Less-Than-10% Shareholders Responsible For Corporate Income Tax

I have a question for you:  if you and I work for a company and it goes bankrupt, might we have to pay back some of the money we were paid?

The answer – presumptively – is no, as long as we were employees and received payment as fair compensation for our services.

Let’s stir the pot a bit, though, and say that you and I are shareholders – albeit (very) minority shareholders. What if there were bonuses? What if we received dividends on our stock?

Let’s talk about Florida Engineered Construction Products Corp (FECP), also known as Cast Crete Corporation.

FECP had the luck of being a concrete company in Florida in the aughts when the housing market there was booming. FECP had four shareholders, but the two largest (John Stanton and Ralph Hughes) together owned over 90 percent. The balance was owned by William Kardash, who was an engineer, and Charles Robb, who headed sales.

FECP made madman-level money, although they reported no profits to the IRS.

CLUE: If one is thinking of scamming the IRS, one may want to leave a few dollars in the till. It does not take a fraud auditor to wonder how a company with revenues over $100 million uniformly fails to report a profit – any profit – year after year.

The numbers are impressive.  For example, FECP paid Messrs. Hughes and Stanton interest of the following amounts:

                                          Hughes                      Stanton

            2005                    $5,147,000              $4,250,000

            2006                    12,914,000             12,101,000

            2007                      6,468,000               9,046,000

FECP also paid hefty dividends, paying over $41 million from 2005 through 2007.

I am thinking this was a better investment than Apple stock when Steve Jobs came back.

What was their secret?

It started off by being in the right place at the right time. And then fraud. FECP had a loan with a bank, and the bank required an annual audit. FECP made big money quickly enough, however, that it repaid the bank.  Rest assured there were no further audits.

Mr. Stanton opened a bank account in FECP’s name. Problem is that the account did not appear on the company’s books. When the accountants asked what to do with the cash transfers, he told them to “mind their own business.” The accountants, having no recourse, booked them as loans. Eventually they just wrote the amounts off as an operating expense.

COMMENT:  Here is inside baseball: if you have questions about someone’s accounting, pay attention to the turnover in their accounting department, especially the higher-level personnel. If there is a different person every time you look, you may want to go skeptical.

Those massive interest payments to Messrs. Stanton and Hughes? There were no loans. That’s right: neither guy had loaned money to FECP.  I cannot help but wonder how the loans got on the books in the first place, but we are back to my COMMENT above.

Mind you, our two minority shareholders – Kardash and Robb – were making a couple of bucks also. They had nice salaries and bonuses, and they received a share of those dividends.

Proceed into the mid-aughts and there was a reversal in business fortune. The company was not doing so well. They cut back on the bonuses. The two principal owners however wanted to retain Kardash and Robb, so they decided to “loan” them money – to be paid out of future profits, of course. There were no loan papers signed, no interest was required, and Kardash and Robb were told they were not expected to ever “pay it back.” Other than that it was a routine loan.

Do you wonder where all this money was coming from?

FECP filed fraudulent tax returns for 2003 and 2004, reporting losses to Uncle Sam.

Ouch.

FECP tightened up its game in 2005, 2006 and 2007: they did not file tax returns at all.

Well, if you are going to commit tax fraud ….

But the IRS noticed.

After the mandatory audit, FECP owed the IRS more than $120 million. FECP agreed to pay back $70,000 per month. While impressive, it would still take a century-and-a-half to pay back the IRS.

Mr. Stanton went to jail. Mr. Hughes passed away. And the IRS wanted money from the two minority shareholders – Kardash and Robb. Not all of it, of course not. That would be draconian. The IRS only wanted $5 million or so from them.

There is no indication that Kardash and Robb knew what the other two shareholders were up to, but now they had to reach into their own wallets and give money back to the IRS.

On to Tax Court.  

And we are introduced to Code section 6901, which allows the IRS to assess taxes in the case of “transferee liability.”

NOTE: BTW if you wondered the difference between a tax attorney and a tax CPA, this Code section is an excellent example. We long ago left the land of accounting.

There is a hurdle, though: the IRS had to show fraud to get to transferee liability.

It is going to be challenging to show that Kardash and Robb knew what Stanton and Hughes were doing. They cashed the checks of course, but we would all do the same.

But the IRS could argue constructive fraud. In this context it meant that Kardash and Robb took from a bankrupt company without giving equal value in return.

The IRS argued that those “loans” were fraudulent, because they were, you know, “loans” and not “salary.” However the IRS had come in earlier and required both Kardash and Robb to report the loans as taxable income on their personal tax returns. Me thinketh the IRS was talking out of both sides of its mouth on this matter.

The Court decided that the “loans” were “compensation,” fair value was exchanged and Kardash and Robb did not have to repay any of it.

That left the dividends (only Stanton and Hughes had loans). Problem: almost by definition there is no “exchange” of fair value when it comes to dividends. FECP was not paying an employee, contractor or vendor. It was returning money to an owner, and that was a different matter.

The Court decided the dividends did rise to constructive fraud (that is, taking money from a bankrupt company) and had to be repaid. That cost Kardash and Robb about $4 million or so.

