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Wisconsin Tax Appeals Commission
STATE OF WISCONSIN
TAX APPEALS COMMISSION
WAYNE D. RODEN & SUZANNE BALISTRERI,
Petitioners, vs. WISCONSIN DEPARTMENT OF REVENUE, Respondent. | DOCKET NO. 05-I-157
DECISION AND ORDER |
THOMAS J. MCADAMS, COMMISSIONER:
This matter comes before the Commission on a stipulation of facts, with supporting exhibits numbered 1 through 26, filed by the parties on January 7, 2008 (the "Stipulation"). Petitioners appear by Attorney Grant R. Niehus, Law Offices of Grant R. Niehus, Ltd., P.C. Respondent, the Wisconsin Department of Revenue (the "Department"), appears by Attorney Sheree Robertson. As stipulated by the parties, the only issue before the Commission concerns the substantiation of Subchapter S corporation flow-through losses that Petitioners claimed on their Wisconsin income tax returns for the tax years 1999 through 2002, inclusive (the "years at issue").(1)
Having considered the entire record before it, the Commission finds, concludes, rules, decides and orders as follows:
FINDINGS OF FACT(2)
A. JURISDICTIONAL FACTS
1. Under the date of December 13, 2004, Respondent issued a Notice of Amount Due resulting from an assessment of additional income tax against Petitioners with adjustments being made to their reported income for the tax years 1999, 2000, 2001 and 2002 (the "assessment"). (Exhibit 1).(3)
2. On or about February 16, 2005, Petitioner Wayne Roden filed on behalf of Petitioners an objection to the assessment, with a copy of a Power of Attorney attached, which Respondent considered their Petition for Redetermination, and was received by Respondent on or about February 16, 2005. (Exhibit 2).
3. Under the date of August 8, 2005, by its Notice of Action letter, Respondent denied Petitioners' Petition for Redetermination. (Exhibit 3).
4. On or about September 23, 2005, Grant R. Niehus, Petitioners' attorney, filed on their behalf a Petition for Review with the Commission. In their Petition for Review, Petitioners disagreed with two adjustments reflected in the assessment: (1) the disallowance of Golf Fitness, Inc.'s losses due to basis limitation; and (2) the determination that they underreported $100,441 of pass-through income from Balistreri & Associates Physical Therapy, Inc. on their 2002 Wisconsin individual income tax return. In their Petition for Review, Petitioners conceded certain adjustments related to life insurance premiums. (Exhibit 4).
5. During the September 25, 2007 telephone pretrial conference, Petitioners' attorney, Grant Niehus, informed Commissioner Diane E. Norman that Petitioners also conceded that they underreported their 2002 income by $100,441, which he attributed to a mathematical error. During the telephone pretrial conference, Attorney Niehus informed Commissioner Norman that there was only one issue before the Commission, which concerned the deductibility of the losses for Golf Fitness, Inc. that Petitioners claimed on their 1999 through 2002 Wisconsin individual income tax returns.
B. EVIDENTIARY FACTS
6. Petitioners are full-time residents of the State of Wisconsin and were full-time residents during the tax years 1999 through 2002.
7. Petitioners filed joint Wisconsin individual income tax returns for tax years 1999 through 2002. (Exhibits 19, 20, 21 and 22).
8. Petitioner Suzanne M. Balistreri is a physical therapist and Petitioner Wayne D. Roden is a physician.
9. Golf Fitness, Inc. ("Golf Fitness") is a Wisconsin corporation incorporated on July 25, 1997 in the State of Wisconsin. Golf Fitness is treated as a Wisconsin S Corporation under the Internal Revenue Code of 1986, as amended ("IRC"), and Wisconsin income tax laws.
10. Golf Fitness is a separate and distinct corporate entity.
11. Golf Fitness did business in the State of Wisconsin in the years 1999, 2000, 2001 and 2002 and continues to do business in Wisconsin. Golf Fitness operated three businesses at various times during its existence, which included body balance for golfers, acceleration programs for athletes that focused on strength and flexibility, and a health club.
