Family Businesses Should Take These Steps to Survive IRS Scrutiny

The American dream for many is to start a business, create a legacy, and pass it on to their children. But all too quickly, that dream can become a nightmare for families blindsided by obscure tax issues.

An IRS examination can be an all-consuming distraction at its best and a world-destroyer at its worst. By understanding and avoiding common pitfalls, family businesses can ensure their legacy lives on.

Often, IRS agents expect family businesses to operate with the same formalities of a Fortune 500 company. That misconception, along with inadequate recordkeeping, leads to confusion about “ordinary and necessary” expenses and heightened expense substantiation issues. It also leads to questions about reasonable executive compensation, constructive dividends, and personal holding company tax pitfalls—to name a few.

Here’s a rundown of the most common problems and how to navigate them.

Ordinary and Necessary

Section 162 of the tax code permits deductions of ordinary and necessary business expenses. Whether an expense constitutes an ordinary cost of a business turns on the time, place and circumstance of the expense, under Commissioner v. Tellier.

“Necessary” means expenses that are “appropriate and helpful,” under Welch v. Helvering. The IRS raises Section 162 where expenses have no connection to the business operation, lack documented substantiation, or appear excessive to the agent.

The IRS uses Section 162 to challenge corporate-owned private aircraft, employee vehicles, rent paid by a corporation to a shareholder, and payments between related entities. Travel expenses require an additional level of substantiation under Section 274(d). Taxpayers must document the amount of each expense, dates and duration of travel, destination, and business purpose.

While most receipts establish the first three elements, most taxpayers struggle establishing business purpose. A lack of detailed contemporaneous notes as to the reason for each expense is often the culprit. It is important for businesses to establish procedures for documenting the business purpose of each expense.

Reasonable Compensation

Section 162 also affects employee compensation. In a family business, executives and family members are often shareholders or board members. These closely held companies make compensation decisions without independent oversight, and those decisions are subject to increased scrutiny.

The IRS often challenges the reasonableness of compensation. Reasonable to the IRS doesn’t mirror reasonable to the entrepreneur. The courts often look to the “independent shareholder” test from Exacto Spring Corp. v. Commissioner, which asks whether an independent shareholder would be satisfied with the return on equity through growth/appreciation of the business.

Depending on the circumstances, there can be an incentive to overpay or underpay an executive to take advantage of deductible compensation or capital gains rates on dividends. There also can be a temptation to provide compensation to a spouse, child, or other family member. It is important for companies to make rational compensation decisions and document those reasons.

Constructive Dividends

A dividend is a distribution by a corporation to its shareholders, which can take the form of property or money. Constructive dividends arise when corporate activities benefit shareholders through use of corporate assets, payment of personal expenses, below-market services, etc. In family businesses, the lines between corporation and family are often blurred. Often, the IRS raises attacks on closely held corporations that act as pocketbooks for the shareholders.

The determinative issue is whether the primary beneficiary of the expense is the business or the shareholder. It is important for business owners to document the reason for an expense and to establish arm’s-length methods for dealing with family members. Best practices involve drawing a line between the business and the individual to ensure accurate accounting of expenses and compensation.

Personal Holding Company Tax

Section 541 imposes a 20% tax on undistributed income of personal holding companies. A personal holding company means a corporation with no more than five owners holding at least 50% ownership, and at least 60% adjusted gross income from personal holding company income.

Under Section 543(a), personal holding company income means income from dividends, interest, royalties and annuities, adjusted income from rents; mineral, oil, and gas royalties; copyright royalties; produced film rents; use of corporate property by a shareholder; personal service contracts; and estates and trusts.

The tax was instituted to prevent what Congress perceived as a measure of tax avoidance: the incorporated pocketbook. Today, lower corporate rates and higher individual income tax rates may give in to increased enforcement for family businesses retaining funds for increased capital.

Limitations on Losses

Closely held family corporations are also subjected to loss recognition limits for passive activity losses under Section 469(a)(2)(B) and Section 465 at risk limitations. Closely held family corporations must be aware of whether their activities meet the definition of a passive activity under Section 469, including rental activities.

Family corporations involved in holding, producing, or distribution of motion pictures; farming; leasing of Section 1345 property; or exploration and exploitation of oil and gas resources and/or geothermal deposits can’t deduct losses that exceed their amount at risk—the amount of money invested and borrowed.

What to Do

Family businesses should consult experienced advisers to develop sustainable recordkeeping and conduct thorough audits of their expenses. It is important for the business to be aware of its tax obligations and adequately document expenses and other business decisions. It may often be difficult to separate business from family, but for companies that want to survive IRS scrutiny, running the business like a business remains an essential first step.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jasen D. Hanson is a shareholder in the tax controversy and litigation group of Chamberlain Hrdlicka in Atlanta. He represents individuals and business entities before the IRS and Department of Justice’s Tax Division.