And thus the Court pierced the corporate veil.

But consider the extreme facts that it required. Stanton and Hughes drained the company so hard for so long that they bankrupted it. That might work if one left Duke Energy and the cleaning company behind as vendors, but it doesn’t work with Uncle Sam.  You knew the IRS was going to look in every corner for someone it could hold responsible.

Pilgrim's Pride, A Senator And Tax Complexity

The Democratic staff of the Senate Finance Committee published a report last month titled “How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions.”

I set it aside, because it was March, I am a tax CPA and I was, you know, working. I apparently did not have the time liberties of Congressional staffers. You know the type: those who do not have to go in when it snows. When I was younger I wanted one of those jobs. Heck, I still do.

There was a statement from Senator Wyden, the ranking Democrat senator from Oregon:

Those without access to fancy tax planning tools shouldn’t feel like the system is rigged against them. 

Sophisticated taxpayers are able to hire lawyers and accountants to take advantage of … dodges, but hearing about these loopholes make middle-class taxpayers want to pull their hair out.”

There is some interesting stuff in here, albeit it is quite out of my day-to-day practice. The inclusion of derivatives caught my eye, as that of course was the technique by which the presumptive Democratic presidential nominee transmuted $1,000 into $100,000 over the span of ten months once her husband became governor of Arkansas. It must have taken courage for the staffers to have included that one.

Problem is, of course, that tax advisors do not write the law.  

There are complex business transactions taking place all the time, with any number of moving parts. Sometimes those parts raise tax issues, and many times those issues are unresolved. A stable body of tax law allows both the IRS and the courts to fill in the blanks, allowing practitioners to know what the law intended, what certain words mean, whether those words retain their same meaning as one travels throughout the Code and whether the monster comes to life after one stitches together a tax transaction incorporating dozens if not hundreds of Code sections. And that is “IF” the tax Code remains stable, which is of course a joke.

Let’s take an example.

Pilgrim’s Pride is one of the largest chicken producers in the world. In the late 1990s it acquired almost $100 million in preferred stock from Southern States Cooperative. The deal went bad.  Southern gave Pilgrim an out: it would redeem the stock for approximately $20 million.

I would leap at a $20 million, but then again I am not a multinational corporation. There was a tax consideration … and it was gigantic.

You see, if Pilgrim sold then stock, it would have an $80 million capital loss. Realistically, current tax law would never allow it to use up that much loss. What did it do instead? Pilgrim abandoned the stock, meaning that it put it outside on the curb for big trash pick-up day.

Sound insane?

Well, the tax Code considered a redemption to be a “sale or exchange,” meaning that any loss would be capital loss. Abandoning the stock meant that there was no sale or exchange and thus no mandatory capital loss.

Pilgrim took its ordinary loss and the IRS took Pilgrim to Court.

Tax law was on Pilgrim’s side, however. Presaging the present era of law being whatever Oz says for the day, the IRS conscripted an unusual Code section – Section 1234A – to argue its position.

Section 1234A came into existence to address options and futures, more specifically a combination of options and futures called a straddle. . What options and futures have in common is that one is not buying an underlying asset but rather is buying a right to said underlying asset. A straddle involves both a sale and a purchase of that underlying asset, and you can be certain that the tax planners wanted one side to be capital (probably the gain) and the other side to be ordinary (probably the loss). Congress wanted both sides to be capital transactions (hence capital gains and losses) even though the underlying capital asset was never bought or sold – only the right to it was bought or sold.

This is not one of the easiest Code sections to work with, truthfully, but you get an idea of what Congress was after.

Reflect for a moment. Did Pilgrim have (A) a capital asset or (B) a right to a capital asset?

Pilgrim owned stock – the textbook example of a capital asset.

Still, what is stock but the right to participate in the profits and management of a company? The IRS argued that – when Pilgrim gave up its stock – it also gave up its rights to participate in the profits and management of Southern. Its relinquishment of these rights pulled the transaction into the ambit of Section 1234A.

You have to admit, there are some creative minds at the IRS. Still, it feels … wrong, doesn’t it? It is like saying that a sandwich and a right to a sandwich are the same thing. One you can eat and the other you cannot, and we instead are being wound in a string ball of legal verbiage.

The Tax Court agreed with the IRS.  Pilgrim appealed, of course. It had to; this was a $80 million issue. The Appeals Court has now overturned the Tax Court.

The Appeal Court’s reasoning?

A “right” is a claim to something one does not presently have. Pilgrim already owned all the rights it was ever going to have, which means that it could not have had a right as envisioned under Section 1234A.

The tax law changed after Pilgrim went into this transaction, by the way.

Do I blame the attorneys and accountants for arguing the issue? No, of course not. The fact that an Appeals Court agreed with Pilgrim means the tax advisors were right. The fact that the law was later changed means the IRS also had a point.

And none of the parties involved  – Pilgrim and its attorneys and accountants, the IRS , the Tax Court and the Appeals Court wrote the law, did they?

Although the way Congress works nowadays, they may have been the first ones to actually read the bill-become-law. There perhaps is the real disgrace.

