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.
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Lesser Included Offense to Rescue a Conviction After Confusion of Liability as Aider and Abetter or Causer

I have recently had several blogs arising from the Larson and Pfaff petition relating to the concepts of aider and abetter liability and causer liability under 18 USC §§ 002(a) and (b), respectively.  (To review those, click on the labels below.) Contemporaneously, in the Tax Fraud and Money Laundering class that Larry Campagna and I teach at the University of Houston Law School, we recently covered the lesser included offense concept.  So, I  present today one case where these concepts came together.  I think it nicely illustrates the lesser included offence concept in a nontraditional setting where it is used to save a conviction after the prosecution blurred the roles of the two types of liability under 18 USC § 2.

In United States v. Motley, 940 F.2d 1079, 1082 (7th Cir. 1991), the defendant, an income tax preparer who prepared false returns, had been charged and convicted under 18 U.S.C. §§ 287 and 2(a). The court held that the defendant was not guilty of aiding and abetting under subsection § 2(a) under which he was tried because the Government failed to prove the taxpayers committed the underlying crime. The Seventh Circuit refused to allow the Government to switch on appeal to subsection § 2(b), causer liability, which does not have the element of requiring that there be one or more other persons guilty of the underlying crime. But, the Seventh Circuit saved the day for the Government by holding the defendant liable for the lesser included offense of § 7206(2) which did not have the element requiring that another person (here the taxpayers) be guilty of the crime. The Court reasoned after giving the taxpayer his accomplice victory:
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Odd Aiding and Assisting Case

In United States v. Davis, ___ F.3d ___ (5th Cir. 2010), Davis was a preparer who assisted taxpayers by preparing false returns. At Davis' recommendation, the taxpayer added near the signature and jurat the phrase "without prejudice." Davis and the taxpayer were indicted -- one count of conspiracy, 4 counts of tax perjury for the taxpayer, and 4 counts of aiding and assisting for Davis. After a bench trial, Davis was convicted on 3 counts of aiding and assisting.

On appeal, Davis argued that the addition of the without prejudice language negated the jurat, thus precluding him from being guilty of the aiding and assisting charge. Davis relied on certian civil tax cases that held that altering the jurat might in some cases negate it sufficiently that the taxpayer has not filed a return.

Section 7206(2) is the aiding and assistance statute, and says:

Any person who--

(2) Aid or assistance

Willfully aids or assists in, or procures, counsels, or advises the preparation or presentation under, or in connection with any matter arising under, the internal revenue laws, of a return, affidavit, claim, or other document, which is fraudulent or is false as to any material matter, whether or not such falsity or fraud is with the knowledge or consent of the person authorized or required to present such return, affidavit, claim, or document;

shall be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 3 years, or both, together with the costs of prosecution.

So, as the court of appeals notes in a footnote at the conclusion of its discussion of Davis' argument, it does not matter whether the purported returns were or were not returns, for § 7206(2) covers other documents which are false as to any material matter. (See footnote 4.) Notwithstanding that Davis' argument was a nonsequitur that could have been (and I submit should have been) disposed of for that reason alone, the Court does address the merits of the argument as to whether the purported returns were returns.

After discussing the authority which, in civil cases, gives the IRS some leeway to speak from both sides of its mouth on the issue of whether a document is or is not a return because of alterations to the jurat, the Court concludes:

In cases such as this, where there is some ambiguity as to language's effect on the jurat, we agree with the Seventh Circuit that the IRS "should be entitled to construe alterations of the jurat against the taxpayer, at least when there is any doubt." Sloan, 53 F.3d at 800. "We refuse to require [the IRS] to engage in guessing games to determine what disclaimers like this one mean. To require such would drastically hinder the [IRS's] ability to process returns effectively and efficiently." Williams v. Comm'r., 114 T.C. 136, 142 (2000). Here, the IRS did not reject Oden's Forms 1040 based on the additional language. We therefore hold that the Forms 1040 were valid, though fraudulent, tax returns.

The problem, of course, in the case at hand was that the Government had determined that it was in the Government's interest to treat the purported returns as returns because it wanted to charge the taxpayer with tax perjury which, of course, requires returns. But, I wonder whether on these facts, a court might also sustain a failure to file, § 7203, charge against the taxpayer. In other words, does the ambiguity give the Government an election as to how to charge?

In this particular case, the Government would not have wanted to charge the taxpayer with failure to file because the really bad guy appears to have been the preparer and thus it needed an aiding and assisting charge to guard against Davis getting off with a full acquittal (assuming it was unable to sustain a conspiracy charge).