houston tax attorney sham entity

If a taxpayer forms a legal entity and it is taxed as a C corporation, can the IRS disregard the legal existence of the corporation and assess the corporation’s tax to the owner? The court addresses this in Russell v. Commissioner, T.C. Memo. 2019-146.

Facts & Procedural History

The taxpayer filed his personal income tax return for 2000 late. The late-filed tax return did not report income earned by his wholly-owned corporation.

The corporation was apparently taxed as a C corporation. Thus, it filed its own tax returns–or should have. The corporation did not file its return.

The corporation’s bank account reflected $328,440 in deposits from a hospital group that it provided services for. It also reflected personal expenses for the taxpayer, such as school tuition.

The taxpayer was charged and convicted of tax evasion and filing a false tax return for 2000 (and several other tax years). He was sentenced to 66 months of imprisonment. This happened in 2010.

In 2015, presumably after the taxpayer was released from prison, the IRS audited the taxpayer‘s individual tax return. The audit concluded with the IRS agent assessing tax based on the $328,440 received by the taxpayer’s corporation. Litigation ensued.

Corporations are Taxed Separately

The court starts with the general rule that “[taxpayers] have the right to shape business transactions to minimize the incidence of taxation, including the right to use corporate entities.” Entities taxed as C corporations are generally treated as separate entities apart from the owners. They report and pay tax on the income they earn separately from the individual income tax returns of the owners.

But this isn’t always the case. The court goes on to note that a “corporate entity is deemed to exist as a separate taxpayer if it is organized to carry on a business activity or if, in fact, it has carried on such activity.”  The court cites the Supreme Court’s Moline Properties v. Commissioner case.

The Sham Entity Exception

Moline is the landmark decision that addresses whether a corporation can be disregarded for tax purposes. Tax planning attorneys often cite the decision for what qualifies as a “business activity” when structuring tax transactions–particularly those involving holding companies.

The court in Moline lists several acceptable justifications that can be cited to show that an entity is valid: “Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator’s personal or undisclosed convenience, so long as that purpose is the equivalent of business activity….”

Moline also sets up the sham transaction exception: “in matters relating to the revenue, the corporate form may be disregarded where it is a sham or unreal. In such situations the form is a bald and mischievous fiction.”

Evidence of a Sham Transaction

This brings us back to the current case. The court concludes that the corporation was a sham entity.

It reached this conclusion by noting that the taxpayer disregarded the separate existence by running his personal expenses through the business checking account. And it failed to pay dividends or keep its own books.

Importantly, the court also noted that the company that paid the corporation had actually entered into an independent contractor directly with the taxpayer, not with the taxpayer’s corporation.

Consequences in this Case

The result in this case is unusually harsh. The taxpayer was ordered to pay the IRS $1.5 million in restitution pursuant to his criminal conviction. The taxpayer apparently served his prison sentence.

Because fraud was involved, the IRS wasn’t precluded from auditing the taxpayer’s personal income tax return nearly fifteen years after it was filed. It isn’t clear from the court case whether the additional tax assessed in the IRS audit was already included in the criminal restitution assessment. Presumably it was not.

Given the lengthy time that passed, the interest and penalties on the underlying tax re-allocated from the corporation to the taxpayer from this IRS audit, the penalties (including the civil fraud penalty of 75% and the failure to pay penalties) and interest on this additional tax is no doubt significant. Maybe the taxpayer can at least get the failure to pay penalties abated.

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