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.
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