Its Risky, Doctor, To Take Loans in Lieu of Salary

Over the past few years, I have taken loans routinely from my corporation, rather than a salary. At year end, I convert these loans into taxable salary, through a bookkeeping entry, to eliminate any taxable income to my professional corporation. Through this nifty strategy, I delay the payment of federal and state payroll and income-tax withholdings, so that I make money off of this money, rather than the government. My accountant says that this no longer will fly and wants me to stop it immedia

Dec 1st, 1995

Charles Blair, DDS and

John McGill, MBA, CPA, JD

Question:

Over the past few years, I have taken loans routinely from my corporation, rather than a salary. At year end, I convert these loans into taxable salary, through a bookkeeping entry, to eliminate any taxable income to my professional corporation. Through this nifty strategy, I delay the payment of federal and state payroll and income-tax withholdings, so that I make money off of this money, rather than the government. My accountant says that this no longer will fly and wants me to stop it immediately, or else he no longer will sign the tax returns. Do you agree with him?

Answer:

Yes! Several recent Tax Court cases have looked at the issue of whether withdrawals from a corporation were dividends, rather than loans, at the time that they were made. The courts look at a number of factors to determine whether or not the doctor had an intent to repay the loan at the time that he withdrew the funds from the corporation. If not, the amounts may be taxable income at the time withdrawn as salary (deductible to the corporation) or, worse, dividends (not deductible to the corporation).

In a recent Tax Court case (Epps vs. Commissioner), the court found that withdrawals were dividends, rather than loans, subjecting the business owner to substantial corporate and individual income taxes, as well as interest and penalties. Because the upside potential of this strategy is so limited, and the potential audit consequences are so severe, we do not recommend that the doctor take loans throughout the year in lieu of salary. Rather, we recommend taking a regular monthly salary in order to make for ease in business and personal budgeting.

Question:

A few years ago, I bought a business car personally. Thereafter, I incorporated my practice, but left the car in my personal name. Over the past two years, I have taken depreciation and other deductions for the car through my professional corporation, since my accountant mistakenly understood that the corporation owned the car. When he learned otherwise, he said that these deductions were improper. How can this be so when I`m using the car for business purposes?

Answer:

Your CPA is correct. In a recent Tax Court case, a corporation was denied a depreciation deduction for automobiles, when they could not prove that the corporation actually owned the car involved (Extrusions Division, Inc. vs. Commissioner).

In your particular situation, your best bet is to have the corporation reimburse you for your personally- paid, business-car expenses, which would, thereby, entitle the corporation to a tax deduction.

Question:

I was contacted by a charitable organization that wanted me to donate $500 of dental services to the charity`s auction. I agreed to do so and planned to deduct the $500 as a charitable contribution. However, my accountant says I cannot do this. Is he working for me or the IRS?

Answer:

Your accountant is telling it like it is. While you may deduct the out-of-pocket costs incurred by the practice in providing this service, you are not entitled to deduct the value of your personal services for federal income-tax purposes. Allowing a separate, charitable-contributions deduction would, in effect, give you a double deduction for the expenditures incurred.

Question:

My daughter is planning to attend a small, private college beginning next year. I recently thought of a creative way to deduct the cost of her education that I wanted to share with you. I am planning to write a check for $10,000 a year to the college as a charitable contribution to a scholarship fund, with my daughter designated as the recipient of the scholarship. Rather than paying the tuition and other expenses directly to the college with after-tax dollars, I am able to fully deduct my daughter`s educational cost. Isn`t this great?

Answer:

Not really. The tax law defines a charitable contributions as a payment made to a charitable organization without receiving something in exchange of more than nominal value. Your so-called charitable gift is conditioned upon the funds being used to provide a scholarship for your daughter, which does not qualify as a charitable contribution. In fact, the 1993 Tax Act requires all charitable organizations to provide a written receipt for all gifts in excess of $250. This receipt must state that no goods or services were provided in exchange for this contribution. As a result of this law, the college would be unable to provide you with the receipt for your contribution since, in fact, your daughter was receiving her college education as a condition of the gift. You would not be entitled to a deduction for those payments.

Question:

I have found a "can`t miss" investment in a new oil and gas property. This will require a $100,000 investment on my part, which I plan to borrow. Could I deduct the interest if I borrow this? What about if I use a home-equity line of credit?

Answer:

The interest paid on the $100,000 invested would be deductible as investment interest, even if this is not secured by a mortgage on your home. However, investment interest generally is deductible only to the extent of investment income. Accordingly, if this "can`t miss" investment in oil and gas bombs, as over 90 percent of oil and gas investments historically have done, the investment-interest expense would have to be carried forward from year to year until sufficient investment income is generated to allow deductibility.

However, through securing this loan by a mortgage on your home, the interest can be converted to fully-deductible home-mortgage interest, provided the total loan amount does not exceed the fair- market value of your current principal residence. Thus, the interest on this debt would immediately be deductible, irrespective of the amount of investment income, if any.

Question:

I was contacted by the IRS and notified that I was the subject of an audit. My CPA told me that this probably would be an "economic reality" audit. What does he mean?

Answer:

The IRS generally defines it as the process whereby the IRS agent looks at the taxpayer`s entire return and financial situation, and not just at what appears on the face of the return. Economic reality requires IRS agents to determine whether income has been properly reported. One internal auditing standard requires that agents probe for unreported income. Since IRS internal studies indicated that agents were routinely overlooking the possibility of unreported income, the IRS instituted a training program to remind agents of their obligation to look for this. The term "economic reality" arose from the training given IRS agents to take a more comprehensive look at tax returns.

Dr. Blair is a nationally-known consultant and lecturer. McGill is a tax attorney and MBA. They are the editors of the Blair/McGill Advisory, a monthly newsletter helping dentists to maximize profitability, slash taxes and protect assets. The newsletter ($130 a year) and consulting information are available from Blair/McGill and Company, 4601 CharlottePark Drive, Suite 230, Charlotte, NC 28217, phone (704) 523-5882.

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