A recent decision by a federal court in Rhode Island reminds businesses that “once a corporation, always a corporation.” This lesson is just as applicable to San Diego businesses as businesses on the east coast. See Morowitz v. United States, No 1:17-CV-00291 (US Dist. R.I. March 7, 2019).

In that case, the issue involved payment of federal taxes. The taxpayer, David Morowitz, operated his law office as a sole proprietorship for several years. In the normal course of business, he filed personal tax returns and, in general, filed various Schedules C which listed his business expenses. After several years, he decided to incorporate his law firm. In 1999, Morowitz filed articles of incorporation with the Office of the Rhode Island Secretary of State and began operating his law firm as “The Law Office of David Morowitz, Ltd.” This is the same process used here in California. To incorporate, articles are filed and fees paid with the California Secretary of State, as well as other documents being drafted and filed to form a corporation. An experienced San Diego corporate attorney can help with this process.

As is generally done, Morowitz then made the election to have his corporation taxed as an “S” corporation. Making this election avoided double taxation, at least for federal tax purposes. As an “S” corporation, Morowitz then began filing a Form 1120S, which is the IRS tax return form for an “S” corporation which is used to report the income earned and the expenses incurred by the corporation. For 10 years, Morowitz was the only shareholder of his company.

In 2009, Morowitz decided to partner up and brought in a new shareholder. Morowitz amended the name of the pre-existing corporation to “Morowitz & Barry, Ltd.” but did not dissolve the corporation, did not re-incorporate, did not change its corporate structure, and did not change its federal employer identification number. The corporation continued to operate as before under its new name.

As should be done, Morowitz and his new partner negotiated and signed a Shareholders’ Agreement. These types of agreements are essential in small, closely-held corporations. An experienced San Diego corporate lawyer can ensure that the agreement meets the needs of the shareholders and complies with applicable laws. Among other things, the Morowitz-Barry shareholder agreement provided that the company would segregate “[f]ees earned and monies paid on Mr. Morowitz’s pre-existing cases.” According to the agreement, those fees would not belong to the corporation, but would belong to Mr. Morowitz.

In the following tax year, various fees and monies paid were duly segregated and then paid out to Morowitz. Then, as part of his personal income tax return, Morowitz filed a Schedule C with respect to those fees and monies as though Morowitz had returned to being a sole proprietor. Morowitz deducted various business expenses against the earned fees and money paid. The monies claimed by Morowitz were deposited into the corporation’s account and the expenses paid were paid through the corporation’s financial accounts.

The new Schedule C raised “red flags” with the IRS and an audit was initiated. The IRS disallowed all of the claimed expenses and the matter was appealed to the federal court in Rhode Island.

The district court ruled in favor of the IRS. Among the many problems for Morowitz was the fact that, once he incorporated, he was no longer allowed to treat corporate income and expenses as personal income and expenses. In general, unless steps are taken to dissolve a corporation, a business owner cannot go back to operating as a sole proprietorship. That is, once a corporation; always a corporation. Three salient facts torpedoed Morowitz’s arguments to the contrary:

• The clients had signed retainer agreements with the corporation
• As noted, the funds were deposited into, and then paid from, corporation’s account and
• The expenses that were paid — and that Morowitz sought to deduct — were paid for from the corporation’s financial accounts

From these facts, it was “easy” for the court to conclude that the monies were corporate monies and could not be claimed on Morowitz personal tax returns. The District Court affirmed the IRS disallowances and the fees and penalties assessed.

Contact San Diego Corporate Law Today

For more information, contact attorney Michael Leonard of San Diego Corporate Law. Mr. Leonard provides a full panoply of legal services for San Diego and California businesses including corporate entity formation and annual maintenance services. Mr. Leonard can be reached at (858) 483-9200 or via email. Like us on Facebook.

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