12. Golf Fitness filed 1999 through 2002 Wisconsin Tax Option S Corporation Franchise or Income Tax Returns, which have not been amended. (Exhibits 13, 14, 15 and 16).
13. Petitioner Suzanne M. Balistreri owns 50% of stock in Golf Fitness and Petitioner Wayne D. Roden owns the remaining 50% of stock in Golf Fitness.
14. Golf Fitness reported on Line 22 of federal Schedule L, which is attached to its 1999 and 2000 Wisconsin Tax-Option S Corporation Franchise or Income Tax returns, capital stock in the amount of $1,000. (Exhibits 13 and 14).
15. Golf Fitness reported losses on its 1999 through 2002 Wisconsin Tax-Option S Corporation Franchise or Income Tax Returns. On Line 1 of Golf Fitness' 1999 Wisconsin Schedule 5K, attached to its 1999 Wisconsin Tax-Option S Corporation Franchise or Income Tax Return, Golf Fitness reported $146,073 as an ordinary loss. The 1999 Tax-Option S Corporation Shareholder's Share of Income, Deductions, etc., Wisconsin Schedule 5K-1 for Petitioner Suzanne M. Balistreri reported her share of the ordinary loss as $73,351. The 1999 Tax-Option S Corporation Shareholder's Share of Income, Deductions, etc., Wisconsin Schedule 5K-1 for Petitioner Wayne D. Roden reported his share of the ordinary loss as $73,351. On federal Schedule E attached to their 1999 Wisconsin individual income tax return, Petitioners each reported $73,351 as "[n]on passive loss from Schedule K-1" for Golf Fitness.
16. On Line 1 of its 2000 Wisconsin Schedule 5K attached to its 2000 Wisconsin Tax-Option S Corporation Franchise or Income Tax Return, Golf Fitness reported $76,539 as an ordinary loss. Golf Fitness' 2000 Tax-Option S Corporation Shareholder's Share of Income, Deductions, etc., Wisconsin Schedule 5K-1 for Petitioner Suzanne M. Balistreri reported her share of the ordinary loss as $38,270. Golf Fitness' 2000 Tax-Option S Corporation Shareholder's Share of Income, Deductions, etc., Wisconsin Schedule 5K-1 for Petitioner Wayne D. Roden shows his share of the ordinary loss as $38,270. On federal Schedule E attached to their 2000 Wisconsin individual income tax return, Petitioners reported $39,959 and $38,270, respectively, as nonpassive losses from Schedule K-1 for Golf Fitness.
17. On Line 1 of its 2001 Wisconsin Schedule 5K attached to its 2001 Wisconsin Tax-Option S Corporation Franchise or Income Tax Return, Golf Fitness reported $124,219 as an ordinary loss. The Wisconsin Schedule 5K-1 identifying Petitioner Suzanne M. Balistreri as a shareholder, a copy of which is attached to Golf Fitness' 2001 Wisconsin return, shows her share of the ordinary loss as $62,110. The 2001 Wisconsin Schedule 5K-1 identifying Petitioner Wayne D. Roden as a shareholder shows his share of the ordinary loss as $62,109. On federal Schedule E attached to Petitioners' 2001 Wisconsin individual income tax return, they reported $62,109 and $62,110, respectively, as nonpassive losses from Schedule K-1 for Golf Fitness.
18. Golf Fitness reported an ordinary loss of $54,871 on Line 1 of its 2002 Wisconsin Schedule 5K attached to its 2002 Wisconsin Tax-Option S Corporation Franchise or Income Tax Return. On Golf Fitness' 2002 federal Schedule K-1 identifying Petitioner Suzanne M. Balistreri as a shareholder, her share of the loss is $27,436. Petitioner Wayne D. Roden's share of the loss is $27,435. On the 2002 federal Schedule E attached to their 2002 Wisconsin individual income tax return, Petitioners reported $36,815 and $27,435, respectively, as nonpassive losses from Schedule K-1 for Golf Fitness.
19. Balistreri & Associates Physical Therapy, Inc. (a/k/a and herein, "BAPT") is a Wisconsin corporation incorporated on April 19, 1991 in the State of Wisconsin. BAPT is treated as a Wisconsin S Corporation under the IRC and Wisconsin income tax laws.
