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Court Rejects Attempt to Use Dissolved S Corp to Deduct Trust Fund Penalty Taxes

(Parker Tax Publishing February 2017)

The Tax Court held that a married couple that owned an S corporation, which had been administratively dissolved, could not deduct a trust fund liability payment made on behalf of the dissolved corporation. The court found that, while the dissolved corporation filed a return for the year the trust fund liability payment was made and passed through a deduction for the payment to the couple, the corporation did not exist and was not engaged in a trade or business in the year of the payment and, even if it was in existence, no deduction is allowed for trust fund recovery penalties. Brown v. Comm'r, T.C. Memo. 2017-18.


Philip Brown and his wife, Amber, owned 100 percent of Quantum Group Inc. (Quantum Inc.) During tax years 2000 through 2002, Quantum Inc. accumulated unpaid payroll tax liabilities, for which trust fund recovery penalties (TFRPs) were assessed. Quantum Inc. did not file any tax returns from 2003 through 2011 and was administratively dissolved by Arizona in 2007 for failing to file required reports. During 2012, Quantum Inc. was not registered as an active entity with any state; nor did it provide any services during 2012 or generate any income.

Philip also founded Quantum Group, LLC (Quantum LLC). The Browns held 100 percent of the membership interests in that entity until 2012, when the company added two additional members, whereupon the Browns' interests were reduced to 87.5 percent. Both Quantum Inc. and Quantum LLC were S corporations.

In 2012, the Browns owed at least $180,911 in trust fund recovery penalties. On December 31, 2012, Quantum LLC sent $215,000 from its bank account to the trust account of the Brown's attorney. The attorney then sent a certified check in that amount to the IRS along with a letter saying that the amount was to be applied to trust fund taxes for Quantum Inc. and any remaining amount should be applied to accrued interest arising from the nonpayment of the certain trust fund taxes. Quantum Inc. filed a tax return for 2012, indicating that it was a cash basis taxpayer and showing no assets, income, or other tax items, with the exception of a deduction of $180,911 for salaries and wages. Quantum Inc. did not issue a Form W-2 to anyone for 2012. According to the Browns, the deduction for salaries and wages reported on Quantum Inc.'s 2012 return was for salary and wage expenses not deducted by Quantum Inc. for tax years 2000 through 2002. The deduction was passed through to the Browns as an ordinary business loss.

The IRS disallowed Quantum Inc.'s 2012 deduction of $180,911 for salaries and wages and also adjusted the Browns' Schedule E income, disallowing their claimed corresponding loss of $180,911 from Quantum Inc.

IRS's Arguments

According to the IRS, the salaries and wages expense reported by Quantum Inc. was nondeductible because the company did not incur or pay any expenses in 2012 while carrying on a trade or business. Additionally, the IRS asserted that the payment of TFRPs is not deductible by the operation of Code Sec. 162(f), which prevents the deduction of payments of fines or similar penalties made to a government for the violation of any law. The IRS also pointed to several Tax Court cases, including Patton v. Comm'r, 71 T.C. 389 (1978), denying deductions for TFRP payments by reason of Code Sec. 162(f).

Taxpayers' Arguments

The Browns claimed that, while Quantum Inc. did not operate for several years and was dissolved in 2007, it still had liabilities for outstanding employment taxes. They alleged that Quantum Inc. was routinely contacted by the IRS with demands for payment. The Browns contended that they contributed $180,911 to Quantum Inc. which the corporation then used to pay the outstanding payroll tax liabilities. According to the Browns, the payment of the outstanding liabilities was deductible by Quantum Inc. as an amount representing the employees' portion of payroll tax withholding, which is deductible by a corporation as an ordinary and necessary business expense.

The Browns pointed out that Code Sec. 162(a) allows a deduction for "ordinary and necessary" business expenses, which requires that such expenses be "appropriate and helpful" but not necessarily unavoidable, habitual, or common. Accordingly, they argued, reasonable direct compensation to employees, including the payment of their payroll taxes, is deductible. This is so, they said, even in the absence of an underlying legal liability on the employer's part to pay such taxes.

The Browns further contended that Quantum Inc. was carrying on a trade or business because it paid payroll tax expenses related to the previous operations of its business, which should be considered a continuation of the corporation's business activities from previous years. According to the Browns, the act of filing a tax return proved that Quantum Inc. was in fact carrying on a trade or business.

Finally, the Browns argued that the employment taxes ostensibly paid by Quantum Inc. were not TFRPs because Quantum Inc. did not owe any TFRPs. The payment of employment taxes by a corporation, the Browns said, was a deductible expense regardless of the fact that an owner of the corporation may get a secondary benefit from the payment of the taxes.

Tax Court's Decision

The Tax Court held that the Browns were not entitled to deduct the payment of the TFRPs by their dissolved S corporation. In so holding, the court listed several reasons. First, the court said, Quantum Inc. was not engaged in a trade or business in 2012. The court rejected the Browns' argument that by filing a tax return, Quantum Inc. proved it was in a trade or business. Second, the court noted, even if Quantum Inc.'s liabilities arose from the conduct of a prior trade or business, it was not entitled to a deduction for 2012 for salaries and wages because by 2012 it was no longer in existence. Third, even if Quantum Inc. did exist in 2012, it was not entitled to the deduction because it did not actually pay the amount in question. Finally, the court said, even if Quantum Inc. existed in 2012 and paid the amount in question, it would not be entitled to the deduction because the payment was for nondeductible TFRPs assessed against the Browns.

For a discussion of the TFRPs, see Parker Tax ¶210,108.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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