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.