20. BAPT did business in the state of Wisconsin in the years 1999, 2000, 2001 and 2002 and continues to do business in Wisconsin. Its address during the years at issue was in Kenosha, Wisconsin.
21. BAPT offers physical therapy services to its clients. Petitioner Suzanne M. Balistreri was employed by BAPT in 1999, 2000, 2001 and 2002 and received salaries in the amounts of $72,084, $74,007, $74,035 and $74,720, respectively. Petitioner Suzanne M. Balistreri owned the building that BAPT rented during the years at issue and it paid to her the following rent: $43,200 in 1999, $43,200 in 2000; $43,200 in 2001; and $43,200 in 2002.
22. Petitioner Suzanne M. Balistreri owns 100% of the stock in BAPT.
23. BAPT is a separate and distinct corporate entity.
24. BAPT filed 1999 through 2002 Wisconsin Tax-Option S Corporation Franchise or Income Tax Returns, which have not been amended. (Exhibits 7, 8, 9 and 10).
25. On the 1999 through 2001 federal Schedule M-2 attached to its Wisconsin Tax-Option S Corporation Franchise or Income Tax Returns for those years, BAPT reported $0 distribution. On the Schedule 5M attached to its 2002 Wisconsin Tax-Option S Corporation Franchise or Income Tax Return, BAPT reported a $244,700 distribution to Petitioner Suzanne M. Balistreri.
26. On its 2002 federal Form 1120S, Schedule L, which is attached to its 2002 Wisconsin return, BAPT reported $697,801 as an ending balance for "[o]ther current assets." According to Statement 4 attached to the 2002 return, other current assets consist of a note receivable from Golf Fitness for that amount.
27. On Golf Fitness' 2002 federal Form 1120S, Schedule L, which is attached to its 2002 Wisconsin Tax-Option S Corporation Franchise or Income Tax Return, Golf Fitness reported $626,670 as an ending balance for "[o]ther current liabilities." According to Statement 3 attached to the 2002 return, other current liabilities consist of a note payable to "BAPT" in the amount of $626,355.
28. On BAPT's 2003 federal Form 1120S, Section L, which is attached to its 2002 Wisconsin return, BAPT reported an ending balance for "[o]ther current assets" in the amount of $707,406. According to Statement 3 attached to the 2003 return, other current assets consist of the Golf Fitness note receivable in the amount of $707,406. (Exhibit 11). The other current assets reported as $759,015 on BAPT's 2004 federal Form 1120S, Schedule L, consist of the Golf Fitness note receivable in the amount of $759,015. (Exhibit 12).
29. On Golf Fitness' 2003 federal Form 1120S, Schedule L, Golf Fitness reported $707,406 as the ending balance for other current liabilities. And, according to Statement 4 attached to the 2003 return, the ending balance of $707,406 is the note payable to "BAPT". (Exhibit 17). For the tax year 2004, Golf Fitness reported on federal Form 1120S, Schedule L, the ending balance for other current liabilities as the $759,015 note payable to BAPT, as shown on Statement 3. (Exhibit 18).
30. In a letter to Petitioners dated September 23, 2004, Alan Rickey, an Auditor for Respondent, wrote to them regarding the pass-through losses for Golf Fitness, which they claimed on their 1999 through 2002 Wisconsin individual income tax returns. (Exhibit 5).
31. In a letter to Petitioners' attorney, Grant Niehus, dated June 16, 2005, Shirley Henika, a Resolution Officer for Respondent, requested that Petitioners' basis in Golf Fitness be substantiated. (Exhibit 6).
32. Petitioners' representative submitted to Ms. Henika, for her review, bank statements showing checks written on BAPT's checking accounts with M & I Bank of Kenosha and deposited in two of Golf Fitness' checking accounts with the M & I Bank of Kenosha for the following amounts: $133,277 for the year 1999; $80,373 for the year 2000; $110,722 for the year 2001; and $55,045 for the year 2002 for a total of $379,417.
