Some weeks, the mail brings tax news that suggests a previously undetected link between the dreary world of income taxes and the dreary world of supermarket tabloids. Some examples:
*Naked women and SOBs. The lawyer for a topless dance club ended up owning the dance club through a series of machinations coordinated with his client. The IRS asserted a claim against the lawyer/owner for taxes arising from his acquisition of the bar, which had taken place more than three years before the collection attempt. The normal statute of limitations for taxes is three years, but the time is extended to six years in cases of fraud. Consequently, in order to reach back to the tax years in question, the IRS had to prove that the lawyer had committed fraud in connection with the acquisition.
As a key part of his case, the lawyer argued that the assets acquired were worthless because he was never able to obtain an ASOB permit (the municipality’s acronym for a sexually oriented business permit). The court agreed with the lawyer. For complicated reasons, this meant that while the machinations may or may not have constituted a fraud against the local liquor board, the lawyer had not committed tax fraud. Consequently, the statue of limitations became a bar to the IRS collection action.
Some lessons from this case:
First, avoid excessive entanglements with your clients’ internal business affairs, whether you are a professional adviser, landlord or supplier.
Second, file returns on time and start the limitations clock running. The statute of limitations begins to run when a return is filed for the period in question.
Third, don’t take fraudulent positions on your tax return. No taxpayer who followed the advice of a competent, fully informed tax adviser has ever filed a fraudulent tax return.
*Slush funds. The federal government put a taxpayer on trial for criminal tax evasion. Two things then happened that the government didn’t like: First, the jury acquitted the defendant in the criminal case. Second, a corporation wholly owned by the defendant paid the shareholder’s legal expenses, even though the prosecution arose from actions taken prior to the organization of the corporation. As is predictable in matters of personal pride, the government responded to its loss in the criminal case by attacking the manner in which the defendant financed his defense.
The IRS argued, and the Tax Court agreed, that the payments from the corporation on behalf of its sole shareholder were, in fact, disguised dividends. In other words, the payments were taxed as if the corporation had made a nondeductible dividend payment to its shareholder (which is taxed as ordinary income), and then the shareholder had paid the legal fees in his own name.
First, don’t engage in tax evasion. Aggressive tax planning is OK, provided you are sure your tax adviser is at the top of his or her game. There are too many easy ways to make money honestly.
Second, the government could not have exacted its revenge if the shareholder had organized his business as an S corp., limited liability company or other pass-through entity. Instead, he organized it as a C corp., thus setting himself up for expensive, constructive dividend treatment. Make sure your choice of entity or entities is an informed one.
Third, on the transfer of the sole-proprietorship assets to the corporation, the corporation should have explicitly assumed the sole proprietorship’s liabilities — known and unknown, fixed and contingent. Had his paperwork been in order, the stockholder would have had a much greater chance of defeating the IRS’ claims of constructive dividend.
*Betrayal. If you are married to a tax cheat and you sign and file joint returns, you are potentially liable for unpaid taxes related to the cheating. There is an exception, however, for innocent spouses, meaning spouses who are not aware of the cheating activity.
Although the rules have been relaxed of late, a court recently held that a wife who knew the source of a large sum of money but who honestly didn’t know that it was taxable was not entitled to relief under the innocent spouse rule. The court reasoned that, by virtue of her knowing where the money came from, she couldn’t be deemed an innocent spouse. In other words, she was charged with knowing the complicated tax rules behind a transaction her husband had barely mumbled something to her about.
This is a tough spot for a wife or husband to be in. Imagine hiring an accountant to tell you whether your husband or wife is on the up and up.
*Prophets of doom.
A monastic order proposed selling its distinctive traditional caskets to the general public. Each casket was to include materials explaining the monastery’s values relating to the end of life and funeral rites.
The IRS ruled that while casket sales to adherents of the monastery’s religion furthered the organization’s charitable purpose, sales to the general public did not and were therefore taxable.
The National Enquirer does not have a monopoly on bad taste.
© Maryland Gazette. Reprinted with permission.