The IRS Did Not Like This Bonus

Let’s say that you own 100% of a company. Let’s say your company is quite profitable, and that you take out massive bonuses at year-end. The bonuses serve two purposes: first: why not? You took risk, borrowed money and worked hard. If the thing folded, you would have sunk with it. If it succeeds, why shouldn’t you succeed with it? After all, no politician built it for you. Second, bonuses help reduce taxes the company has to pay. Granted, they increase the taxes the shareholder has to pay, but that is a conversation for another day.

Let’s say the IRS questions the bonus.  They think your bonus is unreasonable.

Let’s discuss the Midwest Eye Center case.

Dr. Afzal Ahmad was the sole shareholder of Midwest Eye Center (Midwest), a multi-location ophthalmology and eye care center in Chicagoland. This is a pretty large practice, with approximately 50 employees, five surgeons, three optometrists and so on. Dr. Ahmad was doing well, receiving a salary of $30,000 every two weeks. At the end of the year he would also draw a sizeable bonus, which coincidently reduced corporate taxable income to zero. In 2007 he took a bonus of $2,000,000.   

Dr. Afzal Ahmad

There were reasons for the bonus. One of his busier surgeons quit unexpectedly in June, 2007. That surgeon was generating approximately $750,000 in revenues, and Dr. Ahmad took over the additional patients. Then there was another doctor who was reducing her workload as she established her own practice. Dr Ahmad starting absorbing some of these patients too.

Busy year for the doctor.

One more fact: Midwest filed taxes as a C corporation, which means it paid its own taxes.

The IRS came in and disallowed $1,000,000 of the bonus. Why $1,000,000 exactly? Who knows, except that (1) it is an impressive amount, and (2) it is close enough for government work.

As Midwest was a professional services corporation, its tax rate was the maximum, so there immediately was additional tax of $340,000.  The IRS also assessed penalties of over $62,000.

This was a nice audit for the IRS: limited issues and big bucks.

So how did the tax advisor defend Midwest?

There is standard text that any tax practitioner (at least, one who follows tax cases) has read a thousand times:

“Deductions are a matter of legislative grace and are allowed only as specifically provided by statute.”

Basically the tax Code says that everything is taxable and nothing is deductible – unless the Code says otherwise.  IRC Section 162 allows us to deduct “reasonable and necessary expenses.” So far, so good. Salaries have to be deductible, right? Hold up. The Code says that a “reasonable allowance for salaries or other compensation” is deductible.

We have to show the “reasonableness” of the salary.

The first way is to show that an “independent investor” would have paid the salary. Midwest decided not to use this line of defense, as no dividends were paid and no profits were left in the company. You have to leave some crumbs on the plate so the investor does not starve. Granted, Warren Buffett does not pay dividends, but he always leaves profit in Berkshire Hathaway.

OBSERVATION: The lack of dividends does not have to be fatal, but it does complicate the argument. For example, if I owned an NFL team, I might be willing to operate it at a loss. The value of my team (if I were to sell it) would likely be increasing more than enough to offset that operating loss.

The next way is by comparison to other businesses. Think professional athletes. If a team is willing to pay the salary, the player must then be worth it. Therefore if someone somewhere with your job duties has a similar salary, there is a prima facie argument that your salary is reasonable. This is more difficult to do with closely-helds than publicly-tradeds, as closely-helds do not tend to publish profitability data.  

A third way involves profit-sharing and other incentive plans, hopefully written down and providing formulas should certain thresholds be met. It is important to establish the plan ahead of time and to be certain there is some rhyme or reason to the calculations. Examples include: 

1.  Documenting the doctor’s activities over the years, putting a value to it and keeping a running tally of how compensation is still due. This can be done to “reimburse” the shareholder for those start-up years when the money was not there to properly compensate the shareholder, for example.
2. Setting up a bonus formula and following it from year-to-year. If there isn’t enough cash to pay out the amount generated by the formula, then the business would accrue it as “compensation payable.” It is not deductible until paid, but it does indicate that there is a compensation plan in place.
3. Having an independent Board of Directors, who in turn decide the amount of compensation. This can be done on an annual basis, preferably earlier rather than later in the year. This technique is not often seen in practice. 
4. Valuing the company on a regular basis (perhaps as frequently as annually). The intent is to attribute the increase in the value of the business to the shareholder’s efforts. The business would then share some of that increase via a bonus.

So what did Midwest do?

They did nothing, that’s what they did.

And I am at a loss. Midwest had a professional tax preparer, but when push came to shove the preparer provided the Court … nothing.

On to the penalty. The IRS will reverse a penalty if the taxpayer can show that he/she relied upon professional advice. The insurance companies go apoplectic, but it is common (enough) practice for a CPA to fall on the sword to get the client out of a penalty. 

But Midwest’s tax preparer was nowhere to be found.

The IRS won on all fronts.

My thoughts?

My corporate clients have overwhelmingly shifted to S corporations over the years. S corporations have their own tax issues, but reasonable compensation is not one of them. It is rare for a tax practitioner to recommend a C corporation nowadays, unless that practitioner works with Fortune 500 companies.

Midwest is an example why. It is a second pocketbook for the IRS to pick.