Inheriting A Tax Debt

 I am looking at a decision coming from a New Jersey District Court, and it has to do with personal liability for estate taxes.

Clearly this is an unwanted result. How did it happen?

To set up the story, we are looking at two estates.

The first estate was the Estate of Lorraine Kelly. She died on December 30, 2003. The executors, one of whom was her brother, filed an estate tax return in September, 2004. The estate was worth over $1.7 and owed $214 grand in tax. Her brother was the sole beneficiary.

OK.

The estate got audited. The estate was adjusted to $2.6 million and the tax increased to $662 grand.

COMMENT: It does not necessarily mean anything that an estate was adjusted. Sometimes there are things in an estate that are flat-out hard to value or – more likely – can have a range of values. I will give you an example: what is the likeness of Prince (the musician) worth? Reasonable people can disagree on that number all day long.

The estate owed the IRS an additional $448 grand.

The brother negotiated a payment plan. He made payments to the IRS, but he also transferred estate assets to himself and his daughter, using the money to capitalize a business and acquire properties. He continued doing so until no estate assets were left. The estate however still owed the IRS.

OK, this is not fatal. He had to keep making those payments, though. He might want to google “transferee tax liability” before getting too froggy with the IRS.

He instructed his daughter to continue those payments in case something happened to him. There must have been some forewarning, as he in fact passed away.

His estate was worth over a million dollars. It went to his daughter.

The daughter he talked to about continuing the payments to the IRS.

Guess what she did.

Yep, she stopped making payments to the IRS.

She had run out of money. Where did the money go?

Who knows.

COMMENT: Folks, often tax law is not some abstruse, near-impenetrable fog of tax spew and doctrine descending from Mount Olympus. Sometimes it is about stupid stuff – or stupid behavior.

Now there was some technical stuff in this case, as years had passed and the IRS only has so much time to collect. That said, there are taxpayer actions that add to the time the IRS has to collect. That time is referred to as the statute of limitations, and there are two limitations periods, not one:

·      The IRS generally has three years to look at and adjust a tax return.

·      An adjustment is referred to as an assessment, and the IRS then has 10 years from the date of assessment to collect.

You can see that the collection period can get to 13 years in fairly routine situations.

What is an example of taxpayer behavior that can add time to the period?

Let’s say that you receive a tax due notice for an amount sufficient to pay-off the SEC states’ share of the national debt. You request a Collections hearing. The time required for that hearing will extend the time the IRS has to collect. It is fair, as the IRS is not supposed to hound you while you wait for that hearing.

Back to our story.

Mrs. Kelley died and bequeathed to her brother.

Her brother later died and bequeathed to his daughter

Does that tax liability follow all the way to the daughter?

There is a case out there called U.S. v Tyler, and it has to do with fiduciary liability. A fiduciary is a party acting on behalf of another, putting that other person’s interests ahead of their own interests. An executor is a party acting on behalf of a deceased. An executor’s liability therefore is a fiduciary liability. Tyler says that liability will follow the fiduciary like a bad case of athlete’s foot if:

(1)  The fiduciary distributed assets of the estate;

(2)  The distribution resulted in an insolvent estate; and

(3)  The distribution took place AFTER the fiduciary had actual or constructive knowledge of the unpaid taxes.

There is no question that the brother met the Tyler standard, as he was a co-executor for his sister’s estate and negotiated the payment plan with the IRS.

What about his daughter, though?

More specifically, that third test.

Did the daughter know – and can it be proven that she knew?

Here’s how: she filed an inheritance tax return showing the IRS debt as a liability against her father’s estate.

She knew.

She owed.

Our case this time was U.S. v Estate of Kelley, 126 AFTR 2d 2020-6605, 10/22/2020.

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.