S corp. expenses not personally deductible by shareholder as a sole proprietor

A district court denies a taxpayer's refund claim.
By Mark Aquilio, CPA, J.D., LL.M.

A district court granted summary judgment denying an attorney's claim for reimbursement of assessed taxes, penalties, and fees because he was not entitled to the disallowed deductions claimed on his individual tax return. It held that there was no clear evidence that he operated his law practice as a sole proprietorship separate from an S corporation that retained cases. Thus, he was not entitled to deduct on his individual return costs related to those cases or bonus payments he made to legal secretaries for work associated with the corporation, the court held.

Facts: In 1999, David Morowitz incorporated his law practice, the Law Office of David Morowitz Ltd., as an S corporation. The corporation reported all its income and expenses as an S corporation through 2009. At that time, Morowitz brought Patrick Barry into the corporation as a new shareholder and changed the corporation's name to Morowitz & Barry Ltd. He did not dissolve the original corporation, amend its corporate structure, or change its federal employer identification number (EIN).

In conjunction with the name change, Morowitz and Barry entered into a shareholder agreement segregating "[f]ees earned and monies paid on Mr. Morowitz's pre-existing cases" that would not belong to Morowitz & Barry. However, funds earned from the preexisting cases flowed through an account of the S corporation. In addition, the preexisting clients had executed retainers solely with the Law Office of David Morowitz and did not sign a new retainer agreement with either Morowitz & Barry or Morowitz individually.

In 2010, Morowitz & Barry operated using the same EIN and filed as an S corporation. However, Morowitz filed a Form 1040, Schedule C, Profit or Loss From Business, claiming deductions as a sole proprietor with regard to costs of preexisting cases paid out of the S corporation's bank account. Also, he claimed a deduction for $15,000 that he personally paid as bonuses to the S corporation's legal secretaries for work performed on a preexisting case. The IRS denied each of the deductions; Morowitz paid the assessment and brought a refund claim in the District Court for the District of Rhode Island. The government filed for summary judgment.

Issues: Morowitz contended the payments he made for the preexisting cases were unrelated to the corporation but were from a separate sole proprietorship and that Morowitz & Barry, while technically not a new entity, reflected his intent to form a new firm.

In Moline Properties, Inc., 319 U.S. 436 (1943), the Supreme Court held that a corporation exists for tax purposes if it is formed for a business purpose or carries on a business activity. The court stated that when a taxpayer chooses the advantages of incorporation to conduct business, it must also accept the tax disadvantages. In National Alfalfa Dehydrating & Milling Co., 417 U.S. 134 (1974), the Supreme Court found that taxpayers are free to organize their business as they choose, but they must accept the tax consequences of their choice, even if not intended, and may not enjoy the benefit of another choice not selected.

Holding: The court granted summary judgment to the government, holding that there was no clear evidence that Morowitz operated a law practice as a sole proprietorship separate from the S corporation. It noted the practice had continued to elect to file as an S corporation after its name change and the addition of a shareholder, and that it continued to operate under the same EIN.

The court further held that Morowitz did not individually pay the costs for the preexisting cases out of the corporation's account, as he did not operate a business separate from the S corporation. Citing the holding in Grothues, T.C. Memo. 2002-287, that a shareholder's payments of a corporation's expenses are a loan or contribution of capital to the corporation, and, if deductible, are deductible by the corporation, as opposed to by the shareholder, the Tax Court held that Morowitz was not entitled to personal deductions for the costs of the preexisting cases retained and expensed through the S corporation.

  • Morowitz, No. 1:17-CV-00291 (D.R.I. 3/7/19)

— By Mark Aquilio, CPA, J.D., LL.M., professor of accounting and taxation, St. John's University, Queens, N.Y.

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