Ms. Henika reviewed the bank statements and concluded that they do not show that Petitioners either loaned money to Golf Fitness or invested money in Golf Fitness. She also concluded that the bank statements do not substantiate Petitioners' basis in Golf Fitness. Ms. Henika also concluded that it was unclear if the salary paid to Petitioner Suzanne M. Balistreri in 1999 through 2002 and the rent that BAPT paid in 1999 through 2002 is included in the transactions reflected in the bank statements. (Exhibits 23 through 26).
FEDERAL STATUTES AND CASES
Wisconsin's income tax law generally follows federal law, including applicable S corporation law. IRC Subchapter S states that a small business may elect to have its profits and losses allocated pro-rata to its shareholders, who then report the profits and losses on their individual income tax returns. IRC § 1366(a). Corporations making elections under this sub-chapter function as "pass-through" entities for tax reporting purposes. A shareholder, however, may deduct his or her share of the S corporation losses only to the extent of his or her adjusted basis in the stock of the S corporation and the shareholder's adjusted basis of any indebtedness of the S corporation to the shareholder. IRC § 1366(1)(a) and (b). In brief, this limitation prevents a shareholder from deducting more than he or she has invested in the S corporation. S. Rep. No. 85-1983 (1958). Losses that cannot be deducted in a particular year may be carried over indefinitely. IRC § 1366(c). Basis in an S corporation may be acquired either by contributing capital or by directly lending funds to the company. IRC § 1366.
Case law has set forth several principles relating to the basis limitation of IRC § 1366(d)(1)(B) and the situations in which a shareholder can acquire basis with regard to indebtedness. First, the shareholder of the S corporation must make an actual economic outlay. Grojean v. Commissioner, T.C. Memo 1999-425, aff'd, 248 F.3d 572 (7th Cir. 2001). The economic outlay must leave the taxpayer "poorer in a material sense" in order for it to be respected. Bergman v. United States, 174 F.3d 928, 933 (8th Cir. 1999). Second, the S corporation's indebtedness must run directly to the shareholder, and an indebtedness to another pass-through entity that advanced the funds and is closely related to the taxpayer does not satisfy this requirement under IRC § 1366. Burnstein v. Commissioner, T.C. Memo 1984-74.
Basis-generating debt of the S corporation to the shareholder generally arises when a shareholder makes a loan to his or her S corporation. The fact that a shareholder funded the loan to the S corporation with money borrowed from a third party lender does not change the tax consequences. Hitchins v. Commissioner, 103 T.C. 711. (U.S. Tax Ct. 1994). Where the source of the funds is a related party, however, courts have often found that the shareholder made no economic outlay sufficient to generate basis as the necessity of repayment of the funds is uncertain. Underwood v. Commissioner, 535 F.2d 309 (5th Cir. 1976).
Case law has placed a heavy burden on shareholders who seek to rearrange the indebtedness of related closely-held S corporations. Bhatia v. Commissioner, 72 T.C. Memo 1996-429. The existence of a close relationship between the parties to the transaction "is not necessarily fatal if other elements are present which clearly establish the bona fides of the transactions and their economic impact." Id. As a general rule, a transaction must have a purpose or a utility beyond creating a tax deduction for it to have that tax effect. Gregory v. Helvering, 293 U.S. 465, 469-70 (1935). Tax minimization is not an improper management goal, but transactions may be disregarded if they are not what they are claimed to be. Haberman Farms, Inc. v. United States, 305 F.2d 787, 791 (8th Cir. 1962).
In this case, the Petitioners argue that the Commission should look to the substance of the transactions and not the pure form, perhaps conceding that the form of these transactions was not technically sufficient to increase the Petitioners' basis. (Petitioners' Brief, p. 4.) The Petitioners discuss at length both Culnen v. Commissioner, T.C. Memo 2001-280, revd. on another issue, 28 Fed. Appx. 116 (3d Cir. 2002), and Yates v. Commissioner, T.C. Memo 2001-280, apparently relying sub silentio on the "incorporated pocketbook" exception those two cases set forth.
