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Have Funds to Cover Your Check

Published on: 11:09AM Sep 12, 2014

The US Tax Court released a case yesterday that Joe Kristan from the Tax Update Blog did a great job of recapping so I will not go into too much detail since he covers the facts.

However, the key point from this case is as follows:

  • If you issue a bonus check at year-end that the corporation does not have enough funds to cover and the IRS audits the return, the whole face value of the bonus may be disallowed and we now have a Tax Court case reaching that conclusion. In the case, the corporation had about $815,000 of taxable income before the bonus and issued a $815,000 bonus to its 100% shareholder to get income down to zero. The bank account had substantial funds in the account (almost $300,000) but the corporation did not have sufficient funds to clear the net $460,000 check to the owner/officer. Instead of disallowing the portion in excess of the funds in the account, the Tax Court denied the whole bonus.
  • The Tax Court touched briefly on whether the bonus to the owner was "reasonable" compensation, but did not fully address it since they disallowed the whole bonus based on the facts shown above. Even though this is a personal service corporation and the assumption is that these corporations can bonus out all income of the corporation; I am not sure if the court agrees with this conclusion or not, but based upon my reading between the lines of the case, I am not quite sure they do.

Many farmers write checks at year-end and may not have sufficient funds in the account to fully cover the check. This case now gives the IRS additional ammunition to go after those farm businesses and not only disallowed the amount of the deduction that is not covered by funds in the account, but if the check is large enough, may in fact, disallowed the full face value of the check. Here is an example:

Suppose a farmer issues a check to the local coop for $325,000 for prepaying farm expenses at year-end. The bank account had $320,000 in the account when the farmer wrote the check and by the time the coop received the check, the farmer had deposited another $25,000 to cover the check. The IRS audits the return and instead of disallowing $5,000 (the amount that was not covered by funds in the bank), it disallows the full $325,000 check. Based on this court case, the IRS will most likely win their argument.

Therefore, use care at year-end to make sure you have sufficient funds to cover any checks you might mail out.

Cite: Vanney Associates, Inc., T.C. Memo 2014-184.