Lesson from Tax Court: Don’t Trap Yourself!
Are you considering buying or selling a business? The IRS is often interested in the details of these transactions and by scrutinizing them, may find that sellers aren’t reporting all income. If you’re selling, make sure your books are in order. Telling a potential buyer “you can’t tell how good the business is from my tax return” could be a big mistake, as one owner found out.
The irony is the taxpayer trapped himself by revealing his falsified tax returns and double set of books to the IRS.
Facts of the case: The taxpayer owned a “gentlemen’s club called Potter’s Pub, Inc. It was a cash-based business that derived receipts from food and drink charges run through the cash register, and from door cover charges, juke box and pool table receipts and money paid to the pub by the performers for the privilege of “dancing.” The taxpayer signed the Form 1120 corporate return, which reported losses for 2002 and 2003 and zero taxable income for 2004 and 2005. His personal returns for those years reported no wages, dividends or other income from the corporation for any of the years at issue.
In December 2006, IRS special agents engaged in an undercover investigation of Potter’s Pub, posing as buyers interested in acquiring the business. The taxpayer assured the agents the business was much more profitable than it appeared. He explained that he deposited in the corporate account only enough of the business revenues to cover its expenses and that he wired the balance to his personal bank account in Florida. The wire transfers were structured in amounts of less than $10,000 to avoid reporting obligations by the bank to the IRS.
The taxpayer told the IRS agents the pub grossed more than $1 million annually and he took home between $400,000 and $520,000 each year. He showed the agents ledgers for 2003 and 2004 that supported the gross receipts claimed, acknowledging that it might have been unwise to maintain documentary evidence of his skimming.
In a subsequent search, the agents seized upwards of $200,000 in cash and obtained the clandestine sales ledgers. The ledgers confirmed that Potter’s Pub annual receipts for 2002 to 2005 were vastly in excess of the amounts the taxpayer reported to the IRS. The difference between the actual and the amounts reported on the Forms 1120 for those years exceeded $2 million.
When he realized he was under criminal investigation, Potter prepared amended tax returns. The IRS assessed additional income tax on the basis of the amounts shown on the amended returns for 2003 to 2005 (no amended return was filed for 2002).
In January 2009, the taxpayer was criminally charged with eight counts for making and subscribing false tax returns, and for assisting in the preparation of false returns for himself and Potter’s Pub. He pleaded guilty and was sentenced to 18 months’ prison time and one year supervised release. He was also ordered to pay restitution of $400,000.
In April 2009, he signed a Form 870 waiver of restriction and collection, agreeing that Potter’s Pub was liable for tax deficiencies (in addition to those previously collected) in excess of $340,000 and fraud penalties of $250,000.
As the court explained, “fraud is intentional wrongdoing designed to evade tax believed to be owing.” Its existence “is a question of fact to be resolved upon consideration of the entire record.”
Despite the criminal fraud conviction, the civil fraud penalty wasn’t automatic. The Tax Court noted the IRS must prove fraud by clear and convincing evidence. The court looked to the “badges of fraud,” which include:
- Understating income;
- Maintaining inadequate records;
- Concealing income or assets;
- Providing incomplete or misleading information to one’s tax preparer;
- Filing false documents (including tax returns);
- Engaging in illegal activities;
- Failing to file returns; and
- Dealing in cash.
The court found some of the factors didn’t apply, but noted the taxpayer acknowledged he intentionally underreported income, kept a dual set of books, concealed income by structuring the deposits to keep them under $10,000 (so the bank wouldn’t report them to the IRS), provided his accountant with misleading information and extensively dealt in cash.
The pub owner contended he lacked fraudulent intent because he is “uneducated and unsophisticated” and had to hire professionals to prepare his returns. The court found his education irrelevant, noting the tax laws he violated are “not esoteric.” Indeed, the court noted, he was “sophisticated enough to structure his wire transfers in amounts under $10,000 in the hope of escaping bank reporting to the IRS.”
The taxpayer also claimed he cooperated with the IRS, but the court noted “he began to cooperate only after he knew the jig was up.”
The court held the taxpayer liable for the civil fraud penalties, finding he did not show any of the underpayments were not due to fraud. (John M. Potter, T.C. Memo. 2014-18)
Lessons to Be Learned
The irony in this case is the taxpayer trapped himself by revealing his falsified tax returns and double set of books to the IRS. That may be unusual, but it’s not entirely unique. In another case, a taxpayer bragged to a buyer that the business “did much better than shown on the tax returns.” When the seller and buyer had a falling out, the prospective buyer turned the seller in to the IRS.
If you’re considering buying a business, do you really want to trust someone who would falsify a tax return by that much?
There’s no mention of why the IRS agents started the investigation by posing as buyers. It could have been a tip by a disgruntled employee or customer (in some cases, it’s an ex-spouse). Or, it could have been that the IRS considered it unusual for a “gentlemen’s club” to have several years of losses or no profits. Some businesses are known for cash dealings and profitability.
As the pub owner found out, a taxpayer could be held liable for both criminal and civil fraud. And, it’s not unlikely for a state to follow up an IRS adjustment with its own assessment — often for sales as well as income tax. Being liable for civil fraud is costly. The penalty is equal to 75 percent of the tax deficiency. In the case of fraud, there’s no statute of limitations.
Even honest taxpayers can find themselves accused of fraud. Poor recordkeeping is one indication of fraud. A large deposit from another source that can’t be easily explained, such as from a legitimate cash hoard, is another. And taxpayers who normally deal in cash should be particularly careful to document fund transfers and keep good records. Consult with your tax advisor if you have questions about your situation.