Lack of Paperwork Nails Taxpayer in IRS Audit

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This week we’re focusing on the steps you need to take with your business to protect your assets. When you think about asset protection, you probably first think about protecting your business, your home, your savings account and other things you own against other people’s bad intentions.

There is one more aspect to protecting your assets. You must also protect against excess tax.

Tax is a drag on your wealth-building system.

The more tax you pay, the less money you have to invest, re-invest and grow your business and investments. It’s not just about having more money so you can take a fabulous vacation, tax saving strategies are critical to protecting your business.

In this case, the taxpayer had a C Corporation. That meant that the corporation paid tax at its own level. There was no ‘flow through’ aspect to the income or expenses like you would have with an S Corporation or partnership return.
Because there is no flow through, one of the big questions that C Corporation shareholders often run into is: How do I get money out of my C Corporation?

The three most common ways to take money out of your C Corporation:

  • Best: Tax-free benefits. Make sure you’re got the right plans and that you’re meeting the IRS non-discriminatory rules.
  • Good: Salary. You have to take a salary in order to take advantage of the C Corporation’s enhanced benefit program available. But as your income rises, you may find that you’re simply using the C Corporation to push money to your personal rate anyway because you are starting to grow income inside your corporation.
  • Worst: Personal Loans. There is one big issue with personally borrowing money from your C Corporation. The IRS is going to try to make an argument for constructive dividends. If they prove that the loans were constructive dividends, then the C Corporation won’t get a deduction for the amount PLUS you pay tax on the money received. Under current law, dividend income was taxed at a lower rate so the hit wasn’t as bad. But with the expiring dividend tax rate, and the higher taxes, look for even more scrutiny here. The IRS WANTS to prove that payments you receive really should have been dividends.

Here’s where it went wrong…

In the case of the taxpayer, his C Corporation was selected for audit. At the first “let’s just get to know each other” interview with his auditor, the taxpayer told his friendly auditor that he didn’t have a written note and repayment schedule for the loans on the book.

Guess what. Constructive dividends.

The IRS is training their auditors right now to disarm you in the first interview. Be very careful what you tell them and never ever volunteer more information then they ask. In this case, the taxpayer thought he was just being honest and that it would help in the long run.

It cost him thousands in the long run.

But the real morale of the story is that you must have good paperwork if you take loans from your C Corporation. And even with the paperwork, expect the IRS to challenge the viability of your tax position. They want those to be dividends.
A much better answer is to have a comprehensive tax strategy that includes how you will take money out of your C Corporation.

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