an $85,000 car when it only had one office. That looks like an unnecessary expenditure and an extraction of an otherwise taxable dividend generating profit. It’s also a tax mistake, since the depreciation on that vehicle in the year purchased (100%) could have been better used by the stockholder.

That same year, the corporation hired a vice president. She was paid a lump sum of $63,000. She had no employment agreement, which would have explained her duties and responsibilities. She never came to the office and did nothing identifiable for the corporation. Oh, yes, she was also the sole shareholder’s wife. Red flags all over.

Since my client now owns the corporation that would have to pay any taxes, judgements, fines, penalties or interest, his production capacity would have to carry that load. And those expenses are NOT deductible.

Remember, if you are selling a corporation, sell stock. If you are buying, buy assets.

Categories: Estate Planning

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Before opening the doors of Wade Law, San Diego attorney Jessica Wade spent almost ten years as a corporate attorney at two large, prominent law firms in Los Angeles and Silicon Valley. Her work centered on tackling complex transactional matters and… Read More
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Jay W. Henderson began practicing law in California in 1971. Now Of Counsel to Wade Law, Jay led our predecessor firm, Jay W. Henderson, Ltd., for over 40 years. Jay attended Church College of Hawaii, Laie, Hawaii from 1959 to 1961, where he studied… Read More
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