The "incorporated pocketbook" exception generally holds that an S corporation acts as an agent of the shareholder by making payments on the shareholders behalf, thus allowing the taxpayer to increase his or her basis even though the funds advanced came from a related corporate entity and not from the taxpayer directly. The U.S. Tax Court established the exception in Culnen and Yates. Prior to Culnen and Yates, taxpayers' efforts to build basis in a fashion similar to what the Petitioners attempted here almost always were ineffectual. See, e.g., Golden v. Commissioner, 61 T.C. 343; Prashker v. Commissioner, 59 T.C. 172; Perry v. Commissioner, 54 T.C. 1293; Drobny v. Commissioner, 86 T.C. 1326; Karme v. Commissioner, 73 T.C. 1163. In the Commission's view, the "incorporated pocketbook" exception represents a narrow and fact-specific exception to well-settled law. Given the importance of these two cases to Petitioners' arguments, it will be necessary to examine both cases at some length as well as a case subsequent to the Culnen and Yates decisions where an "incorporated pocketbook" was claimed, but ultimately denied.
A. The Culnen case
In the Culnen case, the court decided that one of the taxpayer's controlled corporations functioned as his de facto agent. The taxpayer was the sole shareholder of a profitable insurance business operated as a C corporation. The taxpayer then started another business in the restaurant field, making the election to operate it as an S corporation. The S corporation lost money and eventually filed for bankruptcy. To fund the loss S corporation, the taxpayer had his profitable C corporation lend more than $4 million to the S corporation. While these were direct transfers from the C corporation to the S corporation, the books of both corporations treated the advances as first a loan from the C corporation to the taxpayer, who then made a loan to the S corporation. In total, over one million dollars of losses of the S corporation passed through as deductions on the personal returns of the taxpayer. Using tax basis from his purported loans to the S corporation, the taxpayer deducted all of the losses. The IRS, however, refused to allow the deductions, arguing that the taxpayer had no tax basis in the loss S corporation as he did not make any of the loans to the S corporation personally.
The Tax Court rejected the IRS's arguments and allowed the deductions. The Petitioner called four witnesses, including several of his accountants, whose uncontradicted testimony was that the profitable corporation had for more than 20 years made payments on behalf of the taxpayer, who was the only shareholder of the corporation. As noted in this case by the Department, some of the factual basis the Tax Court used in Culnen to make its finding was stipulated to by the IRS. In fact, the taxpayer produced substantial documentation that the profitable corporation had made payments of more than $6 million on behalf of the taxpayer, including the $4 million of direct transfers to the S corporation business. In total, there were 88 separate transactions at issue in the case. Based on the specific facts before it, the Tax Court found that the direct advances could be treated, in substance, as a loan from the C corporation to the shareholder, followed by a loan from the shareholder to the S corporation. The corporate accounts reflected the reality of the transactions, and thus the shareholder built tax basis through the loan arrangements.
B. The Yates Case
On similar facts, the Tax Court in Yates also held that the taxpayer acquired basis in his S corporation. In that case, the taxpayer was the only shareholder of two S corporations. The profitable corporation ("AD") was a mining business and the loss S corporation ("FT") was a farming business that had large losses. In the periods at issue, the taxpayer had written checks totaling more than $4 million on AD's account, spending the money on personal expenses not related to the two S corporations. There were 409 payments made directly by the Petitioners and 113 made on their behalf by the accountant. Above and beyond these payments, AD made direct transfers of more than $4.3 million to FT to cover its losses. Despite the direct transfers from AD to FT, the payments were recorded on the books of the two corporations as first a loan from AD to the owner, followed by a loan from the shareholder to FT. From the shareholder's viewpoint, tax basis in FT was established by the note payable from FT to the shareholder. The taxpayer then deducted substantial losses from FT on his personal return. The IRS, however, argued that because the loans were direct advances from AD to FT, the form of the transaction should dictate the tax consequences. In their view, because the taxpayer did not make the payments directly to FT, he should not acquire tax basis in FT. The transaction's form was a loan from AD to FT, and that is how the IRS argued it should be treated for tax purposes.
