Saturday, September 17, 2011

Diverting Corporate Earnings - Constructive Dividends or Wages / Salary (9/17/11)

One of the common ways of cheating on taxes is to divert corporate earnings from a C corporation to an entity that is off the IRS's radar screen. The diversions may be of the income which never hits the corporation's books and thus is not reported as income on its tax returns; they may also occur after the income is recorded with the diversion achieved by making payments from the corporation for goods or services which are deducted.  When the transactions thereafter get on the IRS's radar screen, the issue is whether the diversion was an underpayment of tax at the corporate level. 

In a wholly owned corporation, particularly a personal service corporation providing professional services, the corporate income arises from the personal services of the sole shareholder. In such a case, the corporation could easily pay the shareholder wages or salary of the entire net income before payment of compensation. (I refer to this as wages, as did the Court in the case I discuss below.) There would certainly be no unreasonable compensation issue. But, by paying the amount as wages, although fixing the tax issue at the corporate level, the income still is taxed at the shareholder level and the corporation has to withhold, payover and provide a W-2 for an easy IRS match at the shareholder level. By diverting that amount via  either diverting the income or through falsely deductible payments to a shareholder designated entity which does not pay tax, the tax cost at both the corporate and the shareholder levels are avoided (at least until caught). When caught, of course, in order to minimum the tax avoided, the corporation and the shareholder may try to claim that the diversion payments were really wages to the sole shareholder rather than dividends thereby eliminating the corporate level tax. Sometimes, when caught, the shareholder will cause the corporation to amend its returns making that claim.

In United States v. Ellefsen, 655 F.3d 769 (8th Cir. 2011), here, Brian Ellefsen, an orthopedic surgeon, provided services through his wholly owned corporation. The surgeon entered into an illegal trust scheme (the Aegis variety) to divert the income as deductible management fees to offshore entities which he beneficially owned. He and the corporation filed tax returns accordingly -- the payments at the corporate level were deducted at the corporate level, and he omitted the payments from his form 1040.  The surgeon and his brother (his office manager) were indicted for conspiracy, the surgeon for tax perjury (Section 7212), and the brother for aiding and assisting (Section 7206(2)).

In her testimony, the IRS agent characterized the amount diverted as a dividend from the corporation to the surgeon, its sole shareholder, and calculated the corporate tax avoided on that basis. On appeal, the defendants urged that, since his personal services earned the corporate income in question, the payments should be treated as wages, thus eliminating the corporate level tax. The court rejected the argument as follows:
We conclude that the district court did not abuse its discretion in allowing Vandenberg to testify that the funds flowing through the Aegis system constituted constructive dividends. "[W]here controlling shareholders divert corporate income to themselves, such diverted funds should be treated as constructive dividends." Simon v. Comm'r, 248 F.2d 869, 873 (8th Cir. 1957); see Truesdell v. Comm'r, 89 T.C. 1280, 1300 (1987) ("In concluding our discussion of the constructive dividend issue, we would emphasize that in a case such as this diverted amounts taxed to a shareholder as constructive dividends also remain fully taxable to the corporation to which attributable."). [the corporation]. paid [the surgeon] a salary for his personal services, presumably the salary that he, as sole shareholder, demanded. Although the corporation likely could have paid him more for those services and properly deducted that amount as a business expense — with [the surgeon] then paying income tax on his additional compensation — the Ellefsens did not structure Brian's income in that way. They instead decided to utilize the Aegis system and falsely deduct management fees from [the corporation's] corporate tax returns. The income was not taxed at all — despite the fact that [the surgeon] was spending the money — until after the government subpoenaed documents from [the accountant] and [the surgeon] decided to amend his personal tax returns. In these circumstances, we conclude that the so-called management fees were properly considered constructive dividends.

5 comments:

  1. I guess I'm confused.

    So what if the taxpayer argued it was wages rather than a constructive dividend. He didn't report the income, whether wages or constructive dividends. For my money it was wages, not that it mattered, if one recharacterize the fake management fees as wages, the easiest path for the prosecution. I couldn't find the DC opinion, but this seems much ado about nothing, in terms of one of the taxpayer's defense. Which seems, by the way, that the IRS was confused about that very issue (wages v. constructive dividend), that suggested uncertainty in application of the law, and therefore he should get off? Now, what planet was his lawyer orbiting? Or perhaps I am missing something? Easy case: fake deductions which should be recharacterized as payment for services that the taxpayer did not report on his 1040?

    Anyone else take a look at this pretty interesting case, and thank you Jack for bringing it to our attention.

    ReplyDelete
  2. Patrick,

    Your comments are always good. I spotted that issue but did not chase it down. I just assumed that it made a difference somewhere because the court of appeals and the parties focused on it. The larger point I wanted to address was that, when it is important to skinny down the potential tax at the corporate level, one of the first lines of defense that practitioners think about is to assert that the diversions represent additional compensation. Certainly, there is theoretical force to the argument in a personal service, single practitioner business because the income relates to the personal services and his compensation should be wages (or salaries) rather than dividends. But, generally I think, if the corporation has not actually treated the diversion as compensation, it will not be treated as compensation and the default will be dividend.

    Now, having said that, the corporate level treatment will be important if the criminal charge is made for the false corporate return or, even if the charge is only at the shareholder level, the corporate tax diverted will be relevant conduct that can affect sentencing. Presumably ex post facto recharacterization of the diversion will not be permitted for that purpose either.

    Thanks,

    Jack Townsend

    ReplyDelete
  3. Agreed Jack.

    You would expect the prosecution will put up a "pick your poison" strategy: (i) constructive dividends to taxpayer and false tax return for the corporation and taxpayer or (ii) wages to taxpayer and false tax return for corporation since the recharacterization of "management fees" as compensation is a false entry.

    What seems to have happened here is that all the prosecution got locked into position (i), which the defense tried to exploit by the tactic of confusing the jury.

    As a substantive matter though the taxpayer's argument holds no water, though it may have made sense to the defense to try to exploit the error: it had no real defense.

    Thanks for the comment and response. Always interesting here.

    PATRICK CARMODY

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  4. Ahem... This was a Personal Service Corporation with B Ellefsen as the single shareholder/employee which made him the only income producing capital of the corporation. The corp could not have maintained a functioning tax existence minus the efforts of B Ellefsen. Accordingly, Ellefsen personally brought the income of the corporation into existence by his own hand as there was no other income producing capital (other doctors). Thus, any income/profit produced at the corporate level represent the true earnings of the individual. Reclassification of the mgmt fee at the corp level could only be considered as an additional component of Ellefsen's compensation (deductible by the corp) and impossible to be characterized as a dividend. If people could avoid employment taxes on personally earned income (by calling it a dividend) they would do it. However, a proper reading of IRC Sec. 3121 and Sec. 3101 proves otherwise.

    The fact that that was a PSC with a single shareholder/employee and not a regular C corporation makes all the difference in the world. You simply cannot avoid employment taxes on personally derived income 100% produced by your efforts.

    In this case a dividend violates not only the Code but Social Security's entitlement to collect employment taxes as well.

    ReplyDelete
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