USA Is this proposed setup tax evasion? Seems fishy to me

Jul 21, 2020
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United States
I'm an attorney setting up my own firm. As part of my practice I will have to advance client costs, often in significant sums. The IRS and numerous tax court cases have made absolutely clear that these advances are NOT expenses in the year that they are made, but rather are considered loans to clients. The effect on income vs. cash in a hyper-simplified example is thus as follows:

Year 1: Income $100,000; Advance: $20,000; Cash balance $80,000; taxable income $100,000.
Year 2: Income $100,000; Advance recovered $20,000; Cash balance $120,000; taxable income $100,000.

Thus, in year 1 I pay taxes on the full $100,000, even though I don't have $20,000 of it. In Year 2, I recover the $20,000 advanced expenses and these are not taxable (because I paid taxes on that amount in Year 1).

Here's the advice that seems fishy to me: I've been told by apparently reputable professionals that if I set my firm up as an S corporation, in Year 2 I can DEDUCT that $20,000 recovered advance from my taxable income as a payroll expense. This would reduce my Year 2 taxable income to $80,000.

I'm neither a tax lawyer nor an accountant, but this looks like tax fraud to me. This scheme would allow me to avoid paying any net taxes on the $20,000 I advanced, simply because I loaned it out and recovered it. So in my example, despite having what should be $200,000 in taxable income over the two year period, because of the advance my taxable income is actually only $180,000.

Is this a legitimate accounting procedure? It is very important to me that I account for everything correctly, and while I don't want to pay more taxes than needed I do want to follow the law and pay what I owe.


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