Relying on Culnen, the U.S. Tax Court allowed the taxpayer the loss deductions, looking to the true substance of the transactions. Based on the evidence, the court accepted the contention of the taxpayer that AD was his "incorporated pocketbook." The court cited the long pattern of the taxpayer using the funds of AD for personal expenses. The direct advances from AD to FT were nothing more than an extension of his "incorporated pocketbook," with AD performing as an agent for the shareholder lending money to FT. The corporate books reflected the economic substance of all of the transactions, which included a note payable from FT to the taxpayer as shareholder of FT. Thus, tax basis was acquired and the shareholder was permitted to deduct FT's losses. While Culnen and Yates provide an opening for the taxpayer who seeks to build basis, a subsequent case would show just how narrow and fact-specific that opening is.
C. The Ruckriegel Case
In Ruckriegel v. Commissioner, T.C. Memo 2006-78, two brothers were each 50% shareholders of an S corporation. Also, they were equal partners in a separate partnership. The S corporation had had substantial losses of $6 million since its founding. In order to acquire tax basis in the S corporation, the two brothers had the partnership borrow more than $4 million from banks and then transfer those funds directly to the S corporation. All of the loans were guaranteed by the two taxpayers, the partnership, and the S corporation. The taxpayers used all $4 million for tax basis in the S corporation for deducting losses from the S corporation. They argued that the direct advances from the partnership to the S corporation were evidence of tax basis.
The I.R.S. denied the loss deductions, finding that the direct transfers were debts of the S corporation to the partnership, and therefore no tax basis in the S corporation should be allowed to the taxpayers. The U.S. Tax Court found for the I.R.S., denying any tax basis to the shareholders for the $4 million, and thus disallowing the deductions on their personal income tax returns. The court noted that because the taxpayers were the sole shareholders of both entities, they had a heavy burden to prove that the substance of the transactions should be given a tax result different than the form.
The court also rejected the taxpayers' invitation to use the "incorporated pocketbook" exception and find that the partnership was acting as the taxpayers' agent in making the direct advances of $4 million to the S corporation. Distinguishing Yates and Culnen, the court said that the term "incorporated pocketbook" describes a situation where a company has made significant personal expenditures on behalf of the owner to third parties over an extended period of time. The existence of an "incorporated pocketbook" is a question of fact to be determined in each individual case. The term "incorporated pocketbook" describes a set of facts, not a legal conclusion. In the Ruckriegel court's view, it is not a term of art. Although there were 86 checks written over 5 years, the court said that the facts in this case clearly showed that an "incorporated pocketbook" did not exist. Although there were some payments by the partnership for personal expenses of the taxpayers, the amounts involved did not rise to the level of an "incorporated pocketbook." Instead, the court decided that the payments by the partnership should be treated as constructive dividends of the partnership profits to the taxpayers and not payments made in an agency relationship on behalf of the taxpayers.
DECISION
Assessments made by the Department are presumed to be correct, and the burden is upon the Petitioners to prove by clear and satisfactory evidence in what respects the Department erred in its determination. Edwin J. Puissant, Jr. v. Dep't of Revenue, Wis. Tax Rptr. (CCH) 202-401 (WTAC 1984); Wis. Stat. § 77.59(1). Statutes that grant exemptions from tax, tax credits or tax refunds are matters of legislative grace, and a taxpayer claiming an exemption must establish that the property or transaction at issue is clearly within its terms, with all doubts being resolved in favor of taxability. Dep't of Revenue v. Johnson Welding & Manufacturing Co., Inc., 238 Wis. 2d 243, 250, 617 N.W.2d 193 (Ct. App. 2000).
Relying on the principles of law discussed above, the Petitioners' proof fails in several respects. First, pursuant to Grojean, the Petitioners did not make an actual economic outlay by transferring funds from the profitable S corporation (BAPT) to the loss S corporation (Golf Fitness) to pay the loss corporation's payroll and tax obligations. On this point, the Petitioners have not demonstrated that they are "poorer in a material sense" because of the alleged economic outlay. In essence, the taxpayers merely moved money from one S corporation to another, a move which may have been convenient and practical for the taxpayers, but which was ineffective at building their basis in the loss corporation. As we view the matter, the transactions at issue in this case amount to little more than the posting of offsetting book entries, accompanied by the drafting of notes that may never be paid. In pure, pragmatic terms the payments at issue here left the petitioners economically unimpaired, both actually and constructively. The tax benefits of creating indebtedness may be set aside if the taxpayers' economic situation has not actually changed. See, e.g., Drobny v. Commissioner, 86 T.C. 1326. In this case, there was no actual economic outlay because no "new" funds were advanced. Bergman, 174 F.3d at 933.
Second, while the Petitioners in their brief have encouraged the Commission to look to the economic outlay of the group, the law is clear that but for the existence of an "incorporated pocketbook," an S corporation's indebtedness to another closely-held pass-through entity that advanced the funds does not satisfy IRC § 1366.(4) While it may have been possible for the Petitioners to structure these transactions so that they acquired tax basis, the taxpayers must generally accept the consequences of their choices and cannot recast transactions in order to obtain tax advantages. Simply put, the indebtedness here does not run directly to the shareholder as required by Burnstein. As discussed above, the "incorporated pocketbook" exception is quite narrow, and this case is more like Ruckriegel in terms of time and quantity than Culnen and Yates. The success or failure of the "incorporated pocketbook" exception depends upon the facts of each individual case. The I.R.S. (and presumably the Department) has not accepted the "incorporated pocketbook" exception, so it is up to the taxpayer in any given case to convince the courts of its merit. As one commentator recently observed, this is not a theory that taxpayers and their counsel should "hang their hat on" while setting up proper funding of an S corporation.(5) Other commentators have noted that a troublesome consequence of the "incorporated pocketbook" exception is that a court essentially rewards conduct generally regarded by taxing authorities as anathema: the payment of personal expenses with corporate funds through a corporate account.(6)
Third, the Petitioners have not demonstrated the necessity of repayment of the funds advanced to Golf Fitness, despite the existence of a note between the two related S corporations. Indeed, the stipulation of facts and exhibits that is the evidentiary record in this case does not establish the terms of the note and whether or not a payment was ever made on the note. Had there been an unrelated third party interposed to enforce the debt, the result here may have been different. The presence of a third-party lender as a source of funds lent by the shareholder to the S corporation has been an important factor in determining whether the shareholder made an actual economic outlay. The certainty that an unrelated, arm's-length lender will enforce repayment from the shareholder supports the conclusion that the shareholder has made an economic outlay in connection with lending funds to an S corporation. Bergman, 174 F.3d at 934. Finally, relying on Culnen and Yates as they must, the Petitioners have not demonstrated that the comparatively fewer and smaller payments of business expenses at issue here ($379,417 between 1999 and 2002) constitute the existence of an "incorporated pocketbook" such that they may deduct the flow-through losses in question.
ORDER
The Department's action on the Petitioners' petition for redetermination is affirmed.
Dated at Madison, Wisconsin, this 26th day of January, 2009.
WISCONSIN TAX APPEALS COMMISSION
David C. Swanson, Chairperson
Roger W. Le Grand, Commissioner
Thomas J. McAdams, Commissioner
ATTACHMENT: "NOTICE OF APPEAL INFORMATION"
1 The Petitioners previously conceded the remaining adjustments to their income tax returns for the tax years 1999 through 2002.
2 The Commission's Findings of Fact consist of ¶¶ 1 through 32 of the Stipulation, with certain non-substantive revisions made for form and consistency.
3 "Exhibit" and "Exhibits" refer to Respondent's Exhibits 1-26 filed with the Commission on September 24, 2007 and incorporated into the Stipulation pursuant to its terms.
4 Petitioners' brief does not explicitly argue that BAPT was an incorporated pocketbook for the Petitioners. The facts in this case, thus, are in contrast to those in Yates, where there was uncontradicted testimony from the accountant that there was a long history of the profitable corporation paying personal expenses for the taxpayer.
5 The S Corporation and Real Estate Ventures, 36 Real Est. L.J. 49
6 Robert J. Haft and Peter M. Fass, 4B Tax-Advantaged Securities § 22:55 (October, 2008).